Short Term Financing

Definition: Required amount of fund collected by a business enterprise for running day to day
operations and meeting up emergencies from different available sources for less than one year time
period is known as short term financing.

Importance: Its importance cannot be exaggerated because each day mangers are concerned with
their current assets and liabilities position and it accounts almost 40% of the total financial needs.

Risks return trade off: In short term financing risk refers to the risk of insolvency the inability pay
bills as they come due. The risk is related to net working capital or current ratio. Since working
capital involves investment decision so the question of risk return trade off arises.

Why do firms’ need to maintain Cash (liquidity)?

An important aspect of short term financial management is cash management. Firms need to
maintain cash for the following reasons:

1. Firms must be able to pay their bills as they fall due, since the cash inflow and outflow never
synchronized cash must be maintained (transaction motive)
2. As most firms depend on commercial banks and they require a firm to keep a minimum
deposit level (Compensating balance)
3. Large unanticipated cash outflows might occur (Precautionary motive)
4. The firms may speculate on interest rate movements by buying securities when interest rate
are expected to decline (Speculative motives)

Types and Sources of Short Term Financing

(A) Spontaneous Financing

a) Trade Credit (Open account, Notes payable, Trade acceptance)
b) Advances from Customers & deferred income
c) Accrued Expenses
(B) Money Market Credit
a) Commercial Paper
b) Banker’s Acceptance
(C) Short Term Unsecured Bank Loan
a) Line of Credit
b) Revolving Credit
c) Single Payment Credit/Transaction Loan
(D) Secured Short Term Bank Credit

Sources of Spontaneous Financing

Trade Credit: Trade credit is an interim debt arising from credit sales and recorded as an account
receivable by the seller and as an accounts payable by the buyers. It is a credit that a customer gets
from supplier of goods in the normal course of business.

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Advances from Customers: One source of short term credit is the advances received from
customers before the services are enjoyed. For example Telephone Company receives money from
public before line is given.

Accrued Expenses: Sometimes payments like salary, taxes are deferred. So it acts as a temporary
source of financing. For example if the salary of 100 workers is delayed for 7 days, then company
has a source of fund.

Types of Trade Credit

Open Account- An invoice is send to the purchaser in this type of credit where the amount, rate
and condition of sales are mentioned. This type of credit is grunted based on the goodwill and
repayment record of purchaser.

Notes Payables/Promissory Note- Here the purchaser has to sign a document acknowledging that
goods have been bought on credit. In this type of trade credit a particular date is mentioned within
which the credit must be repaid.

Trade Acceptance- Here the creditor also has to acknowledge that goods have been brought on
credit. Even before the goods sold on credit the seller prepares a draft in the name of the buyer and
after the buyer sign that document the goods are sent. The buyer makes arrangement to repay the
seller through a particular bank within a specific date. The marketability of the buyer depends on
his/her goodwill and repayment record.

Characteristics of Trade Credit

1. Credit purchase or sale- it is created through credit sale not cash sale.
2. Less formalities- there is less formalities especially in case of open account.
3. Timing- usually extended for three months.
4. Financing volume- the financing volume depends on amount of purchase and the timing of
repayment
5. Cost of financing- it depends on the terms impose by seller
6. Purpose- usually provided for the purpose of purchasing raw material
7. Security- no security is required
8. Continuing credit- it can be provided by different financial institutions with easy term and at
a continuous rates
9. Resale- The goods bought under this credit must be resold
10. Availability- Almost 40% of the short term financial requirement of business is meet from
this type
11. Mutual trust and good relation- the main basis of this credit is the mutual trust and good
relationship between buyer and seller

Advantages of Trade Credit

1) Availability- It is highly available with no special arrangement. So smaller companies

prefer this

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 2) Flexibility- if the firm’s sale increase then purchase of goods and services will increase and
so will trade credit
3) Few or no instructions- in general the terms are less restrictive

Cost of Trade Credit

There are some visible and hidden costs. Hidden costs are difficult to determine like the
deterioration in the firm’s credit rating.

Prompt payment:
Visible cost- None
Hidden cost- These costs are passed on to the buyer by the seller, like carrying cost, credit
checking, bad debt losses. These costs are passed to the buyer by charging higher
price for the product than cash sales.

Delayed payment:
Visible cost- Cost of forgoing cash discount, penalty charge for late payment
Hidden cost- Cost of paying late

Terms of Sale/Conditions of Short Term Financing

Cash on delivery (COD) - In this case payment must be made as soon as goods are delivered.
Since the seller does not provide any facility it does not involve any risk, the only risk is when the
buyer denies taking delivery of the goods.
Cash before delivery (CBD) - The payments must be made before goods are delivered to avoid all
sorts of risk. This condition is given when the amount of credit is more.
No period, No cash discount- A certain period is mentioned within which bills must be paid, for
example it can be net 30 meaning the payment must be paid within 30 days.
Seasonal Dating- The order placed before the season very suitable for buyers and sellers.

Who bears the cost of Trade Credit?

Advantages of Trade Credit

1) Easy availability- it can be availed relatively easily

2) Possibility of more profit by increasing sale- all purchaser prefer to purchase more on credit
so more sales takes place
3) Less formalities- only in case of promissory note and trade acceptance some formalities is
required but not in open account
4) Less costly- if no discount is to be given then there will be cost for the seller otherwise no cost

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5) No need for collateral securities- the reputation and goodwill of the purchaser act as
collateral
6) Benefit of increased volume of credit
7) Development of mutual trust and good relation- a good relationship is crated between buyer
and seller through credit relation
8) Flexibility- the buyer and seller can increase or decrease the amount of credit as required
9) Less risk of bad debt- since the credit worthiness of the purchaser is evaluated less possibility
of default
10) Only the last resource for small traders- specially advantageous for new and small business
who does not have any access to bank loan

Disadvantages of Trade Credit

Shorter repayment period- usually it must be paid within 1 to 3 months

High cost of foregoing cash discount benefit- if there is cash discount benefit then the borrower
cost credit increases
High price of goods- when the seller is in a monopoly position the purchaser has to purchase at a
high rate
Possibility of bad debt loss- there is always a possibility of bad debt
No exemption of tax- since cost of trade credit is not shown as a part of company’s profit or loss it
does not receive any tax exemption

Sources of Money Market Credit

Commercial Paper: It is a form of unsecured promissory note, with maturity 3 to 270 days that the
firm issue to raise short term money. Only the financially strongest and most creditworthy
companies can issue commercial paper and it is issued through dealer or via direct placement.

Banker’s Acceptance: In case of companies engages in international trade Banker’s acceptance of

bank act as a short term source of financing.

Sources of Short Term Unsecured Bank Loan

Transaction Loans: Often referred to as note, the length range from 30 to 90 days. Typically
evidenced by a promissory note and repaid in a single sum. It can be renewed if required and it is
most frequently used by borrowers.

Revolving Credit Agreement: A formal agreement where the bank is legally committed to provide
credit up to a maximum established limit, the firm usually pays a commitment fee between from
.125 percent to .5 percent on the unused portion of the line. If no funds are borrowed commitment
fee must be paid on the full borrowing limit.

Line of Credit: It is an agreement permitting a firm to borrow up to some specified maximum

amount from the bank. This arrangement minimizes the negotiation effort and provides the firm a
very flexible source of financing and the firm will use it only if it needs and the bank is not under
any legal obligation to extend credit.

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Cost of Short Term Bank Loan

It depends on three factors:

1. nominal interest rate
2. method used to compute and collect interest
3. firm’s tax rate

Sources of Secured Short Term Bank Credit

 Nominal interest rate is stated on the loan agreement reflecting the general conditions
prevailing in the economy and the creditworthiness of the applicant firm. Nominal interest
rate is rarely equal to the effective rate.

 Interest rate on secured loan is generally greater than unsecured loan. Any of the firm’s
assets may be put up as collateral like plant equipment even current assets like receivables
and inventory can be used as security.

 There might be other sources like family and friends who give loan and with no interest.

Accounts Receivables- One way firm can acquire short term financing is to sell accounts
receivables to a company that specializes in buying that. These companies are called factors and
this procedure is called factoring.

Inventory of Goods- Inventory is another common source of loan collateral. Because it is fairly
liquid and banks and finance companies willing to accept most standard types of inventory as
collateral however perishable inventories are not acceptable.

Problem Discussion

Cost of Factoring

The factor i.e. bank or financial company provide funds against bills receivable to the bill presenter
after doing the following things:
(1) Evaluation of the bills
(2) Identifying the activities related to collection of bill amount and other administrative activities
(3) The calculation of risk if unable to collect the bill amount
(4) Payment of cash

The amount that will be paid against bills is less than the face value and it also depends upon:
 The factoring commission
 The administrative expenses
 The reserve to be maintained for bad debts

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