Modes of Long-Term Working Capital Financing

Working capital refers to that part of the total capital employed which has been invested for the financing of current assets e.g. inventories, debtors, cash and bank balances, bills receivable, prepaid expenses etc. That is, total of all current assets is working capital.

Firms need both a long-term (or permanent) investment in working capital and a short-term or cyclical one. The permanent working capital investment provides an ongoing positive net working capital position, that is, a level of current assets that exceeds current liabilities. This allows the firm to operate with a comfortable financial margin since short-term assets exceed short-term obligations and minimizes the risk of being unable to pay its
employees, vendors, lenders, or the government (for taxes). To have positive net working capital, a company must finance part of its working capital on a long-term basis. Beyond this permanent working capital investment, firms need seasonal or cyclical working capital. Few firms have steady sales and production throughout the year. Since the demand for goods and services varies over the course of a year, firms need to finance both inventories and other costs to prepare for their peak sales period and accounts receivable until cash is collected. Cyclical working capital is best financed by short-term sources of finance since the seasonal buildup of assets to address seasonal demand will be reduced and converted to cash to repay borrowed funds within a short predictable period. By matching the term of liabilities to the term of the underlying assets, short-term working capital financing helps a firm manage inflation and other financial risks. Short-term financing is also preferable since it is usually easier to obtain and priced lower than long-term debt.

Modes of Long-Term Working Capital Financing

Permanent working capital refers to the minimum amount of investment, which should always be there in the fixed or minimum current assets like inventory, accounts receivable, or cash balance etc., in order to carry out business smoothly. This investment is of a regular or permanent type and as the size of the firm expands, the requirement of permanent working capital also increases.

Permanent working capital should be financed in such a manner that the enterprise may have its uninterrupted use for a sufficiently long period. There are five important sources of permanent or long-term working capital.

  1. Shares. Issue of shares is the most important-source for raising the permanent or long-term capital. A company can issue various types of shares as equity shares, preference shares and deferred shares. Preference shares carry preferential rights in respect of dividend at a fixed rate and in regard to the repayment of capital at the time of winding up the company. Equity shares do not have any fixed commitment charge and the dividend on these shares is to be paid subject to the availability of sufficient profits. As far as possible, a company should raise the maximum amount of permanent capital by the issue of shares.
  2. Debentures. A debenture is an instrument issued by the company acknowledging its debt to its holder. A debenture has been defined as “acknowledgement of debt, given under the seal of the company and containing a contract for the repayment of the principal sum at a specified date and for the payment of interest at fixed rate per cent until the principal sum is repaid and it may or may not give the charge on the assets to the company as security of the loan.” It is also an important method of raising long-term or permanent working capital. The debenture-holders are the creditors of the company. A fixed rate of interest is paid on debentures. The interest on debentures is a charge against profit and loss account. The debentures are generally given floating charge on the assets of the company. When the debentures are secured they are paid on priority to other creditors. The debentures may be of various kinds such as simple, naked or unsecured debentures, secured or mortgaged debentures, and redeemable debentures. Irredeemable debentures, convertible debentures and non-convertible debentures. The debentures as a source of finance have a number of advantages both to the investors and the company. Since interest on debentures has to be paid on certain predetermined intervals at a fixed rate and also debentures get priority on repayment at the time of liquidation, they are very well suited to cautious investors. The firm issuing debentures also enjoys a number of benefits such as trading on equity, retention of control, tax benefits, etc.
  3. Public Deposits. Public deposits are the fixed deposits accepted by a business enterprise directly from the public. This source of raising short term and medium-term finance was very popular in the absence of banking facilities. Public deposits as a source of finance have a large number of advantages such as very simple and convenient source of finance, taxation benefits, trading on equity, no need of securities and an inexpensive source of finance. But it is not free from certain dangers such as; it is uncertain, unreliable, unsound and inelastic source of finance.
  4. Ploughing Back of Profits. Ploughing back of profits means the reinvestment’s by concern of its surplus earnings in its business. It is an internal source of finance and is mot suitable for an established firm for its expansion, modernization and replacement etc. This method of finance has a number of advantages as it is the cheapest and cost-free source of finance; there is no need to keep securities; there is no dilution of control is; it ensures stable dividend policy and gains confidence of the public. But excessive resort to ploughing back of profits may lead to monopolies, misuse of funds, over capitalization and speculation, etc.
  5. Term Loans from Financial institutions. Financial institutions such as Commercial Banks and Development Banks also provide short-term, medium-term and long-term loans. A term loan is a form of medium-term debt in which principal is repaid over several years, typically in 3 to 7 years. Since lenders prefer not to bear interest rate risk, term loans usually have a floating interest rate set between the prime rate and prime plus 300 basis points, depending on the borrower’s credit risk. Sometimes, a bank will agree to an interest rate cap or fixed rate loan, but it usually charges a fee or higher interest rate for these features. Term loans have a fixed repayment schedule that can take several forms. Level principal payments over the loan term are most common. In this case, the company pays the same principal amount each month plus interest on the outstanding loan balance. A second option is a level loan payment in which the total payment amount is the same every month but the share allocated to interest and principle varies with each payment. Finally, some term loans are partially amortizing and have a balloon payment at maturity. Term loans can be either unsecured or secured; a business with a strong balance sheet and a good profit and cash flow history might obtain an unsecured term loan, but many small firms will be required to pledge assets. Moreover, since loan repayment extends over several years, lenders include financial covenants in their loan agreements to guard against deterioration in the firm’s financial position over the loan term. Typical financial covenants include minimum net worth, minimum net working capital (or current ratio), and maximum debt-to-equity ratios. The major advantage of term loans is their ability to fund long-term working capital needs.

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