What is Short Term Finance ?
Finance is the starting point of every business activity. It is the key factor. Adequate finance is necessary for the smooth running of any business. It is life-blood of mod er business. There are different types of finance. Short term finance is one of these types.
Meaning of Short Term Finance
Short term refers to the time for which a loan is required and the period over which its repayment is expected to take place. Short term finance is the capital required for a period of less than one year. It is needed for meeting seasonal or temporary needs of working capital. These finance the day-to-day operations of the business. It includes wages of employees and purchases of inventory and supplies. Supplies are used up quickly and inventory is sold resulting in stock turns. Short term loans can be used to finance accounts receivable contracts which are relatively risk-free, but delayed for one to three months.
Characteristics of Short Term Finance
The main features of Short Term Financing are as follows :
1) Easy Availability :
Easy availability of finance is an important characteristic of short term finance. It is easy to arrange for the short term finance. If the demand for and prices of products of a small enterprise are subject to wide and unexpected fluctuations provision has to be made for arranging higher amounts of working capital Short term finance can be made available easily.
2) Source of Working Capital :
The variable part of working capital is funded through short term finance. Thus, short term finance is an important source of working capital. The main sources of short term finance are trade credit, commercial banks or bank credit, public deposits, accrual accounts, advances from customers, factoring etc.
3) Cheaper / Lower Cost :
The sources of short term finance are generally cheaper. They can be made available in a lower cost. It can be made available either interest free or in a very lower interest rate.
4) Flexible :
Short term finance is flexible as it affords the borrower more flexibility. Bank: credit is flexible because banks offer different schemes of financing working capital. Trade credit is one of the sources of short term finance. It is a flexible source. Wherever necessary, the buyer can delay payment because the seller normally accepts a genuine request. The concern can earn cash discounts by making payments before the expiry of the credit period.
5) Fast :
By short term finance companies are able to get access to funds much more quickly. In the case of factoring and invoice discounting, funds can be available within days. This is an important characteristic of short term financing.
6) Less Formalities :
Short term financing involves less formalities. It means that administrative for malities are reduced for short term loans.
7) Use of Finance :
Short term finance for working capital can be used to enable a retail, service or manufacturing business to purchase raw materials, retail or parts inventories, process or promote these and pay monthly expenses including principal and interest on outstanding term loans, wages and salaries, rentals, leases, utilities etc.
8) Security :
Short term finance may be secured against :
- Any unencumbered physical assets of the business.
- Additional funds from shareholders or personal guarantees from principals.
- Inventories on occasion.
- Assignments of all the receivables and personal guarantee.
Needs for Short Term Finance
Businesses need finance, or money, to pay for their overhead costs as well as their day to day and variable expenses. Short term business finance facilitates businesses and financiers to seize quick business opportunities that require transactions to be completed in short time. The highlight of this kind of finance is its prompt availability to the businessman. Here it is imperative to get the transaction conducted as quickly as possible. Short term business finance is appropriate for both new and existing businesses. Therefore, there are following situations where a business may need short term finance. Purpose of short-term finance are as follows :
1) Starting a Business :
Huge amounts of finance is needed to start a business which requires buying fixed assets, paying rent and other overheads as well as producing or buying the first products to sell. The finance required to start up a business is called start-up capital.
2) Expanding a Business :
When expanding, a lot of capital is needed in order to buy more fixed assets or fund a takeover. Internal growth by developing new products also requires a notable amount of finance for R&D.
3) A Business in Difficulties :
For loss making businesses money is needed to buy more efficient machinery or money is needed to cover negative cash flow. However, it is usually difficult for these firms to get loans.
4) Research &Development (R&D) :
Businesses need finance to develop new products. Multinational businesses usually spend millions of dollars every year in Research and Development purposes. R & D is carried out regularly in big businesses as a mean to get a competitive edge over its competitors.
5) Running of the Business :
Apart from investment at the initial stages a business needs a constant flow of capital in form of working capital. A shortage of working capital might lead to serious consequences for the business or cash flow problems.
6) During Trouble Times :
A business might need additional dose of capital or financial help during troubled times such as a recession, or when the sales of the business fall temporarily due to market conditions.
Types / Sources of Short Term Finance
Short term refers to financing that will be repaid in 1 year or less. Short term financing may be used to meet seasonal and temporary fluctuations in a company's fund position as well as to meet permanent needs of the business For example, short term financing may be used to provide extra net working capital, finance current assets or provide interim financing for a long term project. The variable part of working capital is funded through short term funds. The three major sources of short-term financing are as follows :
Trade Credit
Trade credit i.e. accounts payable refers to balances owed to suppliers. It is the credit extended by the sellers of goods to the buyer as incidental to sale. It is also known as merchantile credit. It arises out of transfer of ownership of goods. Trade credit is available in the ordinary course of business without any security. It is a spontaneous financing source since it comes from normal business operations. The volume of trade credit available to a firm depends upon the reputation of the buyer, financial position of the seller, volume of purchase, terms of credit, degree of competition in the market etc.
Forms of Trade Credit
Trade credit may take two forms :
- An open account credit arrangement
- Acceptance credit arrangement.
In case of open account credit, the buyer has not to sign a formal instrument of debt. Under acceptance credit, the buyer is required to sign a debt instrument eg. a bill of exchange or a promissory note as an evidence of the amount due by him to the seller. In both the cases, credit is made available to the buyer on an informal basis without creating any charge as assets.
Merits / Advantages of Trade Credit
1) Easy Availability :
Trade credit is easily and readily available because no legal formalities are involved.
2) Continuous Availability :
Credit is available on a continuing and informal basis. The concern has not to approach anybody and tell that it is short of working capital.
3) No Charge on Assets :
No charge is created on the assets of the buyer.
4) Flexibility :
Trade credit is a flexible source of working capital. Wherever necessary, the buyer can delay payment because the seller normally accepts a genuine request. The concern can earn cash discounts by making payments before the expiry of the credit period.
Demerits / Disadvantages of Trade Credit
1) High Cost :
While fixing prices, the seller takes into account the interest, risk and inconvenience involved in selling goods on credit. Therefore, the cost of trade credit may be very high.
2) Harmful Over-trading :
Availability of liberal trade credit facilities may induce a concern to over trading which can be harmful.
Bank Credit
Commercial banks are the single largest source of short term finance for industry.
Forms of Bank Credit
They provide working funds in the following forms :
1) Loans :
Loan is an advance with or without security. A lump sum is given to the borrower at an agreed rate of interest. The borrower has to pay interest on the total amount whether he withdraw the full amount of the loan or not. The loan may be repaid in lump sum or in installments. Loans may be term loan or demand loan.
2) Cash Credit :
It is an arrangement under which the borrower is allowed to borrow money upto a specified limit. Cash credit limit is fixed after taking into account the paying capacity and creditworthiness of the client. The credit is given in the form of cash usually against some security or guarantee. Cash credit is a very flexible source of working capital. The borrower can withdraw money as and when required. He has to pay interest on the amount actually withdrawn rather than on the total unit sanctioned.
3) Overdraft :
It is a facility allowed by a bank to its current account holders. The account holder is allowed to withdraw up to a certain limit over and above the credit balance in his current account. It is for a very short duration, generally a week and is used occasionally.
4) Bills Discounted/Purchased :
The customer having a bill of exchange arising out of trade can discount the same with a commercial bank. The term discounting of bills is used in case of time bills whereas the term purchasing the bills is used in respect of demand bills
Merits/Advantages of Bank Credit
1) Cheaper Method :
Bank credit is generally a cheaper method of raising working capital.
2) Flexible :
Bank credit is flexible because banks offer different schemes of financing working capital.
3) Concessional Interest Rates :
Under the directives of Reserve Bank of India, banks provide finance to small scale and cottage industries at concessional rates of interest.
4) Role of Bank as a Friend :
Commercial banks serve as a friend, philosopher and guide to their clients in respect of the most appropriate method of financing and utilization of credit.
Demerits / Disadvantages of Bank Credit
1) Documentation :
In order to raise funds from commercial banks, several documents have to be submitted and signed. It is a time consuming and expensive process.
2) Hypothecation or Pledge :
Commercial banks generally require hypothecation or pledge of assets for granting credit.
3) Serious View in Delay of Payment :
Commercial banks generally take a very serious view of delay in repayment and interest.
Bank Financing of Account Receivables
Receivable financing is also one of the important sources of raising short term finance.
Forms / Types of Bank Financing of Account Receivables
Accounts receivable may be financed under two terms, they are as follows :
1) Factoring :
Factoring refers to the outright sale of accounts receivable to a bank or finance company without recourse. The purchaser takes all credit and collection risks. The proceeds received by the selling company are equal to the face value of the receivables less the commission charge, which is typically 2 to 4 per cent higher than the prime interest rate. The cost of the factoring arrangement is the factor's commission for credit investigation, interest on the unpaid balance of advanced funds and a discount from the face value of the receivables where high credit risks exist. Remissions by customers are made directly to the factor.
2) Assignment :
In an assignment, there is no transfer of ownership of the receivables. Receivables are given to a finance company with recourse. The finance company typically advances between 50 and 85 per cent of the face value of the receivables in cash. The borrower is responsible for a service charge, inter est on the advance and any resulting bad debt losses. Customer remissions continue to be made directly to the company.
Merits/Advantages of Bank Financing of Account Receivables
1) Availability of Cash :
As a result of factoring services, there is immediate availability of cash which is very important in crisis period.
2) Reduction in Overhead :
There is reduction in overhead since the credit examination function is no longer required.
3) Advances on a Seasonal Basis :
Receivables financing provides/facilitates cash advances as needed on a seasonal basis.
4) Advice :
The factoring institutions also provide advice on business trends and other related matters.
Demerits / Disadvantages of Bank Financing of Account Receivables
1) High Cost :
A substantial amount of discount or rebate has to be paid to factoring concern.
2) Poor Impression :
There may be poor impression left with customers because of the change in ownership of the receivables. If the factoring institute uses strong arm tactics to collect it may spoil the image and relations of the firm with its customers.
Explain Advantages and Disadvantages of Short Term Financing as a Working Capital.
Working capital means the amount of funds required by an enterprise to finance its day to day operations. It is that part of the total capital which is employed in short term assets such as raw materials, accounts receivable, inventory, etc. working capital is required to bridge the time gap between production of goods and receipt of cash through sales. The variable part of working capital is funded through short term funds. The merits of the different alternative sources of short term financing are usually considered carefully before a firm borrows money.
Advantages of Short Term Finance
When compared to long term financing, short-term financing has several advantages. They are as follows :
1) Easy :
Short term finance is easier to arrange. It can be proved from the study of various sources of short term finance. Trade credit is easily and readily available because no legal formalities are involved. Accepting public deposits is a very simple method of financing as very little formalities are involved.
2) Less Expensive :
To raise short term finance is less expensive as compared to raising of long term finance. Bank credit is one of the sources of short term finance. Bank credit is generally cheaper method of raising working capital. In the same way public depositor are also a relatively less costly source of short term finance. Advances from customers is also an important source of short term finance. This is a very cheap source because either no interest is payable or the rate of interest payable on advance is nominal.
3) Flexibility :
Short term finance affords the borrower more flexibility. Trade credit is a flexible source of working capital. Wherever necessary, the buyer can delay payment because the seller normally accepts a genuine request. Bank credit is flexible because banks offer different schemes of financing working capital.
4) Seasonal Variations :
Some enterprises need greater working capital during particular seasons. Short term financing may be used to meet seasonal and temporary fluctuations in company's fund position as well as to meet permanent needs of the business. For example, short-term financing may be used to provide extra networking capital, finance current assets, or provide interim financing for a long-term project.
5) Lower Rate of Interest :
As interest rates yields are usually upward sloping, the use of short-term finance will usually mean a lower interest rate.
6) Fast :
Short term finance makes the companies able to access to funds much more quickly. In the case of factoring and invoice discounting, funds can be available within days.
7) Lower Credit Checks and Formalities :
Banks will require a lower level of credit checks as the funds will be outstanding for a shorter period and the administrative formalities are reduced for short term loans.
8) No Loan Covenants and Pre-payment Penalties :
Long term bank loans will require that companies adhere to certain covenants in relation to financial ratio, dividend payouts and the issue of more debt. In the same way, there may be penalties imposed on the pre-payment of a long term. loan. This may not be necessary in the case of short-term loans,
Disadvantages Short Term Finance
1) Fluctuation in Interest Rate :
The drawbacks of short term financing are that interest rates fluctuate more often. Short-term loan is taken for short term. The rate of interest is fixed for the period of loan. When the loan is taken again, there may be change in the rate of interest. It may be very high.
2) High Cost :
Short term financing involves high cost. In case of trade credit, while fixing prices, the seller takes into account the interest, risk and inconvenience involved in selling goods on credit. Therefore, the cost of trade credit may be very high. In case of factoring a substantial amount of discount or rebate has to paid to the factoring, concern. When a company borrows under a line of credit, it may be required to maintain a deposit with the bank that does not earn interest. This deposit is referred to as a compensating balance and is stated as a percentage of the loan. It increases the cost of the loan. Factoring and assignment also include high cost.
3) Effect on Credit Rating :
Some sources of short term financing may negatively affect the firm's credit rating. Delinquent repayment may be detrimental to the credit rating of a borrower who is experiencing a liquidity problem.
4) Restrictions :
Certain lenders may impose restrictions such as requiring a minimum level of net working capital. The bank may place restrictions upon the company, such as a ceiling on capital expenditures or the maintenance of a minimum level of working capital.
5) High Rate of Interest :
The disadvantages of short term loans are that, because it is made for the short-term, it carries a higher interest rate than a secured loan and payment in a lump sum is required.
6) Adverse Effect of Company Image :
Frequent short term financing may adversely affect the image of the company. The mode of financing through public deposits can put the company in serious financial difficulties. Even a rumor that the company is not doing well may lead to a sudden rush of public demanding premature repayments of deposits. If the factoring institution uses strong arm tactics to collect money it will spoil the image and relations of the firm with its customers. The poor impression is left with customers because of the change in ownership of the receivables in the case of factoring.