Short Term financing is very important for any organization. It includes the borrowing and lending of funds for a shorter period of time usually one year or less that. Short term finance is secured for financing the current assets, for example, inventories.
Short term finance is also known as working capital which is the excess of current assets over current liabilities. Current liabilities become due within one year and indicate the amount of short-term credit being utilized by the business. Short term financing is essential for maintaining liquidity of a company.
Table of Content
Short-term finance serves following purposes:
- It facilitates the smooth running of business operations by meeting day to day financial requirements.
- It enables firms to hold inventory of raw materials and finished product.
- With the availability of short-term finance, business can afford to sell its goods on credit. Sales are for a certain period and collection of money from debtors takes time. During this time gap, production continues and money will be needed to finance various operations of the business. Short term sources of finance helps in meeting this requirement.
- Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice.
- Short-term funds are also required to allow flow of cash during the operating cycle. Operating cycle refers to the time gap between commencement of production and realization of sales.
Advantages of Short Term Financing
- Easier to Obtain: Short term credit can be more easily obtained than long term credit. A firm with poor credit standing may be unable to obtain long term funds but it can procure, at least some trade credit from sellers who are anxious to increase their sales.
The short-term creditors, by granting loans, assume less risk than long term creditors because there is less chance of substantial change in the financial soundness of the creditor within a few week’s or month’s time.
- Lower cost: Short term credit may be obtained with lower cost than the long term finance because of priority of creditors in general. Because of the priority given to creditors in the matter of claim to income and to assets at the time of dissolution, creditors generally became ready to accept a relatively low interest.
- Flexibility: Due to seasonal nature of business many firms have a temporary demand for short term funds to carry more inventories in order to meet the growing demand of products or services. Short-term financing is flexible in the sense that the firm is able to secure funds as they are needed and repay then as soon as the need finishes.
Funds may be needed to meet the daily, weekly or monthly requirements. Such funds can be advantageously supplied by short term credit.
In case long term credit is secured to finance the daily or weekly or seasonal variations, it would become inflexible because long term funds cannot be repaid as soon as the need for funds vanishes.
- No dilution of ownership: Obtaining funds form short term creditors prevents the inclusion of more owners through the procurement of owner’s funds (for example equity shares). This results in maintaining the position of control by the existing owners. Suppliers of short term credit have no voice in the operations of the business; therefore there is no danger of dilution of ownership.
- Availability: In many cases, particularly for small enterprises short term credit is the only source available. It may not be possible for a small firm to obtain long term funds because of poor credit standing. Long-term credit is not generally granted without adequate margin of protection which the small firms may not be able to provide with. The small business has then recourse to short term funds.
- Tax Savings: The cost of short term funds are deductible for income tax purposes while the dividend paid to the owners is not deductible. Thus a substantial tax-savings may result from the use of short-term funds.
- Convenience: Short Term credit can be more conveniently secured than the other types of funds. It is more convenient to pay labour weekly or employees monthly than every day
Sources of Short Term Financing
It is one of the important and commonly used methods of financing short term business requirements. Trade credit refers to credit that a customer gets from suppliers of goods in normal course of business. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered immediately but payments are not made until the expiry of period of credit.
This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is cost free source of financing.
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 a 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.
An unsecured, short-term debt instrument issued by a creditworthy corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities.
Maturities on commercial paper vary from 3 to 6 months. Commercial paper is usually issued in large denominations (minimum amount is INR0.5 million). Commercial paper is issued at a discount, reflecting prevailing market interest rates.
Commercial paper is not backed by any form of collateral, so only firms with high-quality debt ratings will easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.
In India, commercial paper was introduced in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors.
Subsequently, primary dealers and all-India financial institutions were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations.
In India, a corporate would be eligible to issue CP provided:
- The tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore.
- Company has been sanctioned working capital limit by bank/s or all- India financial institution/s; and
- The borrower account of the company is classified as a Standard Asset by the financing banks institutions.
Inter Corporate Deposits (ICD)
An ICD is an unsecured loan given by one corporate to another. This market allows corporate with surplus funds to lend to other corporate. Also in India, the better-rated corporate can borrow from the banking system and lend in this market. As the cost of funds for a corporate is much higher than that for a bank, the rates in this market are higher than those in the other markets.
Also, as ICDs are unsecured, the risk inherent is high and the risk premium is also built into the rates. The tenor of ICD may range from 1 day to 1 year, but the most common tenor of borrowing is for 90 days. In India, RBI permits Primary Dealers to accept Inter- Corporate Deposits up to fifty percent of their Net Worth and that also for a period of not less than 7 days. Primary Dealers cannot lend in the ICD market.
Letter of Credit (L/C)
This is a document that a financial institution(Bank) or similar party issues to a seller of goods or services which provides that the issuer will pay the seller for goods or services the seller delivers to a thirdparty buyer. Letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit being provided by the supplier himself.
A letter of credit is issued by a bank on behalf of its customer to the seller. As per this document, the bank agrees to honour drafts drawn on it for the supplies made to the customer if the seller fulfils the condition laid down in the letter of credit.
With rising competition many businesses are finding themselves in shortage of cash due to the demanding terms of their customers. However, there is an alternative financial solution called factoring that allows your business to be more competitive while improving your cash flow, credit rating, and supplier discounts.
Factoring is a financial transaction in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. Under factoring agreement, the business owner sells his receivables in the form of invoice to the factor, which makes an advance of 70-85% of the purchase price of the receivable amount.
A factor is a financial institution which offers services relating to management and financing of debts arising from credit sales. Factoring provides resources to finance receivables as well as facilitates the collection of receivables.
Factoring can improve the profit and offer a company a whole range of benefits, such as:
- Improved cash flow by releasing up to 85% of funds against the value of outstanding invoices
- It gives you access to an ongoing supply of cash that grows as your sales grow.
- In the case of factoring, you work with a dedicated team of professionals who will prepare and send out statements, telephone all of your customers, collect payments for you and maintain professional and detailed accounts of your transactions
- By making use of a factoring facility firm can benefit from improved profitability as it can pay suppliers earlier, buy in larger quantities and take advantage of any volume discounts available
- It is possible to protect your company from bad debts if you decide to choose non-recourse factoring
- The facility provides flexibility for the business and access to a range of additional products such as cash flow loans, trade or transactional finance.
Banks are the main source of short term (working capital) financing. Commercial banks grant short-term finance to business firms which are known as bank finance or credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in instalments as and when needed. Bank credit may be granted by way of loans, cash credit, overdraft and discounted bills.
- Working Capital Loan: A working capital loan is one of the most commonly used sources of financing short term business requirements. Almost all banks and financial institutions provide short term loans to corporate (big or small) to meet their working capital need. When a certain amount is advanced by a bank repayable after a specified period (generally up to 1 year), it is known as bank loan.
Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually loans are granted against security of assets. All most all leading commercial banks in India provide working capital loans to corporate.
- Cash Credit: Cash credit is another popular method of bank finance for working capital requirement. Under cash credit facility, banks allow the borrower to withdraw money up to a specified limit or sanctioned credit limit. This sanctioned limit is known as cash credit limit. Initially this limit is granted for one year. This limit can be extended after review for another year.
Borrower is not required to borrow the entire sanctioned credit once, rather, he can draw periodically to the extent of business needs and repay by depositing surplus funds to his cash credit account. Interest is paid on the amount utilized rather than on the sanctioned credit limit. Rate of interest varies depending upon the amount of limit.
Banks ask for collateral security for the grant of cash credit. Cash credit is a most flexible arrangement from the borrower’s point of view.
- Overdraft: An overdraft facility is a formal arrangement with a bank that allows an account holder to draw on funds in excess of the amount on deposit. This type of financing is most commonly used by businesses as a way of making their working capital more flexible, although it can also be available to individuals.
This limit is granted purely on the basis of credit-worthiness of the borrower. Although overdraft amount is repayable on demand, such facility continues for a long period by annual renewal of the limits. In overdraft facility, interest is charged on daily balances-on the amount actually withdrawn.
There are certain minimum charges that bank charge irrespective of the actually withdrawn amount. Rate of interest in case of overdraft is less than the rate charged under cash credit.
- Bill Discounting: a bill discounting is a process that involves effectively selling a bill to a bank or similar entity for an amount that is slightly less than the par value and before the maturity date associated with the bill of exchange. The debtor tenders payment to the new owner of the discounted bill in the full amount agreed upon originally.
This approach allows the issuer of the bill to receive cash before the actual due date associated with the bill, while also allowing the buyer to make a modest profit on the cash advance extended to the bill’s originator.