Sources of Short-Term Finance
Short-term finance is the money that is borrowed for a short period of time, usually less than a year. Short-term financing is used by a business to bridge the gap between income and expenditure for a short period, such as to purchase raw materials, pay off current liabilities, and meet preliminary expenses. A business requires funds for diverse purposes, such as to meet its day-to-day expenses. For example, raw materials must be purchased at regular intervals; workers must be paid wages regularly. Thus, there is a continuous necessity of shortterm funds to be available for meeting these expenses.
Table of Content
- 1 Sources of Short-Term Finance
Short-term finance serves the following purposes:
- Helps in the smooth running of business operations by meeting day-to-day financial requirements
- Facilitates a business to hold stock of raw materials and finished products
- Helps the business to face sudden changes in market conditions
- Avails the facility of selling goods on credit
- Helps in increasing the volume of production by providing adequate funds for purchasing raw materials, paying rents, and increasing workspace at short notice
The requirement of short-term finance depends upon size, market conditions, and nature of business. Previously, there were only two sources of short-term finance, such as indigenous bankers and commercial banks. However, today many new sources of finances are available in the market, which have made short-term financing an easy process.
Some of the sources of short-term financing are shown in Figure:
Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, or components. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit.
When businesses enter into a trade credit arrangement with their suppliers, a certain credit term is usually set. Cash/cheque payments made within this term may get a certain discount. If payments are not made within this term, all receivables are required to be settled within a time period as specified.
Some advantages of trade credit are as follows:
- Trade credit is a flexible and reliable source of financing.
- Trade credit may be readily offered if the seller is aware of the consumers’ creditworthiness.
- If a firm wants to raise its inventory to meet a projected increase in sales volume in the near future, it can do so with trade credit without the burden of immediate payment.
- It does not place a lien on the firm’s assets while providing financing.
Some limitations of trade credit are as follows:
- Overtrading may occur as a result of the availability of simple and flexible trade credit arrangements, increasing the firm’s risks.
- Trade credit can only create a limited quantity of revenue.
When the purchase order quantity is quite large or things ordered are very costly, businesses insist their customers to make some payment in advance. Customer advances represent advances received from customers for goods or services expected to be delivered within the following year. Customers generally agree to make advances when such goods are not easily available in the market or there is an urgent need of goods. A business can meet its short-term requirements with the help of customers’ advances.
Some advantages of customer advances are as follows:
- The amount offered as advance is interest free. Therefore, funds are available without involving financial burden.
- No tangible security is required while seeking advance from the customer, making assets free of charge.
- Funds received as advance is not to be refunded; therefore, there are no repayment obligations.
Some limitations of customer advances are as follows:
- Customer advances are available to only those businesses, which have goodwill in the market. In other words, it is available to those businesses whose product demand is high in the market.
- The period of customers’ advance is limited up to the delivery of goods and cannot be extended further.
- The amount advanced by the customer is subject to the value of the order, although, the borrowers’ need may be more than the amount of advance.
Short-term finance granted by commercial banks to businesses is known as bank credit. When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or in parts as and when needed. These are secured for which interest is to be paid regularly. These loans help in increasing profit of an organisation as it is a part of expenses, which is deducted from tax. Bank credits have a short maturity period, which is generally less than a year.
Some advantages of bank credit are as follows:
- Banks aid businesses in a timely manner by supplying funds as and when they are required.
- If borrowers fulfil the bank’s lending criteria, they could avail the benefit of lower rate of interest as well as easy repayment terms.
However, the main limitation of bank credit is that banks do a thorough investigation of the company’s affairs, financial structure and other factors, and may also request asset security and personal sureties. As a result, acquiring finances is a little more challenging.
Types of Bank Credit
Various types of bank credit available in the money market are shown in Figure:
Let us explain the types of bank credit in detail.
A loan is a liability, which can be for short or long term, depending upon the requirement of the organisation. When a certain amount is advanced by a bank, which is repayable after a specified period, it is known as bank loan. The amount taken as loan is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan regardless of the amount of loan actually drawn.
Usually loans are granted against security of assets. Bank loans can vary in the length of time in which they are to be repaid. Loans and advances are granted by the bank on personal security of the borrower as well as on the security of some tangible assets, besides the creditworthiness of the firm.
Cash credit is an arrangement whereby banks allow the borrower to withdraw money up to a specified limit. This limit is known as cash credit limit and is granted for one year, which can be extended after reviewing it another year. However, if the borrower still desires to continue the limit, it must be renewed after three years. Rate of interest varies depending upon the amount of limit and collateral security for the grant of cash credit.
In this arrangement, the borrower can draw, repay, and again draw the amount within the sanctioned limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire limit. The limit of the amount that can be withdrawn is decided or sanctioned by the bank depending upon the business cycle of the client, working capital gap, and withdrawing power of the client.
This withdrawing power in turn again is determined, on the stock and book debts statements submitted by the borrower at monthly intervals against the security by hypothecating of stock of commodities and/or book debts. The excess withdrawal of cash is made generally on demand from customers, as they have to pay interest on the excess amount that they have withdrawn.
The interest is charged only on the amount that is drawn in excess. The cash credit facility is useful to those businesses where cash payments, such as wages, transportation, and cash purchases are to be made and the receivables are not realised in time.
Bank overdraft is a facility in which a bank extends credit up to a certain amount called overdraft limit. Against this amount, a current account customer writes cheques or makes withdrawals. It is the most common and popular form of business borrowing. An overdraft is similar to a revolving loan where deposits are available for re-borrowing, and interest is charged only on the daily overdraft balance.
It acts as a good backup resource, which ensures that one can pay bills even when one has not actually received invoice payments. An overdraft generally costs more than a loan for a long-term purchase. In addition, there could be stiff charges if one exceeds the overdraft limit and the bank has the right to ask for repayment for the amount one is borrowing at any time. It is important for businesses to monitor spending carefully and not to exceed their limit, as it would result in paying much more then they initially borrowed.
Discounting of Bills
Negotiable instruments include cheques, bills and promissory notes. Banks also advance money by discounting bills of exchange, promissory notes and hundies. Discounting of bills can be defined as cashing or trading a bill of exchange at less than its par value and before its maturity date. When a bill is presented before the bank for discounting, banks credit the amount to customer’s account after deducting discount. The amount of discount is equal to the amount of interest for the period of bill.
Instalment credit is a form of finance in which a set amount of money is borrowed for a set period of time. The borrower agrees to make a predetermined number of monthly instalments in a certain amount.The payback duration for an instalment credit loan might range from months to years until the loan is paid off. The most common types of instalment loans are:
Working Capital Loans
These loans are taken by organisations to fulfil their daily business requirements, such as buying machinery/equipment, managing business cash flow, purchasing raw materials, enhancing inventory, paying salaries, and so on. Working capital loans are generally short term in which the repayment tenure is up to 12 months. The interest rate offered is a little higher as compared to long-term loans or general business loans. The bank sets a limit for the business to take a loan and the amount can be utilised for specific business purposes.
It is a loan that is to be repaid regularly over a set period of time. Terms loans can be short term or long term. The repayment tenure of these two types of loans ranges between 12 months to 10 years. The loan amount offered by the bank ranges from ₹1 lakh to ₹1 crore and can exceed depending upon business requirements. The repayment tenure for a term loan is finalised by the lender at the time of loan application.
Letter of Credit
It is a type of credit limit wherein the bank or lender provides funding guarantee to organisations that deal in international trade. Letter of credit can be used for import and export purposes. Organisations carrying business activities overseas tend to deal with some unknown suppliers. For that, they require assurance of payment before performing any transaction. Therefore, letter of credit plays a vital role in providing payment assurance to the suppliers.
It is a funding option offered to the borrowers for purchasing new equipment/machinery or upgrading the existing one. Equipment finance is generally used by large-scale manufacturing organisations. Organisations availing equipment loans also enjoy tax benefits. The interest rate, loan amount, and repayment tenure offered vary from lender to lender.
Some advantages of instalment credit are as follows:
- Instalment credit gives borrowers a fixed monthly payment amount for a certain period of time, which makes budgeting easier. Instalment loans can also be extended over time, resulting in reduced monthly payments that may be more in line with monthly cash flow requirements.
- In terms of interest rates and user fees, instalment credit might be less expensive than revolving credit for qualifying consumers.
- Instalment credit lenders, on the other hand, charge lower interest rates, ranging from 2% for secured loans to 18% for unsecured loans. Using the reduced interest rate paid on instalment credit to pay down revolving debt can help a borrower to save a huge amount over the life of the loan. In addition, revolving debt might have high costs for late payments, exceeding credit limits and annual maintenance; on the other hand, instalment credit does not have these expenses.
Although using instalment credit to pay off more expensive, variable revolving debt has some advantages, it also has significant disadvantages. Some disadvantages of instalment credit are as follows:
- Some lenders especially starters are usually not able to pay off loan early. In such a case, penalty or additional interest are imposed by the lenders.
- Instalment credit facilitates the purchase of asset or equipment and does not make cash available, which can be utilised for all needful purposes.
Factoring is a unique financial innovation, which provides both financial and managerial support to the client. It is a financial option for the management of receivables. To put simply, it is the conversion of credit sales into cash. In factoring, a financial institution (factor) buys the accounts receivable of a business (client) and pays up to 80% (rarely up to 90%) of the amount immediately on agreement. Factoring organisation pays the remaining amount (Balance 20%-finance cost-operating cost) to the client when the customer pays the debt.
Collection of debt from the customer is done by either the factor or the client depending upon the type of factoring. Factoring is a financial service covering the financing and collection of accounts receivables in domestic as well as in international trade. Factoring is an arrangement in which receivables on account of sale of goods or services are sold to the factor at a certain discount. As the factor gets title to the receivables on account of the factoring contract, he/she becomes responsible for all credit control, sales ledger administration, and debt collection from the customers.
The factoring process is as follows: Firstly, an organisation sells its product or services to a customer and issues an invoice for the value of the goods or services. Then for factoring the invoice, the organisation follows the sale by sending the factor a copy of the invoice. The factor then processes the invoice, and within 24-28 hours, the factor gives the organisation a percentage of the invoice amount.
When the customer becomes ready to make the payment, he/she directs the payment to the factor. After receiving the payment, the factor withholds a small factoring service fee, and returns the difference or reserve back to organisation. At last, the reserve is the second payment the organisation receives from the factor for the invoice.
Figure shows how invoice factoring works:
Some advantages of factoring are as follows:
- With cash flow accelerated by factoring, the client is better able to satisfy his/her obligations as they arise.
- Factoring is a flexible source of money that enables a predictable pattern of cash inflows from credit sales.
- The client can concentrate on other functional areas of business as the responsibility of credit control is shouldered by the factor.
Some limitations of factoring are as follows:
- When the invoices are many and little in value, this source is costly.
- The factor firm’s advance finance is often accessible at a higher interest rate than the standard rate of interest.
In the early 1990s, commercial paper became a popular source of short-term financing in our country. Commercial paper is an unsecured promissory note that a company issues to raise capital for a limited period of time, usually 90 to 364 days. It is distributed to other businesses, insurance companies, pension funds and banks by a single company. The sum raised by CP is usually rather substantial. Because the debt is completely unsecured, only companies with a solid credit rating can issue a CP. The Reserve Bank of India is responsible for its regulation.
Some advantages of a commercial paper are as follows:
- A commercial paper is sold without any restrictions and is sold on an unsecured basis.
- It has a high liquidity because it is a freely transferable instrument.
- In comparison to other sources, it delivers greater funds.
- A commercial paper delivers a steady flow of cash. This is due to the fact that their maturity can be customised to meet the needs of the issuing corporation. In addition, maturing commercial paper can be repaid by the sale of new commercial paper.
- Businesses can invest their spare cash in commercial paper and make a decent return on it.
Some limitations of commercial paper are as follows:
- Commercial papers can only be used to raise funds by financially sound and highly rated companies. This strategy cannot be used by new or modestly rated businesses to raise financing.
- The amount of money that can be generated through commercial paper is restricted by the amount of excess liquidity available with fund sources at any given time.
- Commercial paper is a faceless form of borrowing. As a result, extending the maturity of commercial paper is not possible if a company is unable to redeem its paper due to financial difficulties.