3.9 Short-term sources of working capital finance
3.9.5 Bank credit
Bank credit form the largest part of short term financial debt and has been an important working capital financing instrument all over the world, particularly in India (Majumdar, 1996).
Narasimhan and Vijayalakshmi (1999) note that excessive dependence on the banking system to provide working capital financing exerts some pressure on banks. For example, in the 1970s the Indian corporate sector excessively used bank credit to finance working capital to the extent
“that the desired correlation between bank credit and the holding of inventory and book debt was hampered in most cases. The Reserve Bank of India instituted several study groups (Dehejia Study Group, Tandon Study Group, Chore Study Group, Marathe
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Committee, Chakraborty Committee) among others to correct the use of bank credit by the corporate sector”.
Majumdar (1996) p.104 All these study groups recommended ‘restraining’ the use of bank credit in financing working capital.
3.9.5.1 Changes in short-term debt
The firm’s short-term financial debt level changes due to either the size effect or the substitution effect (Fosberg, 2012). The size effect is premised on the matching principle that states that current assets should equal current liabilities. Growth in current assets can be financed by spontaneous sources; trade credit and accruals. However, these spontaneous sources may be insufficient to cover all the growth in current assets; hence the need for additional short-term funds to support current assets growth. When current assets equal current liabilities, the firm has a Rand/Dollar in current assets to pay off every Rand/Dollar in current liabilities. However, as a risk management technique, firms tend to maintain a current ratio higher than one, requiring more funding, and this portion is met using long-term funds.
The substitution effect implies that spontaneously-generated resources and short-term debt financing have an inverse relationship. Holding current assets constant, an increase in spontaneously-generated resources reduces the need for short-term financial debt financing and vice-versa. Theoretically speaking, short-term financial debt is an alternative to trade credit because they perform the same function of financing short-term assets. However, in practice short-term financial debt complements trade credit. Financial planning models such as the Percentage of Sales (PoS) (for details see p.86 of Firer et al. (2012)) assume that the growth in current assets is partly financed by spontaneously-generated resources and the shortfall comes from equity, short-term and long-term debt, in accordance with the firm’s financing choices and constraints.
Financing the working capital requirements of firms is one of the key functions of financial institutions, in particular commercial banks; as a result, working capital advances constitute a
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major part of banks’ loan portfolios. In financing a firm’s working capital requirements, banks examine factors such as sales and production plans and a desirable current assets level and then a set a credit limit, which is the maximum amount which a firm can access for working capital purposes from the bank. Banks normally approve different limits for ‘peak season’ and
‘off-peak season’ for firms with seasonal fluctuations. Working capital advances are normally provided in the following forms; cash credit, overdraft, letter of credit, loans, bills financing and working capital demand loans against the security of the borrowing firm’s liquid assets.
3.9.5.2 Cash Credit
This is a loan facility which is similar to a line of credit, except that under the cash credit facility, the borrowing firm establishes a cash account which it can draw on up to the predetermined limit. The cash account enables the borrowing firm to utilise the facility to meet periodic needs;
this helps the firm to minimise interest obligations because it is payable on the amount utilised rather than on a predetermined limit. Repayment can be made any time during the tenure of the facility, which is usually a year.
3.9.5.3 Overdraft
This is a formal arrangement where the bank allows the firm to make withdrawals exceeding its credit balance from its current account up to a specific, agreed limit (Nwankwo and Osho, 2010). Interest on this facility depends on the borrower’s risk profile and security and is payable on the amount actually utilised at any given point in time. According to Firer et al. (2012), South Africa’s strongest public firms are able to secure overdraft interest rates at the prime lending rate. Although the overdraft facility can be recalled on demand by the lending institution, it is classifiable as a permanent source of funds because companies use it on a continuous basis and it is a permanent feature on the balance sheet.
3.9.5.4 Line of credit
This financing instrument can be defined as an open-ended facility where a firm is given a borrowing limit to draw against and is allowed to repay at any time during the term of the loan.
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This facility offers the firm the benefit of borrowing the exact amount required to meet needs that arise which makes it ideal to address the fluctuating working capital needs of the firm.
Such loans normally run for a period of a year and are renewable subject to the annual assessment and commendation of the lender. The two main advantages of a line of credit are that it offers the flexibility of borrowing as the need arises which enables the firm to minimise both the principal borrowed and the interest obligations. In addition, the firm pays interest on the amount borrowed only. The main disadvantages of a line of credit are that the annual renewal subject to the lender’s approval may introduce uncertainty with regard to availability of funds and make it unsuitable to finance permanent working capital needs. In addition, there are potentially higher borrowing costs in the form of a high compensating balance that the lenders might demand.
3.9.5.5 Commercial Paper
This financing instrument is a short-term debt instrument issued directly to investors by large, creditworthy corporate borrowers in the money market. Its main advantage is that it gives highly rated corporate borrowers greater access to cheaper funds than they could obtain from banks while still providing institutional investors with higher interest earnings than they could obtain from the banking system. Money raised by such instruments can effectively be used to fund short-term requirements.
3.9.5.6 Banker’s Acceptance
A banker’s acceptance is a short-term debt instrument issued by a firm which is accepted and guaranteed by a bank to pay a certain sum of money. These agreements typically arise when a seller sends a bill or draft to a customer. The customer’s bank accepts this bill and notes the acceptance on it, which makes it an obligation of the bank. In this way, a firm that is buying goods from a supplier can effectively arrange for the bank to pay the outstanding bill.
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