Working capital finance is a vital aspect of business operations that enables companies to fund their ongoing activities and drive through. Businesses require it to secure the necessary funds for their everyday operations to ensure smooth operations, seize new opportunities, and overcome financial challenges.
The article explores different sources of working capital finance, including long-term to short-term operations, and their significance in sustaining business success.
Before exploring different sources of working capital finance, let us first understand what actually working capital financing is and how it ensures the smooth functioning of any business.
What is Working Capital Financing?
Working capital financing provides necessary funds to businesses and supports their everyday operations. This type of financing focuses on ensuring the availability of capital to meet ongoing expenses and manage cash flow rather than being allocated towards long-term investments or asset purchases.
The financing acts as a lifeline for businesses as it enables them to bridge gaps in revenue and expenditures, maintain stability, and pursue growth opportunities. By leveraging working capital financing, businesses can effectively navigate the complexities of managing their operational expenses and ensure the smooth functioning of their operations.
Now let’s see what options you have at your disposal as working capital finance.
Sources of Working Capital
Businesses rely on diverse sources to meet their working capital requirements. The following table shares an overview of these sources:
| Categories | Sources |
| Spontaneous Sources | Trade credit, outstanding expenses |
| Short-term Sources | Short-term loans, overdrafts, invoice discounting |
| Long-term Sources | Long-term loans, equity investments, debentures |
1. Spontaneous Sources
These sources of working capital emerge naturally from everyday business activities. They require minimal effort and cost compared to traditional financing methods. Trade credit and outstanding expenses are key examples of spontaneous sources, with their availability and credit terms varying across industries. Businesses benefit from the ease and convenience of these sources, enabling smoother operations.
2. Short-term Sources
Designed to meet capital needs for a period of less than one year, short-term sources of working capital offer businesses immediate financial support. Banks and NBFCs provide options such as short-term loans, overdrafts, and invoice discounting. These sources prove invaluable in managing short-term cash flow gaps, facilitating timely payments, and ensuring uninterrupted operations.
3. Long-term Sources
When businesses require capital for an extended duration, generally exceeding one year, long-term sources of working capital come into play. Long-term sources often involve long-term loans, equity investments, debentures, and other forms of financial instruments. Long-term sources provide businesses with the necessary financial stability to support growth initiatives, expand operations, and undertake strategic investments.
Must Read: Types of Working Capital Explained [2023]
Spontaneous sources of working capital
Accounts Receivable
A company creates accounts receivable when it sells goods or services on credit. These are short-term obligations from customers to pay for the products or services at a later date.
Accounts Payable
Whereas accounts payable is a company owned by its supplier for goods or services received on credit. While the company owes these funds, it can benefit from using the suppliers’ credit terms to delay payment and retain cash in the business for a longer period.
Accrued Expenses
Accrued expenses are costs that a company has incurred but are yet to be paid. The inclusions of accrued expenses are salaries, taxes, utilities, and other operational expenses. Having accrued these expenses, a company can defer the immediate cash outflow by effectively providing additional working capital.
Inventory
It refers to the goods or raw materials that a company holds for sale or production. A company can optimize its working capital by managing inventory levels effectively. Businesses can also free up cash for other operational needs by reducing excess inventory or improving inventory turnover.
Prepaid Expenses
The advance payments for goods or services that will be received in the future represents prepaid expenses. The prepaid expenses like insurance premiums or rent provide a source of working capital as the company is already done with the payment for the services but is yet to consume them.
Short-Term Sources of Working Capital
To meet their ad-hoc financial needs, businesses rely on a range of short-term sources of working capital. These sources can be classified into various categories, including internal sources and external sources, each playing a vital role in sustaining day-to-day operations and facilitating growth. Let’s explore these sources in detail:
Internal Sources
Internal sources of working capital originate from within the company itself. They encompass provisions for tax and dividends, representing current liabilities that cannot be postponed indefinitely. While these internal sources are relatively small in value, they are essential for fulfilling crucial financial obligations.
External Sources
External sources of working capital, on the other hand, involve capital obtained from external agencies such as banks, non-banking financial companies (NBFCs), and other financial entities. These sources offer businesses the necessary financial flexibility to address their short-term needs. Some prominent short-term external sources of working capital include:
Loans from Commercial Banks
Businesses, especially MSMEs, can secure loans from commercial banks either with or without collateral security. These loans can be obtained at concessional rates, making them a cost-effective financing option.
Public Deposits
Companies have the option to raise funds for short-term requirements through public deposits. By inviting employees, shareholders, and the general public to deposit their savings, businesses can attract capital. Public deposits offer simplicity and cost-effectiveness, though they may not be readily available during periods of financial stringency.
Trade Credit
Businesses often source raw materials and goods on credit from suppliers. The amount payable to these suppliers serves as a form of working capital. Trade credit provides short-term financing by allowing businesses a credit period ranging from 3 to 6 months. However, the utilisation of trade credit may result in the loss of cash discounts that could have been earned by prompt payment.
Bill Discounting
Instead of waiting for long credit periods, businesses can choose to discount their outstanding invoices with banks or NBFCs. This source of working capital allows businesses to receive a percentage of the invoice amount upfront while the financial institution collects the payment from customers upon maturity. Bill discounting expedites cash flow, enabling businesses to meet short-term capital needs.
Bank Overdraft
Many banks offer businesses the flexibility of overdraft facilities, allowing them to withdraw a certain amount beyond their current account balance. This form of short-term financing charges interest on the overdrawn amount and can be secured against collateral or granted based on the customer’s creditworthiness.
Advances from Customers: Businesses can raise funds for short-term requirements by requesting advance payments from customers. These advances, received before delivering goods or providing services, serve as a cost-effective and convenient source of working capital.
Long-Term Sources of Working Capital Financing
To meet their financial requirements spanning beyond one year, businesses often turn to long-term sources of working capital. These sources provide stability and facilitate strategic investments. Let’s explore the different long-term sources of working capital and their significance:
Share Capital
Companies can raise funds by offering shares to prospective shareholders. Share capital represents an external source of working capital finance, allowing businesses to generate funds for their operational needs.
Dividends paid to shareholders and associated flotation costs are considered the cost of sourcing, but the company has discretion in determining the dividend amount. Share capital is a relatively inexpensive source of working capital, although companies may not rely on it exclusively for their working capital needs.
Long-Term Loans
Also known as working capital loans, long-term loans provide businesses with the necessary capital to meet short-term operational needs. With repayment tenures of a maximum of 84 months (7 years) or more, these loans offer a cost-effective option for securing working capital. It is suggested to utilize long-term sources for permanent working capital requirements besides relying on short-term sources for temporary needs.
Debentures
This is a good option for companies to generate funds. They can issue debentures to the public, financial institutions or other companies. They represent long-term debt options and are different from shares in a company. Debentures are a reliable source for long-term working capital finance, offering businesses the required financial stability and supporting their operations and growth initiatives.
Retained Profits
Retaining a portion of one’s earnings is a source of working capital, different from distributing profits as dividends or investing in new ventures. Companies can become self-sufficient and reduce their reliance on external sources of financing by utilizing retained profits. They serve as an internal source of working capital, allowing businesses to leverage their accumulated earnings for functional operational needs.
Equities
In many cases, businesses can opt to issue equities that indirectly involve investors in the process by putting money into the company’s stocks through mutual funds. This source of working capital allows businesses to add additional financial resources for their long-term requirements.
Conclusion
Understanding and utilizing the diverse sources of working capital finance are crucial for businesses. Spontaneous, short-term, and long-term sources provide the necessary funds to support day-to-day operations and facilitate growth.
By effectively managing working capital and choosing the right sources, businesses can enhance financial flexibility and position themselves for long-term success. It is essential to balance short-term and long-term sources based on specific needs and industry dynamics.
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FAQs
1. Why are sources of working capital important?
Working capital is the everyday requirement of businesses to maintain a consistent stream of cash to pay daily bills, cover unforeseen expenses, and buy raw materials for manufacturing goods.
2. Is depreciation a source of working capital?
Depreciation is not, under any circ*mstances, a source of funds (working capital) or cash.
3. What are sources of capital?
- Equity capital
- Loan capital
- Retained earnings
4. What is working capital meaning?
Working capital is the funding you have on hand to take care of your immediate, short-term requirements. You need to estimate your present levels, forecast your future requirements, and strategies to ensure that you always have adequate cash on hand if you want to make sure that your working capital serves your demands.
