Short term financing sources can be Trade creditors, Factoring services, Bill discounting, Advances from customers, working capital loans from banks, fixed deposits, receivables and payables.
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What is short term financing
Short term financing refers to financing business operations for less than one year. Short term financing is also referred to as capital financing. It arises when a firm needs to fund current assets such as inventory, cash and a bank balance.
Trade credit is an important short-term source of finance. It is generated by the business in the form of delayed payments permitted by the suppliers of raw materials or finished goods. This type of finance is based on the price of the goods. The amount of the loan, with no interest, and the credit period is given in the credit terms of the agreement. Trade credit is a common short-term source of working capital for businesses of any size. Normally the amount and period of credit are dependent on the customs and competition in the industry as well as the credibility of the buyer in terms of liquidity, profit making ability and past records.
Working capital loans are a short-term source of finance product given by financial institutions to help businesses finance their short-term needs, working capital and any operating activities. The need for such short-term loans arises from the working capital cycle. This is the number of days it takes for a firm to convert its inventory into cash. The working capital cycle is calculated in number of days. A lot of businesses cannot fund their businesses with payables only, so they rely on the cash generated internally or short-term finance from external sources. Sometimes the owner of the business injects his own money into the business just to keep it functional. However, with the help of products such as working capital loans from financial institutions additional liquidity can be generated for businesses of all sizes.
Types of working capital loans
- Receivables financing
A firm can sell its account receivables to a financial institution at a discount. This type of facility can be structured as an off-balance sheet if it is a true sale with limited recourse to the seller.
- Invoice discounting
This is a loan given to a business by a financial institution with the accounts receivables as collateral. The amount and pricing of this loan is based on the accounts receivables.
- Inventory financing
This is another type of short-term financing secured by inventory or a part of the inventory. This inventory can be work in progress or finished goods with the amount dependent on the realisable value of the inventory. The creditworthiness of the borrower determines the pricing of the facility.
- Floor planning
Car dealers or firms with a strong balance sheet use this short-term source of financing. The lender buys the firm’s inventory and when the inventory is sold the company pays back the debt.
With this source of short-term finance, the bank pays the firm as soon as an invoice is issued. The firm will then repay the bank at a later date. This way a company can stretch its payables and benefit from better payment terms. This short-term source of finance is provided on an unsecured basis. However, the bank providing this facility will require a guarantee depending on the credit worthiness of the borrower.
Factoring is another short-term source of finance where the business entity sells its receivables to a third party at a discount in order to raise funds. It may seem similar to invoice discounting, but it differs in that invoice discounting involves getting the invoice discounted at a certain rate to obtain funds. With factoring however, the receivables are all sold to an outside agency called a factor. After the receivables have been sold, the factor (the third party that buys the receivables) doesn’t pay for the receivables in full, about 75-80% of the invoice value is paid up after deducting the discount. The remainder is only paid after the factor receives the payment from the seller’s customers.
Types of factoring
- Recourse (a firm will have to buy back any invoices that the factoring company is unable to collect payment on)
- Non-recourse (the factoring company assumes all the risk of non-payment)
- Advance (a certain amount of the receivables in paid to the firm in advance)
- Maturity (collection factoring, no advance is made to the firm, the factoring company only pays the firm upon expiry of the invoice)
- Full factoring (the factoring company performs almost all the services of factoring, it pays the firm a certain percentage in advance and takes the risk of default or non-payment)
- Disclosed and undisclosed
- Domestic and export factoring (In domestic factoring 3 parties are involved, the selling firm, the factoring company and the selling company’s customer. In export factoring there are 2 factors, the export and import factor in addition to the selling company and the selling company’s customer.
Bill discounting or Invoice discounting are used synonymously. This short-term source of finance is normally used by firms that sell goods on credit. It is an arrangement whereby the seller recovers an amount of sales bill from financial intermediaries before it is due. When a firm sells goods on credit and gives its customers a period of 30 days or more to pay, the bank or any other financial intermediary can buy these invoices at a discount. These intermediaries charge a fee for their service. Thus, bill discounting can be referred to as the selling of invoices to invoice discounting companies at a value less than the invoice before the due date of payment. The bill or invoice under bill discounting is called a bill of exchange, which is a negotiable instrument. Like a currency note provides value written over it to the bearer of the instrument a discounted bill is either payable to the bearer or payable to order. This means that after discounting a bill, a bank can get the bill discounted further from other banks.
Other Sources of short term Finance
- Fixed deposits
- Advances received from customers