9. Sources of short-term finance Flashcards
What are internal sources of short-term finance? How can increasing working capital management efficiency be a good source of shortterm internal finance?
Internal sources of short-term finance are funds generated internally by the business in its normal course of operations. For example, the business can raise short-term finance through cash improvements gained by reducing or controlling working capital. Similarly, it can sell assets that are no longer really needed to free up cash or use its internally generated retained earnings.
Internal sources of short-term finance mainly include:
reducing or controlling working capital
reducing inventories
tighter credit control
delaying payments to suppliers
sale of redundant assets
retained profits
A higher level of working capital represents a large commitment of finance and a significant opportunity cost in interest. Efficiency savings generated through efficient management of trade receivables, inventory, cash and trade payables can reduce a bank overdraft and interest charges as well as increase cash reserves that be re-invested elsewhere in the business.
If a company is risk-averse, why might it be more likely to choose a
higher level of working capital? What are the factors to consider in
choosing the right balance of working capital?
If a company is risk-averse, it will choose to have a higher level of working capital so that it has more than enough current assets to meet all of its shortterm financial obligations. A high level of working capital is considered a sign of a company with the potential for growth. Higher working capital indicates liquidity and that it will be easily able to convert its assets into liquid assets or cash to fulfil its obligations.
Working capital has the following components:
current assets: inventory, accounts receivables and cash
current liabilities: accounts payables and bank overdraft
The main objective of working capital management is to get the balance of current assets and current liabilities right. This can also be seen a trade-off between cash flow versus profits. A reduction in working capital and the efficiency savings generated through efficient management of trade receivables, inventory, cash and trade payables can reduce bank overdraft and interest charges as well as increasing cash reserves that can be re-invested elsewhere in the business.
However, too low a level of working capital can result in the inability of a company to meet obligations as they fall due, with the risk of default and insolvency. Similarly, too high a level of working capital represents a large commitment of finance and a significant opportunity cost in interest.
The optimum level of working capital is a trade-off between liquidity and profitability. A company should have current assets sufficiently liquid to reduce the risk of insolvency but also considering profitability by reducing the cost of overtrading and overstocking.
Overdraft specifics
Useful to meet fluctuating financial needs.
The amount can vary on a daily basis.
A limit is agreed with the bank.
Interest rate is usually high.
Interest is charged on a daily basis.
Repayable on demand
Advantages of overdraft
Easy to use.
Immediate access to finance.
Can be reduced anytime if surplus cash is available.
Usually not included in the calculation of capital gearing.
Interest payment is tax deductible.
Usually not included in the calculation of gearing.
Disadvantages of overdraft
Interest rate is linked to LIBOR and hence not predictable.
In theory, overdraft is risky because it is repayable on demand.
May need to offer security.
Banks charge an annual fee on top of the interest.
What is invoice discounting?
The seller borrows from an invoice discounter using the invoice to a customer as collateral.
Up to 80% of the amount is receivable immediately.
Flexible way of financing as the seller can choose the invoice to be discounted.
Advantages of invoice discounting
A quick method to provide trade finance.
Does not need separate collateral.
The seller can finance the working capital needed for other sales transactions.
The buyer gets an interest free credit period.
If necessary, the discounting of the bill need not be ‘disclosed’ to the customer.
Cheaper than offering cash discounts.
Disadvantages of invoice discounting
The fees charged by the discounter reduce the profit margin.
Some customers feel uneasy when their bills are discounted with an external party.
Not all invoices meet the standard for ‘discount-grade’ bill.
Over reliance may create a poor image of the seller in the trade circles..
Factoring
‘whole-sale invoice discounting’. (Don’t use in the examinations)
A business sells all or selected account receivables to a ‘factor’.
The factor advances about 80% of the total value of outstanding invoices.
At the end of the credit period the money is collected from the customer by the
i) factor (disclosed factoring) who then forwards the balance after deducting a fee.
ii) seller (undisclosed factoring) who sends the advance to the factor adding the fee.
Advantages of factoring
Provides immediate access to funds.
The credit control expertise of the factor will be useful in avoiding bad debts.
Can be arranged by a number of organisations.
Other lines of credit are not affected.
Disadvantages of factoring
Not cheap
Disclosed factoring may not be viewed favourably by all customers
With recourse-factoring the risk of bad debt is stil borne by the company
Control of customers is lost with without recourse factoring
New developments
Crowd funding - high return, high risk, usually web-based
Peer to Peer lending
Invoice tradng third party platforms
Advantages of new developments:
Quick access to funds
Borrowers and lenders are connected via the internet.
Can be arranged according to the financing needs of the borrower.
The borrower can avoid unnecessary financial distress.
Disadvantages:
High risk is often associated with new types of finance.
Very expensive ( from borrower’s point of view) .
Not suitable for large sums.
Market is still evolving and not all the associated risk are known.
Internal sources of short term finance
Reducing working capital
- Reducing inventory levels (advatages: reduces holding costs; mimises obsolescence and damage; frees up money-opportunity cost) and (disadvantages: risk of stock out, lost of production time, quantity discounts may be lost)
- Tightening credit control (advantages: frees up capital; bad debts reduced; cost of credit control decreased; reduces opportunity cost) and (disadvantages: loss of customers, reduced sales, profit loss due to reduced sale)
- Delaying payment to suppliers (advantages: improves short term cash flow, no interest on delayed period; reduces own working capital finance) and disadvantages (cannot be used for long time; suppliers may refuse credit in future; loss of reputation
Sale of redundant assets (advantages: frees up capital from an unused asset, no dilution in ownership control) and (disadvantages: no asset available for sale, a one-off event, time to find a buyer; not easy to sell at profit.
Retained profits
Chapter 8 summary
Chapter summary
The main sources of finance are external (raised from outside the business).
External sources of short-term finance available to businesses include:
– bank and institutional loans;
– overdrafts: pre-agreed facilities provided by banks and financial
institutions that allows a withdrawal of money in excess of the
account’s credit balance;
– debt factoring: a financial arrangement whereby a business sells trade
receivables at a price lower than the realisable value to a third party,
known as the factor, who provides an immediate cash fund and takes
responsibility for collecting money from the customers;
– invoice discounting: whereby a company can borrow cash from
financial institutions against the invoices raised;
– alternative finance and online innovation: provides a 21stcentury
alternative to traditional banks; it includes rewardbased
crowdfunding, peer-to-peer lending and invoice trading thirdparty
payment platforms.
Internal sources of short-term finance mainly include the reduction or
controlling of working capital – efficiency savings generated through
efficient management of trade receivables, inventory, cash and trade
payables. These include:
– reducing inventories
– tighter credit control
– delaying payments to suppliers
– sale of redundant assets
Retained profits can be used as both long-term and short-term finance.
