Session 4: Short Term Sources of Finance Learning Objective - Explain to the learner the various sources of finance available to the enterprise.
Important Terms - Factoring
- Invoice discounting
- Bank overdraft
- Forfeiting
Introduction The ultimate source of capital is, of course, the investor, but there are a number of ways by which a business may endeavour to obtain the finance it requires with the maximum of certainty and the minimum of expense.
When seeking to capitalise a business, it is essential to know the amount of finance required, and the type of undertaking and its relevant circumstances. However, it is equally important that the search for funds should be made when the appeal is likely to have the desired effect. It is necessary, therefore, to consider the various methods of raising capital together with the conditions in which a business finds it expedient to apply them. The Financing Decision Some investors are more flexible than others because they are not locked into a few available sources of funds. Investors would like many financing alternatives in order to minimise their cost of funds at any point in time. Unfortunately, not many firms are in this enviable position through the duration of a business cycle.
At the time the financing decision is made, the investor is never sure if it is the right one. Should the financing be long-term or short term, debt or equity, and so on? At each point a decision is made until a final financing method is reached. In most cases the investor will balance short-term versus long-term considerations against a composition of the firm’s assets and the firm’s willingness to accept risk. The ratio of long-term financing to short-term financing at any point will be greatly influenced by the term structure of interest rates (The term structure of interest rates refers to the way in which the yield on a security varies according to the term of the borrowing, that is the length of the time until the debt will be repaid as shown by the yield curve. Normally, the longer the term of an asset to maturity the higher the rate of interest paid on the asset.) Short Term Financing The repayment term of short term financing is usually shorter than one year. Creditworthiness is an important aspect which the entrepreneur or the venture must satisfy before any short term financing will be granted. The following aspects are considered when assessing creditworthiness. Character:
The reputation of honesty and reliability. Capacity:
The business sense of the borrower, the level of experience and business history. Circumstances:
The general business circumstances in the industry and the economy. Insurance Cover:
The extent of the cover of insurable risks taken out by the borrower. Guarantees:
The lender may require the borrower to use assets to guarantee the loan. Different Aspects of Short Term Finance 1) Trade creditors This the basic source of finance and many entrepreneurs do not realise that by acquiring items on credit they are obtaining short term finance. Credit just like any other source of finance has interest element hidden which most are not able to recognise. The discount may be offered to encourage early payment and the receiving company may not advantage of the discount the cost arise.
Assume that a discount of 5% is offered for payment within 30 days. The cost of capital for credit taken over these 30 days is: 
Therefore it is not a cheap source of finance. On occasions, trade credit is used is used because the buyer is not aware of the real costs involved- if he were, he might turn to other sources of trade finance. However, other forms of capital are not always available, and for a company that has borrowed as much as possible trade credit may be the only choice left. This is an important source of capital for many small companies. A company which provides credit to another is in fact putting itself in the position of a banker whose advance takes the form not of cash but of goods for which payment will be deferred. This use of trade credit between companies is extremely important from both an industrial and a national point of view.
Terms of Trade Credit
Terms of credit vary considerably from industry to industry. Theoretically, four main factors are determined the length of credit allowed. - The economic nature of the product: products with a high sales turnover are sold on short credit terms. If the seller is relying on a low profit margin and a high sales turnover, he cannot afford to offer customers a long time to pay.
- The financial circumstances of the seller: if the seller’s liquidity position is weak he will find it difficult to allow very much credit and will prefer an early cash settlement. If the credit term is used as part of sales promotion then, he may allow more credit days and use other means for improving liquidity position.
- The financial position of the buyer. If the buyer is in weak liquidity position he may take long time to settle the balance. The seller may not be will to trade with such customers, but where competition is stiff there is no choice other than accepting such risk and improve on sales levels.
- Cash discounts: when cash discounts are taken into account, the cost of capital can be surprisingly high. The higher the cash discount being offered the smaller is the period of trade discount likely to be taken.
Trade credit are also used as signalling effect on the performance of the both the buyer and the seller. Where the days allowed to customers are increasing it may indicate that the company is slipping in its debt collection and very soon may encounter cash flow problem. More days to the customers also increase the risk of bad debts which will reduce the profit levels of the company. On the other hand reducing credit days to customers may result in loss of some customers as they will always seek a supplier willing to offer more credit days.
For a company, as a buyer having increased credit days may indicate that the enterprise is facing cash problems and is unable to settle their balance in good time, and this may result in loss of business. Allowing cash discounts to pass is also a cost to the business as outlined above. However, reducing the day’s payment to the supplier may also indicate that the company is not trusted by its suppliers. A company with a poor track record will always face difficulties in negotiating for more days, hence the short payment period. 2) Factoring Factoring involves raising funds on the security of the company’s debts, so that cash is received earlier than if the company waited for the debtors to pay. Most factoring companies offer these three services: - Sales ledger accounting, despatching invoices and making sure bills are paid.
- Credit management, including guarantees against bad debts.
- The provision of finance, advancing clients up to 80% of the value of the debts that they are collecting.
a) Sales ledger administration
The factoring company will takeover the administration of receivable department, maintaining the sales records, credit control and the collection of receivables. It is claimed that the factor will be able to obtain payment from customers more quickly than if the company was to make collection on its own. The cost of this administrative service is a fee based on total value of debts assigned to the factor. The fee rate is based on work which is to be done and the risk level of bad debts. b) Credit management
For a fee the factor can provide up to 100% protection against non payment of approved sales. The factoring company will always assess the credit profile of an enterprise before entering into such an agreement. As outlined above the risk level of the company’s debts will be the main factor in determining the fee charge. c) Provision of finance
This is the main product which most factoring companies offer. Factor companies provide finance which is used to boost the working capital; of the business. The factoring is not as cheap as may be the bank overdrafts and because the bank borrowing is also flexible it is imperative that the company should approach the bank first. However, factoring can be particularly useful when a company has exhausted its overdraft and is not yet in position to raise new equity. 3) Invoice Discounting This is purely a financial arrangement which benefits the liquidity position of the enterprise. Invoice discounting is the transferring of invoice to a finance house in exchange with immediate cash. The company makes an offer to the finance house by sending it the respective invoices and agreeing to guarantee payment of any debts that are purchased. If the finance house accepts the offer, it makes immediate cash payment of about 75%, which means that at a specified future date, say 90 days, the loan must be repaid. The company is responsible for collecting the debt and for returning the amount advanced, whenever the debt is collected. 4) Bank Overdraft
One of the most common used sources of short term of finance because of its cost and flexibility. When borrowed funds are no longer required they can quickly and easily be paid. It is also comparatively cheap because the risks to the lender are less than on the long-term loans, and all the loan interests are allowable tax expenses. The bank issue overdrafts with the right to call them in at short notice. Bank advances are, in fact payable on demand. Normally the bank assures the borrower that he can rely on the overdraft not being recalled for a certain period of time.
The borrower is required to use the overdraft to supplement the working capital shortfall. As the bank overdraft is payable on demand it is not wise to use the money in purchasing non current assets like machine. Financing of such assets should be made using long-term finance such as finance lease and loans. Any plans that involve an overdraft or short term loan should therefore refer closely to the company’s cash flow analysis so that it is quite clear how long the funds will be needed and when they can be repaid.
Another purpose for which bank overdraft might typically be used to iron out seasonal fluctuations in trade. The banks assist in providing temporary funds to finance production on the assumption that the goods or products will be sold in a later season. Agriculture is the obvious example of an industry where this type of borrowing is needed. 5) Counter Trade Counter trade is a method of financing trade, but goods rather than money are used to fund the transaction. It is a form of barter. Goods are exchanged for the other goods. This form of business for private enterprises is diminishing in local trading but for international trade is still a popular way of funding the business activities.
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