CHAPTER: SHORT TERM FINANCING

Topics to be Covered:
1. Meaning and nature of short-term financing. 2. Sources of Short Term Financing. 3. Advantages of Short-Term Financing. 4. Disadvantages of Short Term financing. 5. Purpose of Short-Term Financing. 6. “Ideal Concept” of Short-Term Financing.

7. What is Trade Credit?
8. Reasons for the use of Trade Credit.

9. Factors determining the amount of Trade Credit used 10. Cost of Trade Credit
11.

Who bears the cost of Trade Credit?

12. What is Bank Credit? 13. Distinction between Bank Credit and Short Term credit. 14. Characteristics of Short Term financing

they do not require payment on the spot. for example. Finance Companies 5. i. This practice is prevalent where the seller does not wish to sell goods without prepayment and the buyer also can not purchase goods form other sources. usually one year or less in duration. Customers Advances 3. Sources of Short Term Financing. There is variation in the use of short term finance between the large and small sized business establishments. rather they are to be paid after some days from the date of sale. Special type machine manufactures often demand advance payment in order to protect them from the loss caused by cancellation of contract at a time when the machine has been built up or is in work in process. Commercial Paper House 6. Commercial Banks 4. Trade Creditors 2. The seller might require advance it the quantity of goods ordered is so large that he cannot afford to tie up more fund in raw materials or in good-in-process. It has been found in the developed countries especially in USA that even the largest business establishment makes use of short term finance. before the receipt of the goods. Co-operative credit society 10. Trade creditors are those business establishments which sell good to others on credit. Miscellaneous Sources 1.Meaning and nature of short-term financing: Short Term financing is that from of financing which embraces borrowing or lending of funds for a short period of time. In practically all types of business. Short term finance is also known as working capital which is the excess of current assets over current liabilities. 1. Governmental Institutions 8. We find in the balance sheets of almost all the companies some kinds of current liabilities which are the indicator of the uses of short term finance in business. The small concerns make more use of short term financing on account of lower average credit standing and impermanent nature of business. Customers Advances: Customers often finance the seller through advance payment for the goods. inventories. Practically all enterprises use the short-term credit as sources of finance. Trade Creditors: Trade creditors are probably the most important single source of short term credit. Accruals 13. That is. The size of business has an important bearing on the use of short term finance. The prices of the goods to be purchased are paid in advance. Loan Mortgage Banks 11. Current liabilities become due within one year and indicate the amount of short-term credit being utilized by the business. Factors or Brokers 9. 2.e. . Personal Loan Companies 7. there is lesser use of short term credit among larger concerns. Short term finance is secured for financing the current assets. It refers to the finance obtained on short term basis. Money Lender 12.

loan from officer and the company directors and foreign exchange banks Advantages of Short-Term Financing: 1. Finance Companies: Finance companies usually lend money to business. 8. 5. They are—friend and relatives. They are specialized financial institutions and their primary function is to advance funds to the business 5. The small business undertakings can procure fund form such companies 7. 4. . In considering a company’s request for funds we are more interested in the men behind the company their ability. 3. factoring is different from other forms of financing.3. Factors or Brokers: In one basic respect. 6. collecting scattered savings of the people. 7. Easier to Obtain: Short –term credit can be more easily obtained than long term credit. 2. Personal Loan Companies: These companies make small loans to individual generally for consumption purposes. 6. invest a portion of the deposits in the business for a short period of time. The firm having high credit standing can use this source for obtaining short-term funds. 9. 4. Miscellaneous Sources: There are many more sources from which can secure funds for short period. Governmental Institutions: There are some governmental and semi-governmental corporations which are authorized to advance short term funds to business concerns. by granting loans. Easier to Obtain Lower cost Flexibility No Sharing of control Availability Tax Savings Convenience Extension of credit 1. The banks. either with security or without security if the customer is financially established. Commercial Paper House: They are specialized financial agencies and they are created to purchase promissory notes and to sell them. Because of the prior position given creditors in the matter of claim to income and to assets in dissolution they generally will accept a relatively low interest. 2. Their importance is of course not so much less than other sources. Factoring is based on a different philosophy. A firm which poor credit standing may be unable to obtain long term funds but it can procure. Commercial Banks: The commercial banks of a country generally supply funds to the business concerns on a short-term basis. 8. their hopes and aspirations for the future. Lower cost: Short term credit may be obtained with lower cost than the long term finance because of priority of creditors in general. in turn. The short-term creditors. assume less risk than long term creditors because there is less chance of substantial change in the financial soundness of the creditor within a few week’s or month’s time. to other investors who desire to have some shot of short-term liquid assets. In other forms funds are granted to one individual largely on the basis of his property. at least some trade credit from sellers who are anxious to increase their sales. public deposits.

Flexibility: Due to seasonal nature of business many firms have a temporary demand for shortterm funds to carry heavier inventories. Thus a substantial tax-savings may result form the use of short-term funds. The lenders may demand a high interest if the credit involves large amount and the potential credit risk is also high or the debtor may not give suitable security.3. The principal must be repaid when due. Frequent Maturity: Short-Term credit is disadvantageous in the sense that it matures frequently. 7. 4. Short-term financing is flexible in the sense that the firm is able to secure funds as they are needed and repay then as soon as the need vanishes. Most enterprises are in constant need of short term funds. Funds may be needed to meet the daily. collateral protection. supplies and good by ordering from a supplier with the intent of paying after delivery has been made. No Sharing of control: Obtaining funds form short term creditors prevents the inclusion of more owners through the procurement of owner’s funds. Such funds can be advantageously supplied by short term credit. The sorter the credits the greater the potential risk to the owners because of the problem of prompter repayment. it would become inflexible because long term funds cannot be repaid as soon as the need for funds vanishes. particularly for small enterprises short term credit is the only source available. . 2. Then . There may be danger of either meeting the principal payment at maturity of the loan or meeting the principal payment at maturity of the loan or meeting any periodic interest payment or both. Frequent Maturity 2. weekly or monthly requirements. The rate of interest usually depends on the risk involved. It may not be possible for a small firm to obtain long term funds because of poor credit standing. This results in maintaining the position of control by the existing owners. etc. Long-term credit is not generally granted without adequate margin of protection which the small firms may not be able to provide with. Tax Savings: The cost of short term funds are deductible for income tax purposes while the dividend paid to the owners is not deductible. It long term credit is secured to finance the daily or weekly or seasonal variations. otherwise the creditors may close the business. A high interest may also be demanded when the firm can not procure funds form other sources on suitable terms and conditions. Extension of credit: Many enterprises purchase equipments. Availability: In many cases. The use of such credit is also a risk to the owners’ investment from the inability to meet the creditor’s claims when due. if any emergency arises for the purchase of any goods the firm Disadvantages of Short-Term Financing: 1. Because the creditors have no voice in the operations of the business. 5. If subsequently the bills are met promptly. High Cost: The rate of interest paid on sort-term is usually higher than that on long-term credit is usually higher than that on long-term credit. 6. Convenience: Short Term credit can be more conveniently secured than the other types of funds. The small business has then recourse to short term funds. High Cost 1. size of loan. the firm acquires a good credit standing. It is more convenient to pay labour weekly or employees monthly than every day 8.

the creditor may not even be heard from. If the default is only for a few weeks or a month and does not occur frequently. This definition makes it clear that trade credit is a different type of credit than the consumer credit and installment sale credit. Trade credit has been defined as the short-term credit by a supplier to a buyer in connection with purchase of goods for ultimate resale. The credit accepted for the purchase of goods which are consumed by the purchaser is not trade credit—it becomes consumer credit. 2. But obtaining finance from the financial institutions is not so easy. must be extended in connection with the purchase of goods which must be resold. Trade credit has also got widespread use because of the fact that it is less risky than other sources of funds. the trade creditors usually don’t proceed to liquidate the firm. in most cases. Less Risk 5. The lender may impose restrictions on the action of the management. obtaining funds form finance companies or banks gives rise to many complications. they pass through many hands starting from the producers down to the retailer. Trade credit is also used as a matter of convenience. Trade credit. Trade credit is a credit extended for the purchase of goods with the ultimate purpose of resale. The purchaser is to make payment on a stipulated date. in order to be designated as trade credit. Existence of Business One of the most important reasons for the use of trade credit is its cheapness. If the credit can not be repaid by the end of the credit period. the producer may extend credit to the wholesaler. It is convenient to obtain. . Facilitating prosecution of business with other’s money Secure additional fund What is ‘Trade credit’: Trade credit is a kind of business credit which is extended by the seller of goods to the buyer of the same at all levels of production and distribution process down to the retailer. Many formalities are to be performed to obtain funds from such institutions. The only Source 7. Advantages /Reasons for use Trade Credit: 1. Such credits extended by the wholesaler to the retailer or producer to the wholesaler are known as trade credit. who may also facilitate the retailer’s trade by extending credit to him. Lowering of cost (Low cost financing) Raising Funds according to necessity. is cheaper than other sources of credit. For example. 4. In trade credit no specific rate of interest is to be paid. Flexibility 4.Purpose/Goals of Short-Term Financing: 1. 3. The rate of interest to be paid on the funds is also determined in advance. Less Costly 6. Convenience of Informality 3. Trade credit is used by various agencies operating in the trade channel between the producer and the retailer. So a credit. because the purchaser receives the goods from the seller when the latter sends the goods on receipt of the order form the former. Before the goods and services have reached the ultimate users or consumers. It increases profit 2.

the cost in case of 2/10. n/60 would be 14. In the case of Tk 100 in voice. it would have the use of Tk 98 for 20 days. insurance companies and other finance companies hesitate to lend funds to the business enterprises that are small in size and financially weak. Cost of Trade Credit 2. If no cash discount is offered. Frequent Maturity 3. The cost of trade credit is found to occur when the firm forgoes the cash discount and pay its bill on the final due date of the net period.72%. Discount Rate (%) 360 Cost = ---------------------------. Such enterprises do not usually possess a good credit standing and that’s why. the cost of trade credit declines the longer it is able to postpone payment. if a firm takes the discount there is not cost during the discount period. The cost of not taking the cash discount when offered can be substantial. As such. The relationship between the annual interest cost of trade credit and the number of days between the end of the discount period and the end of the net period is shown in the following figure: . For instance. If a firm does not take cash discount.X ---------------------------------------- 100-Discount Rate Credit Period-Discount Period If the length of the net period is longer in relation to the discount period. the cost of trade credit is that additional cost which he may pay if he does not take the cash discount offered by the creditor for prompt payment. The cost of trade credit decreases at a decreasing rate as the net period increases. they can not approach big lending intuitions for loans. This is especially true of small concerns.When other sources of obtaining funds are closed to a business organization trade credit may be obtained easily. For example.18% and if the credit term is 2/10. the cost would be 36. n/30.72%. the small business concerns rely mostly on trade credit. the firm has the use of funds for an additional twenty days if it does not take the cash discount but pays on the final day of the net period. the cost of trade credit declines. In the latter case.7%. By the same token. The banks. They fear that these enterprises would not be able to repay the debt on maturity. Insolvency Cost of Trade Credit: To a business man. there is not cost for the use of credit during the net period. if the credit term is 1/10. Disadvantages of Trade Credit: 1. n/30. the cost would be 18. Thus the annual interest cost is 36.

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