Financing of Working Capital: formula sheet

Key formulas

Annualised cost of discounted instrument (CP, bill discounting)

Annualised cost = (Discount ÷ Net proceeds) × (365 ÷ Days)

Net proceeds = Face value − Discount. This is simple annualisation. If the question asks for the effective annual rate, use the compounded form: (1 + Discount ÷ Net proceeds)^(365 ÷ Days) − 1.

Cost of trade credit (cash discount foregone)

Cost = [d ÷ (100 − d)] × [365 ÷ (Credit period − Discount period)]

d is the cash discount percentage. Use 360 if the question says so.

Factoring advance

Advance = Receivables − Factor reserve − Factoring commission; Interest = Advance × Rate × (Period ÷ 365); Net cash received = Advance − Interest

Interest is charged on the advance, not on receivables, and is usually deducted upfront when the advance is paid. Reserve is returned to the firm when the debts are collected.

Matching principle

Permanent working capital ← long-term funds; Temporary working capital ← short-term funds

A conservative policy uses more long-term funds. An aggressive policy uses more short-term funds.

Cost of factoring (net)

Net cost = (Commission + Interest − Savings) ÷ Advance, annualised

Savings include credit department cost saved and bad debts avoided under without recourse.

Advance from factor

Advance = Invoice value × Advance % (or Advance = Invoice value − Reserve/margin)

This is the gross advance, before any deductions. The reserve is the part of the invoice the factor holds back until collection.

Net cash received

Net cash received = Advance − Factoring commission − Interest (if deducted upfront)

Follow the question's order. If commission and interest are paid later, the net cash received at the start equals the advance.

Factoring commission

Commission = Commission % × Value of receivables factored

Apply the rate to total invoices factored, not to the advance, unless told otherwise.

Interest on advance

Interest = Advance × Rate × (Days ÷ 360 or 365, as given)

Use the day count the question states. If none is stated, say which you assume.

Net benefit of factoring

Net benefit = Savings (admin cost, bad debts, interest on funds made available) − Factor's commission and interest

This gives a rupee figure. Accept the proposal if net benefit is positive. Treat it as a separate method from the effective cost rate below, and do not mix the two.

Effective cost of factoring

Effective cost (%) = (Annual commission + Annual interest − Annual admin and bad-debt savings) ÷ Net funds made available × 100

Net funds made available = Advance − commission − interest deducted upfront. Whether interest saved on released funds goes into the numerator depends on the question. In the method shown here it is left out, and the rate is compared with the bank borrowing rate. In the net benefit method it is counted as a saving. Follow the method the question uses and say which one you used. Annual means multiply the period cost by 365 ÷ days or 12 ÷ months. This gives a simple annualised rate, not a compounded one. You can also work per cycle: period cost ÷ net funds of that cycle, then annualise. Accept only if the effective cost is below the bank rate.

Funds released

Average receivables released = Credit sales per day × Collection period reduced

Funds released earn the firm's borrowing rate saving. You need this figure for the interest saved in the net benefit method. It is not part of the effective cost formula above.

Discount on CP

Discount = Face value − Issue price

Issue price is the cash received from investors before issue costs.

Net proceeds

Net proceeds = Issue price − Issue expenses paid upfront

If expenses are paid at maturity or annually, adjust them in the cost, not here.

Effective cost of CP (simple annualised)

Cost = [(Face value − Net proceeds) ÷ Net proceeds] × (365 ÷ Days to maturity) × 100

Use 360 days only if the question says so. Total cost includes discount plus all issue costs.

Effective annual rate (compounded)

EAR = (1 + Cost for the period)^(365 ÷ Days) − 1

Use when the question asks for the effective or compounded cost. Cost for the period = (Face value − Net proceeds) ÷ Net proceeds.

Issue price from a discount rate

Issue price = Face value ÷ [1 + (Rate × Days ÷ 365)]

Use when the question gives the yield or interest rate on CP, not the price.

Cost of foregoing cash discount (simple)

Cost = [D ÷ (100 − D)] × [365 ÷ (N − d)] × 100%

D = discount %, N = credit period in days, d = discount period in days. Use 360 days if the question says so.

Cost of foregoing cash discount (compound/effective)

Effective cost = [1 + D ÷ (100 − D)]^(365 ÷ (N − d)) − 1

Use only when the question asks for the effective or compounded rate.

MPBF Method I (Tandon)

MPBF = 0.75 × (CA − CL), where CL excludes bank borrowing

Working capital gap = CA − CL (excluding bank borrowing). Borrower contributes at least 25% of the gap.

MPBF Method II

MPBF = (0.75 × CA) − CL (CL excluding bank borrowing)

Borrower contributes at least 25% of total current assets. The 75% applies to current assets only, and CL is deducted in full. Gives lower bank finance than Method I when CL > 0.

MPBF Method III

MPBF = 0.75 × (CA − Core current assets) − CL (CL excluding bank borrowing)

Core current assets are the permanent minimum level of current assets, funded wholly by long-term sources. The borrower therefore contributes the whole of core current assets plus 25% of (CA − core current assets).

Working capital gap

Working capital gap = Current assets − Current liabilities (other than bank borrowings)

Starting point for Method I.

Net amount paid on discounting a bill

Proceeds = Bill value − (Bill value × Discount rate × Days ÷ 365)

Effective cost = discount ÷ proceeds, annualised.

Quick revision

• Working capital finance can be spontaneous (trade credit, accruals), short-term borrowing, or long-term funds for the permanent portion.
• Trade credit is the most common spontaneous source and has no explicit interest unless a discount is lost.
• Cost of forgoing a cash discount = [Discount % ÷ (100 − Discount %)] × [365 ÷ (Credit period − Discount period)]; this is the simple annualised form.
• Cash credit lets you borrow up to a sanctioned limit; interest is charged on the amount actually used.
• Overdraft allows withdrawal beyond the balance up to a limit, usually for short periods.
• Factoring is the sale or assignment of receivables to a factor who collects and may fund an advance. It is usually short-term and mostly domestic, though export factoring also exists.
• With recourse, the seller bears the bad debt risk; without recourse, the factor bears it.
• Forfaiting is non-recourse finance for medium-term export receivables, usually backed by a bank guarantee or aval.
• Commercial paper is an unsecured, short-term promissory note issued by creditworthy companies at a discount.
• Effective cost = (Total cost ÷ Net amount received) × (365 ÷ Days financed).
• Always compare options on the same basis, preferably an annualised percentage.
• Say which option is cheaper and recommend it; a number alone does not complete the answer.

Common mistakes

• Calculating CP or discounting cost on face value instead of net proceeds. Fix: Divide the discount by the amount actually received, which is face value less discount.
• Confusing factoring with forfaiting. Fix: Remember forfaiting is for medium-term export receivables, without recourse to the exporter, typically backed by a bank guarantee or aval. Factoring is mostly short-term, domestic or export, with or without recourse.
• Charging interest on the full invoice value instead of the advance Fix: Calculate the advance first, then apply interest only to it. Commission is the one that uses the invoice value.
• Counting bad-debt savings under recourse factoring Fix: Under recourse, the firm still bears the bad debts. Add the saving only for non-recourse, or as the question says.
• Dividing the discount by face value instead of net proceeds. Fix: The company borrows only what it receives. Always divide by net proceeds, which is the issue price less upfront costs.
• Ignoring issue expenses such as rating fee, stamp duty and agent fees. Fix: List every cost separately. Add them to the total cost, and deduct upfront ones from proceeds.
• Using the credit period N as the denominator instead of N − d. Fix: Always subtract the discount period. The financing period is the days you gain by not taking the discount.
• Dividing the discount by 100 instead of by (100 − D). Fix: The amount you actually borrow is the discounted price, which is 100 − D. Divide by that.

Exam tips

• Expect a theory question asking you to list and explain sources, often with a comparison such as factoring versus forfaiting. Use a tabular-style bullet comparison with clear headings.
• Numerical questions usually ask for cost of CP, trade credit or factoring. Always show the formula and the day-count used.
• In recommendation questions, finish with a clear decision and one reason based on cost.
• Link each source to permanent or temporary need whenever the question mentions a financing policy.
• Read whether the question says recourse, non-recourse or maturity before you write anything. It decides who bears bad debts.
• State your day-count assumption (360 or 365) in one line if the question is silent.
• In theory questions, give differences in points: factoring vs bill discounting on notice, services, risk and off-balance-sheet effect.
• For MCQs, link terms: forfaiting equals export, medium-term, without recourse. Factoring equals receivables, services, short-term.