Short Term Sources of Finance

Principle & Practice of Management

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Short Term Sources of Finance

short term sources of finance

Short Term Sources Finance

Short Term Sources funds have to be used (exclusively) for meeting the working capital requirements only and not for financing fixed assets and for meeting the margin money for working capital loans. The various Short Term sources financing are as follows:

Trade Credit

Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. Trade credit occupies a very important position in short term sources financing due to the competition. Almost all the traders and manufacturers are required to extend credit facility (a portion), without which there is no possibility of staying back in the business. Trade credit is a spontaneous source of finance that arises in the normal business transactions of the firm without specific negotiations (automatic source of finance). In order to get this source of finance, the buyer should have acceptable and dependable creditworthiness and reputation in the market. Trade credit generally extended in the format open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. As such trade credit constitute a very important source of finance, it represents 25 per cent to 50 per cent of the total short term sources for financing working capital requirements.
Getting trade credit may be easy to the well-established or well-reputed firm, but for a new or the firm with financial problems will generally face problem in getting trade credit. Generally, suppliers look for earning the record, liquidity position and payment record which is extending credit. Building confidence in suppliers is possible only when the buyer discussing his/her financial condition future plans and payment record. Trade credit involves some benefits and costs.

Advantages of Trade Credit

The main advantages are:
1. Easy availability when compared to other sources of finance (except financially weak companies).
2. Flexibility is another benefit, as the credit increases with the growth of the firm’s sales.
3. Informality as we have already seen that it is an automatic finance.

Accruals

Accrued expenses are those expenses which the company owes to the other persons or organisations, but not yet due and not yet paid the amount. In other words, accruals represent a liability that a firm has to pay for the services or goods, which it has already received. It is spontaneous and interest-free sources of financing. Salaries, wages, interest and taxes are the major constituents of accruals. Salaries and wages are usually paid on monthly and weekly basis respectively. The amounts of salaries and wages have owed but not yet paid and shown them as accrued salaries and wages on the balance sheet at the end of financial year. Longer the time lag in payment of these expenses, the greater is the amount of funds provided by the employees.
Similarly, interest and tax are other accruals, as a source of short term sources finance. The tax will be paid on earnings. Income tax is paid to the government on a quarterly basis and some other taxes may be payable half-yearly or annually. The amount of taxes due as on the date of the balance sheet but not paid till then and they are showed as accrued taxes on the balance sheet. Like taxes, interest is paid periodically in the year but the funds are used continuously by a firm. All other such items of expenses can be used as a source of short term sources finance but shown on the balance sheet.
The amount of accrual varies with the level of activities of a firm. When the level of activity expands, accruals increase, they automatically act as a source of finance. Accruals are treated as “cost-free” source or finance since it does not involve any payment of interest. But in actual terms, it may not be true, since payment of salaries and wages is determined by provisions
of law and industry practice. Similarly, tax payment governed by laws and delay in payment of tax leads to paying penalty. Hence, a firm must be noted that use of accruals as a source of working capital or it may not be possible to delay in payment of these items of expenses.

Deferred Income

Deferred incomes are incomes received in advance by the firm for supply of goods or services in a future period. These income receipts increase the firm’s liquidity and constitute an important source of short term sources finance. These payments are not showed as revenue till the supply of goods or services but showed in the balance sheet as income received in advance. Advance payment can be demanded by only firms having monopoly power, the great demand for its products and services and if the firm is manufacturing a special product on a special order.

Commercial Papers (CPs)

Commercial paper represents a short term sources unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in the USA and it was an important money market instruments. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul Working Group on the money market. CP is a source of short term sources finance to only large firms with sound financial position.

Advantages of CP:

1. It is an alternative source of finance and proves to be helpful during the period of tight bank credit.
2. It is a cheaper source of short term sources finance when compared to the bank credit.

Disadvantages of CP

1. It is available only for large and financially sound companies.
2. It cannot be redeemed before the maturity date.

Public Deposits

Public deposits or term deposits are in the nature of unsecured deposits, have been solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements.

Advantages:

Advantages of public deposit can be studied from two different views.
1. Company point of view
(a) Simple procedure involved in issuing public deposits.
(b) No restrictive covenants are involved.
(c) No security is offered against public deposits.
(d) Cheaper (post-tax cost is fairly reasonable).
2. Investors point to view
(a) Higher interest rates when compared to other investment avenues.
(b) Short maturity period.

Disadvantages:

These also can be studied from two different points:
1. Company point of view
(a) Limited amount of funds can be raised.
(b) Funds available only for a short period.
2. Investor point of view
(a) Risk since there is no security against PD.
(b) Income received (interest) is taxable.

Intercorporate Deposits (ICDs)

A deposit made by one firm with another firm is known as Intercorporate Deposits (ICDs). Generally, these deposits are usually made for a period up to six months. Such deposits may be of three types:
1. Call Deposits: Deposits are expected to be payable on call. In other words, whenever its repayment is demanded on just one day’s notice. But, in actual practice, the lender has to wait for at least 2 or 3 days to get back the amount. Inter corporate deposits generally have 12 per cent interest per annum.
2. Three Months Deposits: These deposits are more popular among companies for investing the surplus funds. The borrower takes this type of deposits for tiding over a short-term cash inadequacy. The interest rate on these types of deposits is around 14 per cent per annum.
3. Six Months Deposits: Generally, the inter-corporate deposits are made for a maximum period of six months. These types of deposits are usually given to ‘A’ category borrowers only and they carry an interest rate of around 16% per annum.

Commercial Banks

Commercial banks are the major source of working capital finance to industries and commerce. Granting loan to a business is one of their primary functions. Getting bank loan is not an easy task since the lending bank office may ask a number of questions about the prospective borrower’s financial position and its plans for the future. At the same time, bank will want to monitor the borrower’s business progress. But there is a good side to this, that is borrower’s share price tends to rise because investor know that convinces banks is very difficult.

Factoring

Cash lubricates the wheels of trade, business and industry. Cash flow is necessary to meet commitments – statutory or otherwise. But, unfortunately for the sellers of goods and services, credit sale is the order of the day, worldwide. The most vulnerable segments are the small and medium sector enterprises. Delayed realisation of the sales receivables elongates their working capital cycles. Poor bookkeeping and collection mechanisms along with inadequate and delayed institutional credit hasten their untimely sickness. In this backdrop, factoring has evolved as an innovative portfolio of complementary financial services. It is an alternative way of providing post-sales working capital finance to trade and industry, which they traditionally get from commercial banks.