Businesses and individuals use long- and short-term sources of financing to raise capital for improvements and meet financial obligations. Sources of funds like trade credit, cash credit, overdraft, bank loan etc. which make money available for a shorter period of time are called sources of short-term finance. Most short-term sources of financing occur over a period of one year, although some sources can last up to three years or longer. Because short-term financing is repaid over a shorter length of time, the interest rate or cost to borrow money is smaller.
The main focus of short-term financial decisions is to synchronize between:
1) Time structure of assets and liabilities;
2) Payment needs to finance working capital and liquidity constrains of firm;
3) Costs of founds and costs of loose in operational activity.
Time structure of assets and liabilities should be around equal. If assets time structure is longer than liabilities firm meat problem of liquidity and short-term debt repayment. The risk of such situation is probability of sudden lack of funds to finance operational activity. If liabilities time structure is longer than assets firm carry on additional financial costs because long-term debt is more expansive than short-term one.
Purpose of Short-term Finance
After establishment of a business, funds are required to meet its day to day expenses. For example raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus there is a continuous necessity of liquid cash to be available for meeting these expenses. For financing such requirements short-term funds are needed. The availability of short-term funds is essential. Inadequacy of short term funds may even lead to closure of business.
Short-term finance serves following purposes
1. It facilitates the smooth running of business operations by meeting day to day financial requirements.
2. It enables firms to hold stock of raw materials and finished product.
3. With the availability of short-term finance goods can be sold on credit. Sales are for a certain period and collection of money from debtors takes time. During this time gap, production continues and money will be needed to finance various operations of the business.
4. Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice.
5. Short-term funds are also required to allow flow of cash during the operating cycle. Operating cycle refers to the time gap between commencement of production and realization of sales.
Spontaneous Financing
Spontaneous financing arises from firm's day to day transactions. Their magnitude is dependent on company's level of operations. As operations expand, these liabilities typically increase and finance a part of the buildup in assets. Though all spontaneous sources of financing behave in this manner, there still remains a discretion on the part of the company as to the exact magnitude of this financing. Spontaneous financing or trade credit is simply a way of obtaining more cash by:
Establishing a Line of Credit
Lengthening the Disbursement Cycle
Borrowing against your assets
Selling your receivables
There are two types of spontaneous financing :-
Accounts payable( Trade credit from suppliers)
Accrued expenses
Accounts Payable:
Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material, finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days credit. This means that the goods are delivered but payments are not made until the expiry of period of credit. This type of credit does not make the funds available in cash but it facilitates purchases without making immediate payment. This is quite a popular source of finance.
Trade credit is an arrangement between businesses to buy goods or services on account, that is, without making immediate cash payment. The supplier typically provides the customer with an agreement to bill them later, stipulating a fixed number of days or other date by which the customer should pay. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment required to operate the business if it is managed properly. Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses. For example, Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders.
For many borrowers in the developing world, trade credit serves as a valuable source of alternative data for personal and small business loans.
There are many forms of trade credit in common use. Various industries use various specialized forms. They all have, in common, the collaboration of businesses to make efficient use of capital to accomplish various business objectives
Examples of trade credit are:
Open Accounts: the seller ships goods to the buyer with an invoice specifying goods shipped, total amount due, and terms of the sale.
Notes Payable: the buyer signs a note that evidences a debt to the seller.
Trade Acceptances: the seller draws a draft on the buyer that orders the buyer to pay the draft at some future time period.
Terms of Sale:
COD (Cash on Delivery) and CBD (Cash before delivery): the buyer pays cash on delivery or cash before delivery. This reduces the seller's risk under COD to the buyer refusing the shipment or eliminates it completely for CBD.
Net Period - No Cash Discount: when credit is extended, the seller specifies the period of time allowed for payment. "Net 30" implies full payment in 30 days from the invoice date.
Net Period - Cash Discount -- when credit is extended, the seller specifies the period of time allowed for payment and offers cash discount if paid in the early part of the period. "2/10, net 30" implies full payment within 30 days from the invoice date less a 2% discount if paid within 10 days.
Seasonal Dating -- credit terms that encourage the buyer of seasonal products to take delivery before the peak sales period and to defer payment until after the peak sales period.
Trade Credit as a Means of Financing
Trade credit is a source of funds to the buyer because the buyer does not have to pay for the goods, until they are delivered. If the firm automatically pays its bills a certain number of days after the invoice date, trade credit becomes a spontaneous source of financing that varies with the production cycle. As the firm increases its production and corresponding purchases accounts payable increase and provide a part of funding needed to finance the increase in production. In examining trade credit as a discretionary source of financing, we have two situations:
(1) A firm does not take a cash discount but pays on the last day of the net period.
(2) A firm pays its bills beyond the net period.
Payment on the Final Due Date
In this section it is assumed that the firm pays its bill on the final due date of the net period, thus forgoes a cash discount. This case is explained through the following example :
The approximate annual cost to forgo the cash discount of "2/10, net 30" after the first ten days for a 100 $ invoice …
If the firm does not pay within the discount period, it would have the use of $98 for 20 days and for this privilege it pays $2 indirectly. Taking out the annual interest rate:
$2= $98 x Y% x (20 days/ 365 days)
Therefore,
Y% = (2/98) x (365/20) = 37.2%
Thus we can observe that trade credit cn be a very expensive form of short term financing when a cash discount is offered but not accepted.
Approx annual interest cost= % discount x 365 days
(100 - discount) (payment date-discount period)
We can deduct from the above equations that the cost of not taking a discount declines as payment date becomes longer.
