Chapter 10 - Sources Of Short-term Finance Flashcards
What are examples of external sources of short-term finance available to businesses?
- bank and institutional loans
- overdrafts
- bills of exchange
- debt factoring
- invoice discounting
- crowdfunding and web-innovations
What are the advantages / disadvantages of secured and unsecured loans?
Advantages:
- can be set up in a short space of time, providing access to money quickly.
- Businesses normally prefer unsecured loans as they are considered less risky than loans with longer terms.
- good for budgeting as they require set repayments spread over a period of time.
- Loans have more flexible terms than some other sources of short-term finance, for example providing the option for interest-only payments with the balance of the loan to be paid off at a later date.
- Banks do not put as much emphasis on the credit history of the business as they do for longer-term loans.
- Loans do not require giving up control/share of the business.
- Interest and arrangement fees are normally tax deductible.
- They are usually not repayable on demand unless defaulted.
Disadvantages:
- Short-term loans usually have higher interest rates than long-term loans.
- Loans can compound debt problems if a business cannot obtain cheaper long-term finance.
- Defaulting on repayment can damage credit status.
- A term loan is conditional on a loan covenant. The bank can demand repayment of the loan if the business defaults
- There is normally an extra charge for early repayment.
What are the advantages / disadvantages of overdrafts?
Advantages:
- Overdrafts are easy and quick to arrange with immediate access to funds.
- Unlike for many loans, overdraft can normally be cleared anytime without any early repayment penalty.
- They serve as back-up against unexpected expenditures.
- The bank normally allows for an interest-free period with interest paid only on the overdrawn balance.
- They do not require giving up control/share of the business unlike equity financing arrangements.
- Interest and arrangement fees are normally tax deductible.
- Due to its short-term nature, the overdraft balance is not normally included in the calculation of the business’s financial gearing.
Disadvantages:
- Interest is unpredictable as it depends on a variable interest rate and on the amount overdrawn on each day of the charging period.
- Overdrafts are repayable on demand without prior notice, although this is unlikely unless the business experiences financial difficulties.
- A higher rate of interest is charged for using the unauthorised facility.
- Banks often charge an annual arrangement or maintenance fee for providing an overdraft facility.
- Larger facilities will often need to be secured, depending on the lender and the business’s level of risk.
- Failure to pay the interest charges or going back into credit on a regular basis can lead to a fall in credit score.
What are the advantages / disadvantages of bills of exchange?
Advantages:
- The drawer (seller) uses the bill of exchange to obtain money from its own bank or a discount house for a discounted price, thus obtaining immediate funds while allowing the buyer a period of credit.
- It is a convenient method of transmitting money from one place to another.
- The bill of exchange is a legal evidence of a transaction. It legally binds one party to pay another party a specific sum on a specific due date.
Disadvantages:
- The drawer who accepts the bill of exchange bears the risk of not being paid by the drawee. The transaction may often involve assessing the creditworthiness of the issuer before accepting the bill. When the drawee is not able to make the payment on the due date, the bill is said to be dishonoured.
- The drawer uses the bill of exchange to obtain money from its own bank or a discount house for a discounted price in order to obtain funds. The discount provided is the additional cost.
- The drawee may incur penalties if the bill is not paid on the due date.
What are the advantages / disadvantages of debt factoring?
Advantages:
- Debt factoring provides an immediate source of finance.
- It is particularly useful to companies that are expanding rapidly, as it will leave other lines of credit open for use elsewhere in the business.
- SMEs and start-up businesses can benefit from factoring when they cannot gain access to other forms of cheaper finance.
- Debt collection, when outsourced, can increase cash by providing savings in credit management and certainty in cash flows.
- The factor’s credit control system can be used to assess the creditworthiness of both new and existing customers.
- Reduces the probability of bad debts for the company.
- Non-recourse factoring allows for insurance against bad debts.
Disadvantages:
- Factoring can be expensive, with costs normally running at 2% to 4% of sales revenue.
- Debt collection, when outsourced, raises fears about its viability. This may endanger the company’s trading relationships with customers and suppliers, who may not wish to deal with a factor.
- The company risks losing control over its receivables and granting credit to its customers.
- The company still bears the risk of non-payment in factoring (with recourse) where credit risk of non-payment by the debtor is borne by the business.
What are the advantages / disadvantages of invoice discounting?
Advantages:
- quicker method to procure cash than through loans and overdrafts (which often require a credit check).
- provides significantly more cash than a traditional bank.
- accelerates cash flow from customers since generally 80% of the invoices can be converted into cash.
- No fixed assets are required as collateral – borrowings are against sales invoices.
- allows more room for credit sales by making such sales more liquid.
- The borrower maintains control over the receivables.
- Confidentiality of the arrangement can be maintained.
- company can obtain the cash it needs while also allowing the normal credit period to the customers.
Disadvantages:
- The additional fees charged by the discounting providers decrease the company’s profit margin.
- Excessive reliance on invoice discounting may not be taken very positively by all stakeholders. It can give the appearance of the borrower struggling with finances.
- As it is available only on commercial invoices, payments owed from the general public may not be eligible for invoice discounting.
- When a business relies heavily on invoice discounting, it may cause management to lose its focus from strengthening its credit norms.
What are the advantages / disadvantages of alternative finance and web innovations?
Advantages
- Alternative finance provides quick access to money with online applications.
- It provides new, innovative ways to connect borrowers and investors via the internet.
- It can save businesses from unexpected financing distress.
- It provides access to funds previously unavailable by use of non-traditional forms of determining credit worthiness, often in conjunction with credit reports.
Disadvantages:
- Alternative financing is not subject to regulatory reporting requirements in many jurisdictions.
- It costs significantly more than annualised rates associated with conventional financing – anywhere from 30% to 50%.
- amount of money that can be borrowed is quite limited (typically less than £100,000).
- Small businesses simply may prefer working with more established, well-recognised institutions.
- Lenders are subject to increased risk losses due to fraud.
- The market is still evolving with new platforms carrying the different level of risk for both lenders and borrowers.
Describe working capital and explain methods of controlling it?
- Reduction of working capital helps release funds that can be re-invested in the business
- Components: current assets: inventory, accounts receivables and cash current liabilities: accounts payable and bank overdrafts
- Reduction in working capital can be achieved by either speeding up the cycle of accounts receivable and stock, or by lengthening the cycle of accounts payable.
- Working capital finance is required for everyday costs (wages, bills, paying suppliers etc.)
- Adequate/optimum working capital should be maintained at all times
- Conservative approach: higher level of working capital, higher liquidity, cash tied up, lower profitability, lower risk
- Aggressive approach: lower level working capital, lower liquidity, cash savings, higher profitability, higher risk.
What is the reduction of inventory levels and its advantages / disadvantages?
- Cost of holding inventory includes purchasing goods, storing, insuring and managing them.
- Inventory levels need to be tightly controlled whilst retaining the capacity to meet future demand. Inventory management is balancing those 2 opposing factors for optimum profitability and cash savings.
• Advantages:
o Carrying lower inventory reduces costs of storage o Frees up money tied up and reduces risk of deterioration and theft
• Disadvantages:
o Reducing inventories risks possibility of stock-outs
o Higher risk of loss of production time
o Bulk purchase discounts may not be available
What is tighter credit control and its advantages / disadvantages?
- Used in manufacturing and retailing to ensure sales are promptly realised as cash or liquid resources
- Increases cash sales and decreases bad debt
- Discounts can be offered to encourage prompt payment
- The higher the receivables, the most cost due to opportunity cost in interest and the greater risk of losses through bad debts
- Allow too much credit = cash flow problems. Not offering credit = losing customers
• Advantages:
o Savings in opportunity cost in interest
o Reduces cost of credit control and risk of losses in bad debt
• Disadvantages:
o Tighter credit control risks losing the competitive edge of businesses providing credit and resulting in a loss of customers
o Loss of customers = reduced sales and profit.
What are the advantages / disadvantages of delaying payments to payables?
• Advantages:
o Helps cash retention to be used for other purposes
o Viewed as a source of ‘free credit’ and cheap short-term finance
o Buy now / pay later – saving on opportunity cost if paid within the agreed timeframe
• Disadvantages:
o Reputational cost from loss of goodwill that could damage the co’s credit status
o Loss of suppliers from not agreeing to the terms of credit and defaulting by not paying on time
o Supplier may increase prices in future
o loss of benefits from suppliers who provide incentives such as trade discounts on early payments
What are the advantages / disadvantages of the sale of redundant assets?
• Advantages:
o Raises finance from an asset no longer in use
o No interest charges or dilution of control associated with debt/equity
• Disadvantages:
o Surplus assets not always available for sale
o ‘one off’ source of finance (short-term solution only)
o Finding buyers can be a slow process
