Question 4 OR (a)

Sources of working capital finance

4 marks

Time to write: About 8 minutes

From an older CBCS paper

Question

Question 4 OR (a) · 4 marks

Discuss the various sources of working capital finance.

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Read from the question

DiscussEach point named and explained, not just listed.

What the paper leaves open

The question is partly within the current syllabus; the answer keeps to the financing-mix and risk-return view of working capital finance.

Write it in this order

Read; underline the asks; jot your points 1 min
1 Financing mix: hedging, conservative and aggressive approaches 1½ marks 2 min
2 Long-term and short-term sources 2 marks 3 min
3 Risk–return trade-off ½ mark 2 min

123

Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks. End with step 3 in a line or two.

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

Matching the source to the need. Working capital has a permanent part, the minimum level of current assets always needed, and a temporary part that rises and falls with the season. Under the hedging (matching) approach, permanent working capital is financed from long-term sources and temporary working capital from short-term funds. A conservative approach finances the whole estimated working capital requirement, permanent and temporary, from long-term sources, keeping short-term funds for emergencies (safer, but costlier); an aggressive approach finances part of the permanent need short-term (cheaper, but riskier).

Long-term sources (for permanent working capital): issue of shares, debentures, retained earnings (ploughing back of profits), and long-term loans from financial institutions.

Short-term sources (for temporary working capital):

Trade credit: credit from suppliers; flexible, growing with the firm, informal and spontaneous, though it may mean higher prices and lost cash discounts.
Accrued expenses: wages, salaries, interest and taxes incurred but not yet paid, a spontaneous short-term source.
Commercial paper: unsecured promissory notes issued at a discount by large, highly rated companies, for 91 to 180 days.
Bank credit: cash credit, overdraft, loans and the discounting of bills.

Risk and return. Short-term funds are usually cheaper but must be renewed frequently, which raises the risk of not being able to meet obligations; long-term funds are costlier but safer. The choice of sources is therefore a trade-off between cost (profitability) and risk (liquidity).

Where the 4 marks sit

#	Component	Marks
1	Financing mix: hedging, conservative and aggressive approaches	1.5
2	Long-term and short-term sources	2
3	Risk–return trade-off	0.5
	Total	4

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