14.1 Short term finance

Question 1

Management of short term finance

Answer 1

must be carefully managed to ensure current liabilities are not allowed to increase to a level where the cash position and liquidity of the entity is at risk

Question 2

Types of short term financing

Answer 2

• Trade payables
• Factoring or invoice discounting of trade receivables
• Bank overdrafts and short term loans
• Financing exports

Question 3

Trade payables

Answer 3

• A source of short term finance by taking advantage of credit terms offered by suppliers
• By paying on credit the entity is able to fund its inventory of material through its suppliers
• To maximise this benefit the entity should aim to pay as late as possible without damaging its trading relationships with its suppliers

Question 4

Trade payables and cash discounts

Answer 4

• if a cash discount is offered by supplier for early payment the entity must weigh up the saving from discount against the additional cost of borrowing the funds needed to finance the early payment
• entity must also be aware whether the funds are available to take up the discount

Question 5

Benefits of paying suppliers late

Answer 5

• Alleviates cash flow difficulties
• Cash can earn a return whilst still in the paying entitys account

Question 6

Potential problems when paying suppliers late

Answer 6

• loss of any settlement discount
• could obtain a poor credit rating
• suppliers may stop further supplies
• supplier may increase future selling prices to compensate
• could face legal action from the supplier

Question 7

Receivables can be used as a source of short term finance by

Answer 7

• Factoring
• Invoice discounting

Question 8

Factoring

Answer 8

• The debts of an entity are sold to a factoring company (normally owned by bank)
• The factor may take on the responsibility to collect the debt for a fee
• The factor is often more successful at enforcing credit terms, leading to lower levels of debt outstanding
• Factoring is therefore not only a source of short term financing but also an external way to control or reduce level of receivables

Question 9

The factor offers three services

Answer 9

• Debt collection (credit control function) - this is outsourcing of the credit control department to the factoring entity
• Financing - funds may be advanced to the entity before debt is collected (may provide financing element of the arrangement)
• Credit insurance - factor may take responsibility for irrecoverable debt, factor would dictate to whom the entity can offer credit (aka without recourse factoring)

Question 10

Invoice discounting

Answer 10

• This is a service also offered by a factoring entity
• Selected invoices are used as security against which the entity can borrow funds
• This is a temporary source of finance, repayable when the debt is cleared

Question 11

Key advantage of invoice discount

Answer 11

• it is a confidential service and the customer need not know about it
• key financing tool for new businesses (such as management buyouts), creditworthiness of their customers is probably higher

Question 12

Financial institutions

Answer 12

• Are entities where the core focus is on dealing with financial and monetary transactions
• These transactions can be wide ranging and complex and include deposits, loans, investments and currency exchange
• Includes a broad range of business operations within the financial services sector including all forms of banks, trust companies, insurance companies, brokerage firms and investment dealers

Question 13

The main financial institutions which provide short term finance to entities are

Answer 13

• The retail and commercial banks and increasingly internet banks
• Other FI are more typically involved in long term finance or other financial aspects

Question 14

The main types of short term finance provided are

Answer 14

• short term loans
• overdraft facililites

Often also provide factoring and export services

Question 15

Short term borrowing - Bank overdrafts

Answer 15

• Short term, flexible financing linked to company bank accounts that are in deficit
• mainly provided by clearing banks and are an important source of finance for an entity

Question 16

Advantages of bank overdrafts

Answer 16

• Flexibility
• Only pay interest on the balance owed (generally cheaper)

Question 17

Disadvantages of bank overdrafts

Answer 17

• Repayable on demand
• May require security
• Variable finance costs

Question 18

Short term borrowings - Bank loans

Answer 18

• Are a contractual agreement for a specific sum, loaned for a fixed period, at an agreed rate of interest
• they are less flexible than overdrafts, can be more expensive but provide greater security

Question 19

Financing exports (problem)

Answer 19

Entities exporting goods to other countries often have much greater problems with credit and finance than entities selling goods to domestic markets

Question 20

Several methods are available for dealing with problems of financing exports and controlling the credit risk

Answer 20

• Documentary credits
• Bills of exchange
• Export factoring
• Forfaiting

Question 21

Documentary credits (irrevocable letters of credit)

Answer 21

• Trading between countries can be complex, especially when it will take time to ship goods
• The exporter will want payment asap and importer needs to sure terms of sale have been met
• This can be overcome by using a irrevocable letter of credit - an undertaking given by issuer that payment will be guaranteed if terms are met within specified time
• It is issued by bank on behalf of customer, authorising someone to draw a specified amount of money from its branches when conditions are met

Question 22

A bill of exchange (aka acceptance credit)

Answer 22

• is used primarily in international trade and binds one party to pay a fixed sum of money to another party on demand or at a predetermined date (similar to post dated cheque)
• Supplier of goods (drawer) can draw a bill of exchange on a customer (drawee)

Question 23

There are two types of bill of exchange

Answer 23

• A sight draft / bill - which is payable immediately
• A time draft / bill - which is payable at a predetermined future date
• The drawer of a bill of exchange (the supplier) can sell an accepted time draft to a third party (discounting) in order to receive cash earlier than the maturity date
• Or the drawer could transfer the bill to one of its own suppliers to settle debt (transfers customers debt to a third party)
• The drawer and payee are often the same person

Question 24

Significant characteristics of bills of exchange

Answer 24

• The drawee is given a period of credit before having to pay a term bill, but
• The drawer or payee can obtain payment earlier than maturity date, by discounting the bill
• When a bill is discounted it is sold in the financial markets at a discount to face value
• The size of the discount represents the interest rate required by buyer for holding bill to maturity

Question 25

Export factoring

Answer 25

- Similar to ordinary factoring, but the factoring entity agrees to factor the clients export trade receivables (overseas trading) - The factors services include administration of receivables ledge and collecting payment and providing factor finance - The export factor buys the sellers overseas receivables for a lump sum often lower than the outstanding debt owed - The expertise of an export factor can be very helpful particularly for smaller businesses with little experience in collecting foreign payments

Question 26

Forfaiting

Answer 26

- Is the same as export factoring except that the seller (exporter) will receive 100% of the receivable as a lump sum from the forfaiter - The exporter will draw a bill of exchange from an importer (the buyer), this is then purchased by forfaiting company (typically banks) without recourse to the exporter - The exporter receives the total amount owed, the forfaiter chases the debt and the importer settles direct to the forfaiter - The exporter has obtained payment for goods without any risk of having to return money if importer fails to meet payment obligations

Question 27

The key features of forfaiting are

Answer 27

- The importer obtains medium term finance for much of the purchase cost of the goods - The exporter receives immediate payment - The credit risk is accepted by the forfaiting bank, although this risk is reduced by the guarantee of the promissory notes (aka bill of exchange)