Sources of Working Capital

Once a firm knows how much working capital it needs, it must decide where to raise it from. The guiding principle is a matching one: permanent working capital should be financed from long-term sources, and temporary working capital from short-term sources. Financing a permanent need with a short-term loan that must soon be repaid creates a recurring refinancing risk; locking long-term funds into a purely seasonal need wastes those funds in the off-season.

Long-term sources (for permanent working capital):

• Shares — funds raised by issuing equity or preference shares, which form part of the firm's own permanent capital.
• Debentures and long-term loans — borrowed funds repayable after several years, suitable for financing the stable, permanent part of working capital.
• Retained earnings (ploughing back of profits) — profits kept in the business instead of being distributed, a cheap and readily available internal source.

Short-term sources (for temporary working capital):

• Trade credit — the credit period allowed by suppliers, effectively an interest-free short-term source of funds for the buyer.
• Bank overdraft and cash credit — arrangements allowing a firm to draw more than its balance up to an agreed limit, ideal for meeting short-term fluctuations.
• Short-term bank loans — loans taken for a period of up to a year to meet seasonal or temporary needs.
• Bills payable (bills of exchange) — accepting a bill in favour of a supplier defers payment for a fixed short period.
• Outstanding expenses and advances from customers — expenses not yet paid (wages, rent) and advances received against orders both provide short-term funds temporarily.
• Public deposits — deposits accepted from the public for short to medium terms, a source used by many established firms. …