Financial and Strategic Management

What do you understand by the financing of Working Capital?

Sources of financing of working capital differ as per the classification of working capital into permanent working capital and variable working capital.

1. Sources of permanent working capital are the following

  1. The owner’s funds are the main source. The sale of equity stock or preferred stock could provide permanent working capital to the business with no burden of repayment, particularly during a short period. These funds can be retained in the business permanently. Permanent working capital provides more strength to the business.
  2. Another source of permanent working capital is bond financing but it has a fixed maturity period and ultimately repayment has to be made. For repayment of this source, the company provides sinking funds for the retirement of bonds issued for permanent working capital.
  3. Term loan from banks or financial institutions has the same characteristics as the bond financing of permanent working capital.
  4. Short-term borrowing is also a source of working capital finance on a permanent basis.

2. Source of variable working capital

Working capital required for a limited period of time may be secured from temporary sources as discussed below:

  1. Trade Creditors: Trade credit provide a quite effective source of financing variable working capital for the period falling between the point goods are purchased and the point when payment is made. The longer this period, the more advantageous it becomes for the firm to avoid efforts of seeking finance for holding inventories or receivables.
  2. Bank loan: Bank loan is used for variable or temporary working capital. Such loans run from 30 days to several months with renewals being very common. These loans are granted by the bank on the goodwill and the creditworthiness of the borrower and collateral may include goods, accounts/notes receivable, or Government obligations or other marketable securities, commodities, and types of equipment.
  3. Commercial Paper: It can be defined as a short-term money market instrument, issued in the form of promissory notes for a fixed maturity. It will be totally unsecured and will have a maturity period ranging from 90 days to 180 days. It will meet the short-term financial requirements of the companies and will be a good short-term investment for parking temporary surpluses by corporate bodies.
  4. Depreciation as a source of working capital: Increase in working capital results from the difference in the amount of depreciation allowance deducted from earnings and new investment made in fixed assets. Usually, the entire amount deducted towards depreciation on fixed assets is not invested in the acquisition of fixed assets and is saved and utilized in business as working capital. This is also a temporary source of working capital so long as the acquisition of the fixed assets is deferred.
  5. Tax liabilities: Deferred payment of taxes is also a source of working capital. Taxes are not paid on a day-to-day basis rather they are paid periodically, but estimated liability for taxes is indicated in the Balance Sheet. The entity collects taxes by way of income tax payable on salaries of staff deducted at source, old-age retirement benefits, excise taxes, sales taxes, etc. and they are retained by them for some period in business until they are actually paid and hence used as working capital.
  6. Other miscellaneous sources are Dealer Deposits, Customer advances, etc.

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Shreya Kushwaha

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