FINANCING OF CURRENT ASSETS 

Important aspect of working capital management is to decide the pattern of financing the current assets and one of the major problem in working capital management is the decision whether to finance the working capital with one source or the other, the firm has to decide about the sources of funds which can be availed to make investment in current assets.  Breaking down working capital needs into permanent and temporary components over time provides a useful by-product in terms of financing choice.  The permanent component is predictable insofar as it is linked up to expected change in sales or cost of goods sales over time.  The temporary component is also predictable in general as it follows the same pattern every year.  So, the two components of working capital need to be financed accordingly for which the different sources of funds can be grouped as follows:

i)    Long Term Sources which provide funds for a relatively longer period.  Under the category the main sources are the share capital, retained earnings, debentures and long term borrowings.
ii)     Short Term Sources which usually provide funds for a short period say up to one year or so.  In this category, the main sources are bank credit, public deposit, commercial papers, factoring etc.
iii)    Transactionary Sources which provide fund to a business through the normal business operations e.g., credit allowed by suppliers and outstanding labor and other expenses.  To the extent the firm delays or postpones the payments, the funds are available to it and that too generally at no cost.  These are also called spontaneous sources of finance.

For example, as the firm acquires its inventories, the trade credit is often made available spontaneously or on demand, by the supplier.  The trade credit varies directly with the firm’s purchases of inventory items.  In turn, the inventory purchases are related to the anticipated sales.  Thus, a part of the financing needed by the firm is spontaneously provided in the form of trade credit.  In addition, wages and salaries payable, accrued expenses, accrued interest and taxes also provide valuable sources of spontaneous financing.

It has been noted earlier that the net working capital is the excess of total current assets over total current liabilities.  Thus, a part of total current assets is funded by current liabilities and only the remaining portion of current assets, known as net working capital, is to be arranged for.  Therefore, the financial manager has to arrange funds for making investment in net working capital only.  Different long term and short term sources of funds are available to a firm and all these sources are different from one another with respect to their nature and characteristics.  The working capital requirements of a firm can be financed by all or any combination of these sources.

It may be noted that both the permanent and temporary components are predictable yet they differ on at least one dimension i.e., the permanent component of working capital is similar to an investment in fixed assets because it has to be replenished over time and thus requires financing for the long term.  Consequently, it can be argued that this component should be financed with long term sources – either debt or equity or a combination of the two, depending upon the financing mix the firm chooses to use for financing long term assets.  A part of permanent working capital may be financed by current liability also depending upon the trade-off between risk of having current liabilities and the cost associated with long term financing.  The temporary component of working capital should be financed with pre-arranged lines of short term credit and the current liabilities.    

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