Short and long term financing

Question 1

What is short term finance?

Answer 1

Short-term finance, also called working capital financing, is used to fund business requirements for working capital.

It is normally repayable within one year of the year end.

Its prompt availability enables businesses to seize business
opportunities and run their day-to-day operations.

There are various sources of short-term finance available which require varying levels of collateral and interest rate expense. Short-term finance may be either internal or external.

The main sources of finance are external (raised from outside the business). External sources of short-term finance available to businesses include:

1. bank and institutional loans
2. overdrafts
3. debt factoring
4. invoice discounting
5. alternative financing, such as crowdfunding and other online innovations

Question 2

What do we mean by bank and institutional loans?

Answer 2

Bank and institutional loans are the most popular type of finance. Bank loans are generally a quick and straightforward option for raising short-term business finance.

1. They are usually provided over a fixed period of time and can be short term or long term, depending on the purpose of the loan.
2. Lending to companies for less than one year is considered to be a short-term loan.
3. Loans can be negotiable, whereby the rate of interest, repayment dates and security for the capital offered must be agreed depending on the risk and credit standing of the company.
4. Short-term loans are less risky than loans with longer
   terms and may be the only type of loan available to new businesses.

Question 3

Secured vs Unsecured loans

Answer 3

Secured Loans

Banks and other finance companies often require security for a short-term loan just as they do for a long-term loan.

Security for short-term loans usually consists of trade receivables, inventories or both.

For example, invoice financing uses trade receivables. If the business fails to repay, the lender may take action to seize the security and take legal proceedings against the company. Company directors may also be personally liable, depending on how the loan was arranged.

Unsecured Loans

The most common way to finance a cash deficit is to arrange a short-term, unsecured bank loan. Unsecured loans are normally taken for smaller amounts and take place over a shorter period of time.

Businesses generally pay more interest with unsecured loans as they are not backed up by an asset. There is a higher risk for the lender, as they have no guarantee of getting their money back.

Firms who use short-term bank loans often arrange a line of credit – an agreement between a bank and a customer that establishes a maximum loan balance that the lender permits the borrower to access or maintain.

To ensure that the line is used for short-term purposes, it works as a revolving account.

The borrower can spend, repay it and spend it again, in a virtually never-ending, revolving cycle.

Examples of unsecured lending is using a credit card.

Question 4

What are loan covenants?

Answer 4

Loan covenant

A term loan is conditional on a loan covenant. A loan covenant places a restrictive clause in a loan agreement that
places certain constraints on the borrower, with reference to:

1. financial reporting:

requiring lenders to submit management reporting, including cash flow and forecasts, on a regular basis (such as every quarter);

2. financial ratios:

getting debt or liquidity ratios within an agreed range or requiring working capital to be maintained at a minimum level;

3. regulatory reporting:

requiring the statutory financial statements to be audited annually; or

4. debt covenants: restricting the borrower’s ability to take on more debt without prior consent of the lender or
   forbidding it from undertaking certain activities.

Question 5

What are the advantages of loans on a company?

Answer 5

Advantages of loans on a company are:

1. Loans can be set up in a short space of time, providing access to money quickly.
2. Businesses normally prefer unsecured loans as they are considered less risky than loans with longer terms
3. They are good for budgeting as they require set repayments spread over a period of time.
4. Loans have more flexible terms than some other sources of short-term finance. For example, they may provide the
   option for interest-only payments with the balance of the loan to be paid off at a later date.
5. Banks do not put as much emphasis on the credit history of the business as they do for longer-term loans.
6. Loans do not require giving up control of or a share of the business

Question 6

What are the Dis-advantages of loans?

Answer 6

Dis-advantages of loans are:

1. Short-term loans usually have higher interest rates than long-term loans.
2. Loans can compound debt problems if a business cannot obtain cheaper long-term finance.
3. Defaulting on repayment can damage credit status.
4. A term loan is conditional on a loan covenant. The bank can demand repayment of the loan if the business defaults.

5 There is normally an extra charge for early repayment.

Question 7

What is an overdraft and what are the advantages?

Answer 7

An overdraft is a pre-agreed facility provided by banks and financial institutions that allows a withdrawal of money
in excess of the account’s credit balance.

It is a common way of financing small and medium entities (SMEs) and is often used as a back-up form of financing to ease pressures on working capital.

Overdrafts are ideal for those with fluctuating finance requirements, particularly when a company has to provide for unexpected expenditure such as paying for repairs and maintenance.

They are either provided over a fixed period of time
or as a rolling facility with no end date.

There is no penalty for repayment of an overdraft, unlike the early repayment of a loan

Question 8

What are the advantages to a business having an overdraft?

Answer 8

Advantages to a business having an overdraft?

1. Overdrafts are easy and quick to arrange with immediate access to funds.
2. Unlike many loans, an overdraft can normally be cleared anytime without an early repayment penalty.
3. They serve as backup against unexpected expenditure.
4. The bank normally allows for an interest-free period with interest paid only on the overdrawn balance.
5. They do not require giving up control of or a share of the business, unlike equity financing arrangements.

Question 9

What are the dis-advantages of an overdraft?

Answer 9

Overdraft Disadvantages:

1. Interest is unpredictable as it depends on a variable interest rate and on the amount overdrawn on each day of the charging period.
2. Overdrafts are repayable on demand without prior notice, although this is unlikely unless the business experiences
   financial difficulties.
3. A higher rate of interest is charged for using the unauthorised facility
4. Banks often charge an annual arrangement or maintenance fee for providing an overdraft facility.
5. Failure to pay the interest charges or going back into credit on a regular basis can lead to a fall in credit score.

Question 10

What is debt factoring?

Answer 10

Debt factoring

Debt factoring, or invoice factoring, is a financial arrangement whereby a business sells all or selected trade
receivables at a price lower than the realisable value to a third party, known as the factor, who takes responsibility for
collecting money from the customers.

The arrangement provides an immediate source of cash to the business selling its trade receivables.

There are two types of factoring:

1. With recourse
2. without recourse

Question 11

There are two types of factoring:

1. With recourse
2. without recourse

explain each of the above.

Answer 11

1. With recourse:

the borrower maintains control over the trade receivables and collects from customers. The factor assumes no responsibility for bad debts.

Credit risk of non-payment by the debtor is borne by the borrower and trade receivables are essentially used as collateral.

This approach is least visible to customers and allows
borrowers to keep customers from knowing about any factoring arrangements.

2. Without recourse:

the factor takes control and bears the responsibility for bad debts and any risk of non-payment, subject to the payment of an additional fee.

The lender advances a certain percentage, normally around
80% of the value of the debt, within two or three days of the factoring arrangement.

Besides the assured cash flow, the administrative burden of the supervision of trade credit is reduced, which may be important for small and growing businesses.

The lender monitors all trade receivables due from the customers of the borrower and has payments sent to the lender’s designated location. The factor subsequently pays over the balance, less its administration costs, to the company.

Question 12

What are the advantages of debt factoring?

Answer 12

What are the advantages and disadvantages of debt factoring?

Advantages

1. Debt factoring provides an immediate source of finance.
2. Start-up businesses and SMEs can benefit from factoring when they cannot gain access to other forms of cheaper
   finance.
3. Debt collection, when outsourced, can increase cash by providing savings in credit management and certainty in
   cash flows.
4. The factor’s credit control system can be used to assess the creditworthiness of both new and existing customers.
5. Reduces the probability of bad debts for the company.

Question 13

What are the disadvantages of debt factoring?

Answer 13

Dis-advantages of debt factoring:

1. Factoring can be expensive, with costs normally running at between 2% and 4% of sales revenue.
2. Debt collection, when outsourced, raises fears about its viability. This may endanger the company’s trading
   relationships with customers who may not wish to deal with a factor.
3. The company risks losing control over its trade receivables and granting credit to its customers.
4. 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.

Question 14

What is invoice discounting?

Answer 14

Invoice discounting, also referred as ‘bills discounting’ or ‘purchase of bills’, is a short-term borrowing arrangement
whereby a company can borrow cash from financial institutions against invoices raised with customers.

The company uses unpaid trade receivables as collateral.

Generally, a company can use up to 80% of the value of all invoices which are at less than 90 days to borrow within 24
hours.

Invoice discounting is a quick way to improve cash flow but may cause management to lose focus from the administrative and compliance aspect.

Invoice discounting should be used as an additional facility. The key focus should be on improving credit control to improve the working capital cycle and liquidity.

Question 15

What are the advantages of invoice discounting?

Answer 15

Advantages of invoice discounting:

1. Invoice discounting is a quicker method to procure cash than through loans and overdrafts (which often require a
   credit check).
2. It provides significantly more cash than a traditional bank.
3. It accelerates cash flow from customers, since generally up to 80% of the invoices can be converted into cash.
4. The borrowers maintains control over the trade receivables.
5. Confidentiality of the arrangement can be maintained.
6. The company can obtain the cash it needs while also allowing the normal credit period to its customers.

Question 16

What are the dis- advantages of invoice discounting?

Answer 16

Dis-advantages of invoice discounting:

1. The additional fees charged by the discounting providers decrease the company’s profit margin.
2. 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.
3. As it is available only on commercial invoices, payments owed from the general public may not be eligible for
   invoice discounting.
4. When a business relies heavily on invoice discounting, it may cause management to lose its focus from strengthening its credit norms.

Question 17

What are the alternative source of finance for businesses?

Answer 17

Alternative source of finance for businesses:

1. reward-based crowdfunding
2. peer-to-peer (P2P) lending
3. invoice trading third-party payment platforms

Question 18

Explain each of the following:

1. reward-based crowdfunding
2. peer-to-peer (P2P) lending
3. invoice trading third-party payment platforms

Answer 18

1. reward-based crowdfunding

• raises funding mostly via the internet (ie. kick-starter, go fund me) , to support a business venture, project or local initiative.
• the investors will sometimes receive shares in the business or a reward such as early receipt of a product and or a discount on the price of the product.
• It uses social media to raise money alongside traditional networks of friends, family and work acquaintances.
• it is used by those with fewer resources
• Crowdfunding platforms may offer higher returns, though there are usually greater risks and new challenges.

2. peer-to-peer (P2P) lending

• Peer-to-peer (P2P) lending, sometimes referred to as crowdlending, is a business borrowing from a collection of private investors, usually through an online platform such as Funding Circle, RateSetter. etc
• The P2P lending business facilitates the arrangement by matching lenders with borrowers and credit-checking the
  borrowers.
• P2P lending operates online therefore operating with lower overheads and providing a lower cost service than traditional lenders.
• As a result, both the lenders and the borrowers expect to get a better rate than they would through banks.

Businesses borrowing money apply online and the software determines the credit risk and the rate of interest to be charged.

• Peer-to-peer loans are normally unsecured but Secured loans are sometimes offered by using luxury assets and other business assets as collateral.

3. invoice trading third-party payment platforms

• Peer-to-peer invoice trading is a new type of invoice finance where businesses (usually SMEs) auction their outstanding invoices via centralised online platforms such as MarketInvoice and Platform Black to obtain immediate cash to boost their working capital.
• It provides an online solution that connects businesses selling invoices with investors lending against those invoices
  for an attractive return.
• The platform charges a fee from both the businesses and the investors for the service provided.
• It provides finance more cheaply and quickly than from traditional providers.

Like factoring, businesses receive funds against invoices without having to wait for the invoices to be settled.

• Unlike factoring, invoice-trading platforms provide finance against individual invoices
• There are no setup or termination fees.

-The business is in control of the number of invoices they sell on a pay-as-you-go basis. Funds can be accessed the same day, with easy applications and online administration

Question 19

Advantages of alternative financing?

Answer 19

Advantages and dis-advantages of alternative financing?

Advantages

1. provides quick access to money with online applications.
2. It provides new and innovative ways to connect borrowers and investors via the internet.
3. It can save businesses from unexpected financing distress.
4. It provides access to funds previously unavailable by use of non-traditional forms of determining credit worthiness,
   often in conjunction with credit reports.

Question 20

Dis-advantages of alternative financing?

Answer 20

Dis-advantages of alternative financing:

1. Alternative financing is not subject to regulatory reporting requirements in many jurisdictions.
2. It costs significantly more than annualised rates associated with conventional financing – anywhere from 30% to 50%.
3. The amount of money that can be borrowed is quite limited (typically less than £100,000).
4. Small businesses simply may prefer working with more established, well-recognised institutions.
5. Lenders are subject to increased risk losses due to fraud.
6. The market is still evolving with new platforms carrying the different level of risk for both lenders and borrowers.

Question 21

What are internal sources of short term finance?

Answer 21

Internal sources of short term finance:

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 the level of
or improving control of working capital.

Similarly, it can sell assets that are no longer needed to free up cash or use its internally generated retained earnings.

Internal sources of short-term finance mainly include:

1. Reducing or controlling working capital

– reducing inventories
– tighter credit control
– delaying payments to suppliers

2. sale of redundant assets
3. retained earnings