Examine the role of bank credit in financing of working capital. what are the types of bank credit? discuss
Answers
Working Capital
Apart from financing for investing in fixed assets, every business also requires funds on a continual basis for carrying on its operations. These include amounts expenses incurred for purchase of raw material, manufacturing, selling, and administration until such goods are sold and the monies realized. Business transactions are generally carried on credit with a number of days elapsing subsequent to the sale being effected for realization of proceeds1. While part of the raw material maybe purchased by credit, the business would still need to pay its employees, meet manufacturing & selling expenses (wages, power, supplies, transportation and communication) and the balance of its raw material purchases. Working capital refers to the source of financing required to by businesses on a continual basis for meeting these needs.
Thus the need for working capital arises from the prevalence of credit in business transactions, need to fund manufacturing and support and to account for the variations in the supply of raw material and demand for finished goods.
Characteristics of working capital
It is continually required for a going concern
However, the quantum of working capital fluctuates depending on the level of activity
Working Capital is impacted by numerous transactions on a continual basis
The above characteristics render limit based financing from banks ideal for working capital financing. This is because the client is charged interest only on the average outstanding utilized and is saved with the bother of reinvesting short term surpluses arising out of low working capital utilization at a point in time. Further since the transactions of the business are generally routed through a current account with a bank, availing a credit limit from the same bank is really convenient. Thus, working capital requirements are generally financed through limit based financing from banks.
Bank Financing for Working Capital
The financing limits are granted based on assessment of the working capital requirement. The assessment factors include various characteristics such as the nature of industry, industry norms, actual level of activity for the previous year and the projected level of activity for the subsequent year to arrive at the working capital requirement. The bank financing limit is thereafter decided after factoring in margins on the different types of current assets forming part of the working capital.
The Bank Financing Limit is fixed on an annual basis. However, since such limit is provided to meet specific requirements, utilizing the limits is subjected to the Drawing Power, which is decided on a monthly/ quarterly basis.
The effective bank financing is therefore to the extent of the lower of:
Bank Financing Limit: Determined on an annual basis based on an assessment of the current year’s projections and the actuals for the previous year.
Drawing Power: Linked to the quantum of current assets (and current liabilities) owned by the business with appropriate margins. Fixed on a monthly/ quarterly basis depending on the submission of Monthly/Quarterly Information System returns indicating the position of the stock statement, receivables, Work in Progress, payables, etc.
Forms of Bank Finance: Working capital advance is provided by commercial banks in three primary ways: (1) cash credits/overdrafts, (2) loans (3) purchase / discount of bills. In addition to these direct forms, commercial banks help their customers in obtaining credit from other sources through the letter of credit arrangement.
1. Cash Credits/Overdrafts: Under a cash credit or overdraft arrangement, a pre-determined limit for borrowing is specified by the bank. The borrower can draw as often as required provided the out standings do not exceed the cash credit/overdraft limit. The borrower also enjoys the facility for repaying the amount, partially or fully, as and when he desires. Interest is charged only on the running balance, not on the limit sanctioned. A minimum charge may be payable irrespective of the level of borrowing for availing of this facility. This form of advance is highly attractive from the borrower’s point of view because while the borrower has the freedom of drawing the amount in installments as and when required, the interest is payable only on the amount actually outstanding.
2. Loans: These are advances of fixed amounts to the borrower. The borrower is charged with interest on the entire loan amount, irrespective of how much he draws. In this respect, this system differs markedly from the overdraft or cash credit arrangement wherein interests is payable only on the amount actually utilized. Loans are payable either on demand or in periodical installments. When payable on demand, loans are supported by a demand promissory note executed by the borrower. There is often a possibility of renewing the loan.