Business finance: sources of business finance: short-term business finance

TOPIC THREE

SOURCES OF BUSINESS FINANCE: SHORT-TERM BUSINESS FINANCE

There is a large and continuing demand for finance in commerce and industry fields. The funds are needed for;-

1. Investing in new fixed assets e.g. Plant, machinery etc. To expand the business
2. Financing additional working capital as a business expands i.e. To increase levels of stocks and debtors
3. In times of high inflation, to maintain the real value of working capital

There are different sources from which a firm can raise funds. These sources vary from one another with respect to;-

– Purpose served,
– Cost and risk involved,
– Effect to managerial control and
– The period for which the funds thus raised would be available for use.

The sources of finance may be classified into the following two categories;-

1. Internal and external sources
2. Long term, medium term and short term sources

Internal sources of finance are those sources which are generated within the business. They consists of;-

– Retained earnings
– Provisions e.g. Provisions for depreciation and provision for taxation
– Sale and lease back

External sources are those sources where the finance is obtained from the owners or creditors. These consist of:

– Ordinary share capital
– Preference share capital
– Debentures
– Trade credit
– Hire purchase
– Loans from banks and other financial institutions

Sources of finance are usually classified as Long-term sources and short-term sources

SHORT-TERM BUSINESS FINANCE

Short-term financing sources provide funds that may be used usually for one to three years. Sometimes, these funds are available only for period of less than one year. These sources help for funding shortages in working capital. They should not be used to finance long-term investments. They are;-

– Bank credit
– Trade credit
– Bills of exchange
– Factoring
– Promissory notes
– Bills of lading
– Warehouse receipt
– Overdrafts
– Invoice discounting
– Hire purchase
– Lease finance
– Accrued expenses

1. Trade Credit or Open book account
It is the list expensive method of raising capital. In all the developed countries of the world, most of the sale and purchase of goods is carried on an open book account. Under this arrangement a firm buys material, equipment etc. from a supplier on a promise to pay the bill at a later date which usually ranges from 7 to 90 days. Although, trade credit is not thought of a loan, yet the fact is that the seller is financing the buyer for the period of time between the receipt of goods and the payment of the bill. Trade credit is granted on the basis of financial standing and goodwill of the purchaser in the market.

Disadvantages

– Loss of cash discount
– It is limited source
– Payment duration is short

When to use Trade credit

a) When it is difficult to get credit facility from the commercial banks
b) When it is cheaper than other alternative sources of finance
c) When the organisation does not have enough assets to offer as security
d) When the terms of credit are more easily as compared to bank credit due to the following reasons.

– It does not involve so many formalities
– It is easy to negotiate with suppliers as compared to banks
– It is possible to get even during the periods of credit restrictions by the banks
– It is more flexible and can be used by small firms as well as

2. Advance

A part of the full price. The remaining amount is paid by the buyer on supply of the commodity. There are some businesses whose products have wide demand in the market. These businesses, sometimes, get advance payments from their customers and agents. These advances are not loan, yet they are a source of finance for the business and help in minimizing their investment in working capital. They also indirectly help in reducing the burden of loan of the business

3. Installment credit

The purchase of goods is taken but the payment is made in installments over a specified period of time. The business by not paying the full price is able to get some funds to meet the short term needs of the business. It is a kind of financial assistance provided in kind.

4. Cash credit
It is the most favourite method of short-term borrowing by the industrial and commercial concerns. The bank allows a business to borrow money up to a certain limit by pledging the goods with it. The goods are released in full or in parts on getting payment. The interest is charged on amount of money actually withdrawn and not on the entire amount of the sanctioned loan. Cash credit is borrowing on a comparatively long-term and on regular basis.

5. Bills of Exchange
Bills of Exchange are a source of finance in particular in the export trade. A bill of exchange is an unconditional order in writing addressed by one person to another requiring the person to whom it is addressed to pay to him as his order a specific sum of money. The commonest types of bills of exchange used in financing are accommodation bills of exchange. For a bill to be a legal document; it must be

a) Drawn by the drawer.
b) Bear a stamp duty
c) Acceptable by the drawee
d) Mature in time.

It is used to raise finance through:

– Discounting it;- the bank gives short term credit to its trusted customers by discounting their bill of exchange. The bank purchases the bill of exchange and credits the customer’s account with the amount of the bill, less discount. the bank gets back the money on maturity of the bill.
– Negotiating;- as a negotiable instrument a bill of exchange can be transferred to another person especially the business financiers or suppliers of goods and services.
– Giving it out as security.

Advantages of Using a Bill as a Source of Finance

– They are a faster means of raising finance (if drawer is credible).
– Is highly negotiable/liquid investment
– Does not require security
– Does not affect the gearing level of the company
– It is unconditional and can be invested flexibly
– It is useful as a source of finance to finance working capital
– It is used without diluting capital.

Disadvantages

– Funds are limited
– Market is impersonal because a bill of exchange can be rediscounted many times before they reach maturity
– This source can be availed only by large firms.

6. Bill of lading

This is a receipt issued by a shipping company for the goods to be transported from the seller to the purchaser. The purchaser can get short-term loan from the bank by offering bill of lading as security for the loan.

7. Overdraft Finance

This finance is ideal to use as bridging finance in sense that it should be used to solve the company’s short term liquidity problems in particular those of financing working capital (w.c.). It is usually a secured finance unless otherwise mentioned. Overdraft finance is an expensive source of finance and the over-reliance on it is a sign of financial imprudence as it indicates the inability to plan or forecast financial needs.

Advantages of Overdraft Finance

– It is useful in financial crisis which an accountant cannot forecast due to abrupt fall in profits thus liquidity problems.
– In some cases it may be secured on goodwill thus making it flexible finance.
– It does not entail preconditions and is therefore investible in high-risk situations when the firm would not have finance in normal circumstances.
– It is raised faster and as usual is ideal to invest in urgent ventures e.g. documentary investments e.g. treasury bonds, shares, treasury bills, housing bonds etc.
– If not used for a long period of time – it does not affect the company’s gearing level and therefore does not relate to company’s liquidation or receivership.
– Less formalities/procedures involved.

Disadvantages of Overdraft Finance

– It is expensive as the interest rates of overdrafts are much higher than bank rates.
– The use of this finance is an indication of poor financial management principle.
– It may be misused by management because it does not carry pre-conditions
– Being a short-term financial arrangement, it can be recalled at short notice leaving the company in financial crisis.

8. Plastic Money (Credit Card Finance)

This is finance of a kind whereby a company will make arrangements for the use of the services of credit card organisations (through the purchase of credit cards) in return for prompt settlement of bills on the card and a commission payable on all credit transactions. This is used to finance goods and services of working capital in nature such as the payment of fuel, spare-parts, medical and other general provisions and it is rare for it to finance raw materials or capital items.

Reasons behind the Fast Development of This Finance (Plastic Money) In Kenya

a) High incidences of fraud by dishonest employees have been responsible for development of this finance as it minimizes chances of this fraud because it eliminates the use of hard cash in the execution of transactions.
b) Risk associated with carrying of huge amounts of cash for purchases which cash is open to theft and misuse has also been responsible for development of this finance.
c) Credit cards have boosted the credibility of holder companies which enables them to obtain trade credits under conditions which would have otherwise been difficult.
d) Of late, Kenya has experienced emergence of elite, middle and high-income groups’ in particular professionals who tend to use these cards as a symbol of status in execution of day to day transactions.
e) These cards have been used by financial institutions and banks to boost their deposit and attract long term clienteles e.g. Royal Card Finance, Standard Chartered.
f) A number of companies and establishments have acquired such cards as a means of settling their bills under certain times when their liquidity is low or when in financial crisis.

Limitations of Credit Cards as a Source of Finance

i) These cards lead to overspending on the part of the holder and as such may dis-organise the organisation’s cash budget and cash planning.
ii) Limited as to the activities they can finance as they are ideal for financing working capital items and not fixed assets in which case they are not a profitable source of finance.
iii) They are expensive to obtain and maintain because of associated cost such as ledger fees, registration, insurance, commission expenses, renewal fees etc.
iv) It is a short-term source and is open only to a few establishments in which case a company can obtain goods and services from those establishments that can accept them.
v) Entail a lot of formalities to obtain e.g. guarantees, presentation of bank statements and even charging assets that are partially pledged to secure expenses that may be incurred using these cards.
vi) They may be misused by dishonest employees who may use them to defraud the organisation off goods and services which may not benefit such organisations.
vii) Credit card organisation may suspend the use of such cards without notice and this will inconvenience the holder who may not meet his/her ordinary needs obtained through these cards.

(Visited 100 times, 1 visits today)

Leave a Reply

Your email address will not be published. Required fields are marked *