2. LEARNING OBJECTIVES
Explain the benefits and costs of trade credit
Focus on the norms used by banks in financing a
firm’s working capital need
Emphasize the importance of commercial paper as
a method of working capital finance in India
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3. Sources of Finance
Spontaneous Sources
Trade Credit
Accrued Expenses and Deferred Income
Short Term Financing
Bank Borrowings
Factoring of receivables
Commercial Paper
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4. Trade Credit and Credit
Terms
Refers to the credit that the customer gets from
supplier of goods in normal course of business.
An informal arrangement, granted on an open
account basis, not formally acknowledged as a
debt.
Trade credit may also take the form of bills
payable.
Credit Terms refers to the conditions of due
date and cash discount.
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5. Benefits and Costs of Trade
Credit
Benefits
1. Easy Availability.
2. Flexibility.
3. Informality.
Costs
1. Implicit Cost.
2. Stretching A/P can prove to be very costly.
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Suppliers sometimes offer cash discount
to buyers for making prompt payment.
Buyer should calculate the cost of
foregoing cash discount to decide
whether or not cash discount should be
availed. The following formula can be
used:
6. ACCRUED EXPENSES AND
DEFERRED INCOME
Accrued Expenses
Accrued expenses represent a liability that a firm has to
pay for the services which it has already received.
1. Accrued Wages and Salaries.
2. Accrued taxes and Interest.
Deferred Income
Deferred income represents funds received by the firm for
goods and services which it has agreed to supply in future.
1. Advance Payments.
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7. Bank Finance for Working
Capital
Overdraft
Cash Credit
Purchase or Discounting of Bills
Letter of Credit
Working Capital Loan
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9. Regulation of Bank Finance
Dehejia Committee (1968)
Tandon Committee (1974)
Chore Committee (1979)
In the deregulated economic environment in India
recently, banks have considerably relaxed their
criteria of lending. In fact, each bank can develop
its own criteria for the working capital finance.
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10. Dehejia Committee–Existing
Deficiencies
It is the borrower who decides how much he would borrow; the banker
does not decide how much he would lend and is, therefore not in a
position to do credit planning.
The bank credit is treated as first source of finance and not as
supplementary to other source of finance.
The amount of credit extended is based on the amount of security
available, not on the level of operations of borrower.
Security does not by itself ensure safety of bank funds since all bad and
sticky advances are secured advances; safety essentially lies in the
efficient follow-up of the industrial operations of the borrower.
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12. The Tandon Committee-
Recommendations
1. Inventory and receivable norms
2. Lending norms
3. Maximum Permissible Bank Finance (MPBF)
First method
Second method
Third method
4. Style of credit
5. Information system
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13. The Chore Committee-
Recommendations
1. Reduced Dependence on Bank Credit.
2. Credit limit to be separated into “peak level”
and “normal non-peak level” limits.
3. Existing Lending System to Continue.
4. Information System.
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14. COMMERCIAL PAPER
Unsecured promissory notes issued by firms to
raise short-term funds.
In India, it was introduced in 1989 on
recommendation of the “Vaghul Working Group”.
Commercial papers sell at a discount from face
value.
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15. Merits
1. It is an alternative source of raising short-term
finance.
2. It is a cheaper source of finance in comparison to
the bank credit.
3. From an investor’s point of view, it provides an
opportunity to make a safe, short-term investment
of surplus funds.
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16. Demerits
1. It is an impersonal method of financing.
2. A firm facing temporary liquidity problems may not
be able to raise funds by issuing new paper.
3. The amount of loanable funds available in the
commercial paper market is limited to the amount
of excess liquidity of the various purchasers of
commercial paper.
4. It cannot be redeemed until maturity.
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