Top 5 External Sources of Short Term Finance | India

This article throws light upon the top five external sources of short term finance. The external sources are: 1. Trade Credit and other Payables 2. Factoring 3. Bank Loan 4. Accounts Payable 5. Bank Overdraft/Cash-Credit.

Short Term Finance: External Source # 1.

Trade Credit and other Payables:

Trade credit is a form of short-term financing common to almost all businesses. It is the largest source of short-term funds for business firms collectively. In an advanced economy, most buyers are not required to pay for goods at the time of taking delivery but are allowed a short deferment period before the actual payment is due. For this period, the supplier of the goods extends credit to the buyer.

Because, suppliers are more liberal in the extension of credit than the financial institutions. In short, Trade Credit is the credit granted by the suppliers of raw materials/ goods etc. to manufacturers and/or wholesalers. It generally takes the form of discount for cash payment on delivery and net for future payment.

The rate of discount and the period of payment may, however, vary Among the twin objectives of trade credit, one is to serve as a source of working capital finance and is referred to as ‘financial’ (The other objective of trade credit is that it facilitates sales and is referred to as ‘Industrial’).

The trend and significance of trade credit as a source of working capital finance, however, depends on several factors, viz., the size and the rate of growth of the company, its financial resources and bank finance.

Trade Credit enjoys the following four remarkable advantages:

(a) It is more advantageous to purchase goods and services on an open-book account in comparison with the payment of cash at the time of making purchases, viz., at the time of taking delivery.

(b) Until and unless the discount which is offered by the suppliers is not taken there is no measurable cost for such credit.

(c) It is a ‘spontaneous’ source of financing compared to other sources of financing, because, in other cases, there is a lead time to arrange the fund and that is why it is a more flexible means of financing.

(d) Trade Credit is advantageous to small firms that have difficulty in obtaining credit elsewhere, or cannot obtain it at all.

However, the advantages of using trade credit must be weighed against the cost. The cost may be necessarily very high when all factors are considered.

Cost of Trade Credit:

Cost of trade credit may be taken into consideration under the two following alternatives:

(i) In case of discounts which are offered by the suppliers;

(ii) Where there is no discount.

It is needless to mention that cost of trade credit is nothing but the discounts which are foregone. That is, the cost is explicit. However, the following formula may be used in order to measure the cost of trade credit.

It may also be taken as 360 for simplicity.

Illustration:

Terms for supply of materials by a firm are ‘3/10, net 30’. It means that 3% discount is offered if payment is made within 10 days of the invoice date, but if the benefit of discount is not taken, full amount is to be paid within 30 days. Calculate the cost of trade credit.

Solution:

From the question, it becomes clear that if the purchaser does not take the advantages of case discount, pays the amount on final day of the net period, he can use the fund for additional 20 days (i.e., 30 -10). So, in case of an invoice of Rs. 100, the purchaser would have the use of Rs. 97 [i.e., Rs. 100- Rs. 3 (3% of Rs. 100)] for 20 days.

As such, cost of trade credit in this case is calculated as under:

From the above it is quite clear, when cash discount is offered, that it is a very expensive from of short- term financing. The only remedy is that cost of trade credit may be declined if the net period, in relation to discount period, is increased.

Consider the following illustration:

Illustration:

If credit terms are taken as ‘3/10 net 30’, ‘3/10 net 60’ and ‘3/10 net 90’ days respectively, calculate the cost of trade in each case.

Thus, if alternative cost of sources becomes, say, 23%, the break-even point is 50 days beyond the discount period. Therefore, trade credit may be used when the terms are ‘3/10 net 60’ and above.

As a result, trade credit can be divided into two following groups when discounts are offered:

(i) Free Trade Credit:

When the credit is received during the discount period, i.e., in the above illustration, it is the amount of purchase for 10 days.

(ii) Costly Trade Credit:

This credit is in excess of free credit and which is equivalent to foregone discounts. It involves a relatively high percentage cost for ensuring early liquidation of creditors. We know that if no discount is offered by the supplier there is no cost of trade credit, i.e., there is no explicit cost of such trade credit.

But it is also a fact that use of funds over time is not at all free. The supplier of goods always tries to pass the cost to the buyer. As such, such costs are hidden in the prices of the goods or services which is practically not possible to measure in future.

The volume of trade credit as a means of short-term financing depends on the following factors:

(i) The terms of trade credit,

(ii) Reputation of the purchasing firm,

(iii) Financial position of the seller;

(iv) Volume of purchase to be made by the purchaser.

Further, since trade credit is costlier than bank loans, it is used as a supplement to bank loans for financing the short-term requirements of firms. Other payables include accrued wages and salaries, commissions and dividends. These outstanding factor payment also help to provide working capital finance, however temporary it may be.

Short Term Finance: External Source # 2.

Factoring:

A person who buys trade receivables with or without recourse, his profit accruing from commissions and from interest on advance, is called a factor. Factors were formerly selling agents for merchandise of various kinds, differing from broker in that the former handled the merchandise themselves.

No doubt, the charges (i.e., the commissions) are less costly than any other source of finance. The primary advantage of this method is that sales may increase without, however, any corresponding increase in the amount to be paid by debtors or receivables.

Short Term Finance: External Source # 3.

Bank Loan:

Firms usually prefer to use Bank Loan in the form of Cash Credit and/or Over­drafts by means of unsecured Promissory notes for 90 to 180 days or against hypoth­ecation of inventories or against endorsement of accounts receivable for financing their working capital.

The advantages of obtaining working capital finance by Bank borrowings in the form of cash credit or overdrafts are that the borrower need not draw at once the whole amount of credit granted to him, but can do so by installment as and when required.

Secondly, he can put back any surplus amount which he may find with him for the time being. Finally, interest payable by the borrower only on the amount to his debit at the end of each day business. But, to what extent a firm can raise its working capital by resorting to these techniques of financing depends, apart from its ability to hypotheticate or pledge securities, upon the credit policy of the Government.

Short Term Finance: External Source # 4.

Accounts Payable (Bills of Exchange):

It is an interest free source. These are created when the firm purchases goods (raw material etc.) for re-sale on credit terms without signing a formal note for the liability. It is needless to mention here that it is the largest single sources of short-term financing on ‘open account. As no specific asset is pledged against it these are treated as unsecured form of financing.

Accounts payables are legally binding obligation of a firm although no formal note is signed against it. As the purchases the goods on credit from the suppliers, he agrees to pay the suppliers the specific amount under the terms of trade. Practically, it is a binding contract.

The disadvantages arises only when the purchaser denies about the receipts of goods. Thus the existence of a note will prove the delivery of goods. Usually, the transactions are made on open account but a note is not taken particularly from an unknown purchaser.

Short Term Finance: External Source # 5.

Bank Overdraft/Cash-Credit:

Bank Overdraft:

Under this method of financing, short-term credit up to a certain limit is granted by the bank and the volume of credit depends on the securities pledged in the form of hypothecation of inventories and receivables.

Cash-Credit:

A certain amount is pledged to the credit of the borrower and at the same time the borrower is allowed to withdraw sums by issuing cheques up to the stipulated amount from time to time. These types of financing are called Secured Loans under the Companies Act, 1956, since credit is allowed by the banks on the basis of securities pledged.

However, these types of financing have certain distinct edges over other forms of financing which are as follows:

(i) These help the firm not to accumulate funds unnecessarily; i.e., they prevent creation of idle capital which ultimately increases cost,

(ii) The rate of interest is normally cheaper in comparison with any other sources of financing debt capital.

But Bank Overdraft/Cash-Credit system is not free from drawbacks which may be enumerated below:

(i) The borrower does not utilise his cash resources properly since the system relieves him of the responsibility of making any conscious effort.

(ii) Quantum of credit which may be granted depends on the securities pledged and not on the purpose for which it is taken or on the profitability which ultimately has some inflationary or deflationary effects, e.g., if price level increases, value of securities already pledged also will increase and, on the basis of the same, more credit may be granted which also further affects the price level.

(iii) Another limitation is that the more efficient firm gets fewer credit facilities since its inventories and receivables are less in comparison with other inefficient firms who have more inventories and receivables.

However, in India, in spite of the above limitations, these types of financing debt capital are very popular and considered as the major sources of finance, particularly in the private sector, because of the flexibility and lower cost.

Practically, the limitation is to some extent (particularly the norms for inventory and receivable holdings and the information system) less relevant after the implementation of the recommendations of the Tandon Committee.