Short-Term Financing

Ashish Pattni

Source:http://reachfinance.blogspot.com

After determining the level of working capital, a firm has to consider just how it will be financed. The sources of short-term financing may be said to fall into three categories:
Credits
Current provisions
Non-bank short-term borrowings
(Since credits are a source of short-term financing, the 'types of credit' and the 'sources of short-term financing are elaborated upon simultaneously).
A. TYPES OF CREDITS
There are various types or kinds of credits extended by banks, firms, people at large and the government. Credits are one source, in fact the major source of short-term financing. The important types that exist today are briefly discussed below:
Trade Credit
Trade credit or accounts payable or sundry creditors is a very important spontaneous source for financing current assets. On an average, it would account for nearly 40 per cent of the current liabilities in general. Trade credit has two important facets. The first is to instil confidence on the part of the suppliers (including wholesalers, jobbers, commission agents, retailers, etc.) by maintaining good relations supported by prompt payment. This will enable a company to obtain trade credit. The second facet of trade credit relates to the cost of trade credit when suppliers provide an incentive in the form of cash discount for prompt payment. It can also be referred to as commercial credit when it is employed in financing the production or manufacture and selling of goods.
Bank Credit
The second major source of credit is the bank credit. Banks provide short-term credit by way of loans, cash credits, overdraft, discounting, purchase of trade bills, etc. Banks ask for security by way of pledges, hypothecation of goods or other collateral security against the loans advanced or loans may be granted without any security. Sometimes banks guarantee the loans provided by third party to the customer of the bank.
Traditionally, bank finance is an important source of short-term financing. It may be either direct or indirect. Under Direct financing, the bank not only provides the finance but also bears the risk. Cash credit, overdraft, note lending, purchase/discounting of bills belong to this category. When a bank opens a letter of credit in favour of a customer, the bank assumes only the risk of default by the customer and the finance is provided by a third party.
Under the cash credit arrangement, the customer is permitted to borrow upto a pre-fixed limit called the cash credit limit. The customer is charged interest only on the amount actually utilized, subject to some minimum service charge or maintaining some minimum balance also known as compensatory balance in the cash credit account. The security offered by the customer is in the nature of a hypothecation or pledge.
Overdraft arrangement is similar to the cash credit arrangement – here the customer is permitted to overdraw upto a pre-fixed limit. Interest is charged on the amount(s) overdrawn subject to some minimum charge as in the case of cash credit arrangement. The drawing power is also determined as in the case of cash credit arrangement. Overdraft account may operate against security in the form of pledge of shares and securities, assignment of life insurance policies and mortgage of fixed assets. It could also operate based on guarantees given by third parties.
A loan arrangement is where the entire amount of the loan (like Working Capital Demand Loan, FCNR 'B' Loan, etc.) is credited by the bank to the borrower's account. In case the loan is repaid in instalments, the interest is payable on the actual balance outstanding.
Unlike cash credit & overdrafts which are running accounts, note lending is for a specified period ranging from one to three months. The customer takes a loan against a promissory note. Interest is charged on the entire amount sanctioned as loan.
With a view to reducing reliance on cash credit & overdraft arrangement, bank provides finance to the customer either by outright purchasing or discounting the bills arising out of the sale of finished goods. Thus, the buyer is time-bound in his payment under the system.
A letter of credit is opened by a bank in favour of its customer undertaking the responsibility to pay to the supplier (or the supplier's bank) in case the customer fails to make payment for the goods purchased from the supplier within the stipulated time. It is popular both in domestic and foreign markets. The bank assumes the risk of non-payment while the supplier provides the credit.
Consumer Credit
The concerns producing or selling consumer items demand advances from their customers against the orders of supply of goods. This is an interest free source of finance. Concerns which sell goods on hire purchase or instalment system, a regular inflow of cash from the purchasers provides a good source of short-term finance.
Individual Credit
Here the banks provide short-term credit in the usual manner but to an individual and not to corporations. This is often the case in case of partnership firms and sole proprietorships where credit is extended to an individual / owner.
Consumptive Credit
It involves the granting of loans or the selling of goods on time to individuals who use the money or the goods received for satisfying consumptive wants.
Public Credit
This could mean the borrowing by Governments. It can be used for long-term and/or short-term requirements.
Capital Credit
This refers to the borrowings by manufacturing concerns to procure the necessary permanent capital required for their operations.
Other sources of Credits
These are also available to the business and take the form of advances from directors and managers, indigenous bankers, securities received from employees, etc.
B. CURRENT PROVISIONS
Accrued expenses
These are basically liabilities covering expenses incurred on and prior to a specified date, payable at some future date. Typical examples are accrued wages and salaries. It would normally constitute a small fraction of current liabilities and its usefulness as a source of financing current assets is very much limited.
Provisions
These are basically charges for an estimated expense. Typical examples are provision for dividends, provision for taxes and provision for bonus. Provisions also do not call for immediate cash drain. The drain on cash resources occurs when the actual amount of liability is known and paid for. The usefulness as a source of financing current assets is very much limited as in the case of accrued expenses.
C. NON-BANK SHORT TERM BORROWINGS
Commercial Paper
Commercial Papers (CPs) are short-term usance promissory notes with a fixed maturity period, issued mostly by the leading, reputed, well established large corporations who have a high credit rating. It can be issued by body corporates whether financial or non-financial. CPs are mostly used to finance current transactions of a company and to meet its seasonal needs for funds.
Factoring
Factoring is a "continuing" arrangement between a financial intermediary called a 'Factor' and a 'Seller' of goods or services. Based on the type of factoring, the factor performs the following services – he purchases all accounts receivables of the seller for immediate cash; administers the sales ledger of the seller; collects the accounts receivable; assumes the losses which may arise from bad debts and provides relevant advisory services to the seller. Factors are usually subsidiaries of banks or non-banking finance companies (NBFCs). It is to be noted that factoring is a continuous arrangement and is not related to a specific transaction. For rendering the services of collection and maintenance of sales ledger, the factor charges a commission which varies between 0.4% and 1% of the invoice value. For making an immediate part payment, the factor collects discount charges from the client. Types of factoring are Recourse Factoring, Non-Recourse or Full Factoring, Bulk Factoring, Agency Factoring, Maturity Factoring and Invoice Discounting.
Inter-Corporate Deposits
As in the case of CPs, these are short-term promissory notes with a fixed maturity period and pertain to the borrowing of one corporate from another. They are also used to finance current transactions of a company and to meet its seasonal needs for funds.
Public Deposits
Mobilization of funds from general public, especially from the middle and upper middle class people, by offering reasonably attractive rates of interest became an important source of obtaining credit. However, these are unsecured and the risk of losing their money is a risk that the people take.