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Sources of Short-Term Capital

By: Mrs. Belen Apostol

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Sources of Short-term Capital

• The total business finance function is composed of three segments:

1.Short-term financing

2.Intermediate-term financing

3.Long-term financing

»Short-term financing – deals with the demand for supply of short-term funds which may either be secured or unsecured.

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Advantages of Short-term Credits

1. They are easier to obtain – the risk involved in lending funds varies according to the length of payment period.

e.g. long-term credits are more risky than short-term credits from the creditors point of view.

2. Short-term financing is less costly – short-term credit is often granted by creditors at less cost

3. Short-term financing offers flexibility to the borrower – the debtor may use other sources of credit after the short-term credit is settled.

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Disadvantages of Short-term Credits

1. Short-term credits mature more frequently – firms with slow moving inventories like manufacturing capital goods worry about short-term creditors more often.

2. Short-term debt may at times, be more costly than long-term debts-risk, collateral, general economic outlook and size of the loan are taken into consideration. Short-term credit may prove to be more costly.

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The Suppliers of Short-term Funds

1. Trade creditors

2. Commercial banks

3. Commercial paper houses

4. Finance companies

5. Factors

6. Insurance companies

7. Company accruals

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Trade Creditors

Trade creditors – credit extended by suppliers to buyers for use in manufacturing, processing, or reselling goods for profit. (from firm to another firm)

- usually unsecured

- also known as trade credit, commercial credit, mercantile credit or accounts receivable credit.

- appears as accounts receivable/ notes receivable in the books of the creditors, and as accounts payable or notes payable in the books of the debtor.

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Trade Creditors

Consumer credit – credit extended to a final consumer.

Installment credit – credit extended to a firm in the purchase of machinery and equipment and secured by the equipment sold.

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Trade Credit Instruments

1. Open-book credit – constitutes a bulk of trade credit, unsecured and permits payment for goods delivered in a specified number of days.

- source of inventory financing

2. Trade Acceptance – a time draft drawn by a seller to a purchaser, payable to the seller as payee, and accepted by the purchaser as evidence that goods shipped are satisfactory and that the price is due and payable.

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Trade Credit Instruments

3. Promissory Note – unconditional promise in writing made by one person (maker) to another (bearer), engaging to pay on demand or at a fixed or determinable future time, a sum certain in money.

- made by a buyer who has a weak credit position.

Advantages:

1. the time and amount of payment are indicated, avoiding litigation over such matters

2. may be endorsed to other parties allowing the creditor immediate use of funds tied up in such credit arrangement.

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Trade Credit

Cost of Trade Credit.

Firms extending trade credit provide incentives to firms who settle their accounts early. Those who do not avail of the trade discount incurs cost related to the trade credit which may be computed as follows:

Annual cost of Discount 360 days

Not taking = ------------- x ----------------------

Discount 1 – Discount Number of - Discount

day’s credit period

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Trade Credit

Cost of Trade Credit.

If the credit term is 2/10, net 30 , the annual cost is computed as follows

Annual cost of .02 360

Not taking = ------------- x ----------------------------

Discount 1 – 0.02 30 days – 10 days

.02 360

= ------------- x ----------------------------

.98 20

= 36.73%

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Commercial Banks

Commercial Banks – institutions which individuals or firms may tap as a source of short-term financing.

- corporations which accept or create deposits subject to withdrawal by check.

Four Components:

1. Commercial Banks

2. Development Banks

3. Savings Banks

4. Rural Banks

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Commercial Banks

Short-term loans – those with maturity periods of one year or less

-generally offered by commercial banks for purposes which included financing of business activities.

Two types of Short-term loans

1. Unsecured loan (clean loan) - does not require a collateral

2. Secured Loans – requires a collateral back-up usually for accounts receivable financing or inventory financing. (a collateral is usually required when the credit standing of the borrower is inadequate to permit unsecured loan).

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Commercial Paper Houses

Commercial Paper – short-term promissory note, generally unsecured which is sold through commercial paper dealers or directly to investors.

- used to finance companies and business firms that borrow funds in the money market.

Commercial Paper Houses (CPH) – firms that buy commercial papers.

- finance short-term fund requirements of borrowing firms.

- include banks and other financial institutions, like those engaged in selling

insurance, educational, pension and mortuary plans.

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Finance Companies

Finance Companies – engaged in making short and intermediate term installment loans to consumers, factor or finance business receivables, and finance the sale of business and farm equipment.

- funds are raised by issuing stock, bonds, borrowing from banks, and selling their commercial papers.

Three major types of finance companies:

1. Sales finance companies

2. Business or Commercial finance companies

3. Personal finance companies

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Finance Companies

Sales Finance Companies – firms specializing in the purchase of retailers of the installment receivables arising out of retail sales of automobiles, household appliances, industrial equipment, farm equipment, and other durable goods sold on the installment payment plan.

Business or Commercial Finance Companies – lend directly to a wide variety of businesses, mainly of small and medium size. Short-term loans are granted by this type of finance companies against the security ofassigned accounts receivable, inventory, and equipment.

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Finance Companies

Business or Commercial Finance Companies (cont)

When using accounts receivable as collateral, the loan arrangement may be considered as:

1. Non-notification plan – the debtors of the borrowing firm are not aware that their accounts have been pledged as collateral for a loan from a finance company.

2. Notification plan – debtors are informed that their accounts have been pledged as collateral for a loan from a finance company.

Personal Finance Companies – engaged principally in personal loans. (may include miscellaneous

business loans & commercial accounts receivable loans.)

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Factors

Factoring – purchase of accounts receivables outright without recourse to the seller for credit losses.

- the factor takes it upon himself to collect the funds from the client’s customers, absorbing any credit losses incurred.

A claim for defective goods or dispute concerning shipments, is not the responsibility of the factor.

Advantages:1. Receivables provide collateral for a loan that might not be

otherwise available to the firm

2. Accounts receivable financing provides flexibility to the firm.

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Insurance Companies

Insurance companies – provide a stable source of short-term funds.

- invest on short-term commercial papers and promissory notes

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Company Accruals

Accrual – expense that has been incurred but has not yet been paid.

- provide a source of short-term financing for business firms.

Two forms:

1. Accrued Wages and Salaries – salaries are paid as soon as they are rendered.

2. Accrued taxes – taxes has a longer time lag before it becomes due.

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Financing Requirements of the Firm & the Sources of Short-Term Capital

Financing Requirements of the Firm

Short-term Medium-term Long-term

Trade creditors

Commercial bank

Commercial paper houses

Finance companies

factor

Insurance companies

Company accruals

Open book

Trade acceptance

Promissory note

Secured loan

Unsecured loan

Sales finance companies

Business finance companies

Personal finance companies

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Thank you for

Listening!