Discuss and evaluate the potential sources of short-term finance available to businesses, identifying the circumstances in which each would be appropriate - Essay Example

Potential sources of short-term finance available to businesses Introduction Short-term financing, also referred to as working capital, is a form of financial cadent representing the circulating cash flow, accessible to corporate houses, trade organisations and governmental bodies, which generally must be paid back within a period of one year (Pike and Neale, 2008).Working capital, along with medium-term financing, is considered as the third most important type, in terms of funding, after equity and long-term debt financing, especially for corporates and traders (Arnold, 2009).

While discussing short-term finances, Stutely presents a rather simplified definition of working capital, which states, “current assets less current liabilities” (2003, p.276). Here short-term (current) assets may comprise of debtors, inventories (related to purchase of raw materials), trade receivables, present state of work and completed products, cash and short-term investments (Arnold, 2005, p.625). Short-term liabilities comprise of creditors, short-term loans and bank credits (ibid).

Working capital is necessary for any business firm to operate, as short-term funds are required to “finance its stocks, through the manufacturing process, from the raw materials to finished goods, and also the time lag between delivery of the goods or services and the payments of customers of accounts receivable” (Davies and Boczko, 2005, p.557). In this context, the paper will now examine the potential sources of short-term finances available to business firms. Discussion Management of working capital cycle (represented in fig 1) is important for long-term sustainability of any firm.

Working capital is akin to engine oil which, if missing the non-current assets of a trader/firm, would fail to function (Pike and Neale, 2008, p.337). Therefore, higher the rate at which the short-term assets of a firm manages to surpassits short-term liabilities, greater the chances are for that firm to achieve solvency (based on the type of its short-term assets) (ibid). Fig 1: Short-term financing or working capital cycle (Arnold, 2005, p.644). Effective management of this cycle is important for the long-time survival any firm; hence, the necessity of seeking sources of short-term financing by the business firms.

Sources of short-term financing The chief sources of short-term financing include bank overdraft/credit, commercial papers or bills, trade credits, invoice finance, factoring and leasing, and leasing (Arnold, 2005; Levy, 2002; Pike and Neale, 2008, p.379-380). Trade credit: it refers to the time granted (credit period of 30-90 days) by raw material suppliers to business firms/traders (as they start their work), before payment must necessarily be made. Here there are no involvements of direct funds but there is purchase facilitation with no paying of interests, and its easy availability makes it a popular choice amongst business firms (Pike and Neale, 2008, p.380). Here credit terms are equated with discounts for when payments are made within the stipulated period.

As for example, a supplier may give 3% discount if a trader makes the payment within 10 days from the date of billing. If the trader does not agree to the discount, then complete payment is compulsorily due within 30-90 days from date of billing (Levy, 2002). Bank credit: Commercial banks provide traders with short-term finances, referred to as bank credit, and in such cases, the debtor can have access to one-time credit or he may receive the credit in instalments. Banks can give credits in various ways, like overdrafts, cash credit, loans, cash credit, or discounted bills (Pike and Neale, 2008, p.382). Bank loans refer to the process when financial advances are given by a bank (against assets security of the firm) that must be repaid within a certain period.

In cash credits, a bank may allow a trader to withdraw money up to a certain limit, and this is known as the credit limit (ibid). The credit limit is initially for only a year, however, is renewable in nature.The interest rate depends on the limit fixed for the trader, and banks provide cash credit against collateral security. Overdraft is allowing a firm/trader to withdraw cash more than the amount actually present in the bank account (to a certain limit) and is based on the debtor’s credit-worth.

Banks also give credit to firms/traders by way of promissory notes and discounting bills, which when presented to the bank, the amount is credited to the borrower’s account, once the discount is removed (Pike and Neale, 2008, p.382-384). Commercial papers/bills: are popular amongst large trading houses for receiving quick short-term funds from financial market. A bank generally issues the papers on behalf of the firm, helps in seeking investors for the papers and, in turn, receives a commission for playing the role of an intermediary in raising funds for the company (Brealey, Myers and Marcus, 2008).

Factoring: refers to trading off a firm’s debt in exchange for liquid cash, and comprises of fund-raising where the company’s debt is held as security, in order to get money earlier, without waiting for debtors to make the payment. Since this involves risk, it is possible only if the firm and its debtors have the strength of solvency and a history of high integrity (ibid). Invoice finance: here debts are traded to the one (a factor) that makes a downright payment of a certain agreed % ofthe debt value, and here only monetary exchange takes place, on which there is a fixed interest.

Thus, the factor is the debt purchaser and the firm becomes the agent for debt collection (Pike and Neale, 2008). Leasing: A short-term finance used for getting to use certain assets without having to actually buy them. This is used for leasing machines, factories, furniture and other items, to be used only for a short time (Arnold, 2009). Conclusion Short-term finances are extremely important for the smooth operation of any business firm and their long-term survival in the market. Hence, it is also important for the business houses to select the right source of working capital to complete an undertaken project successfully.

References Arnold, G., 2009. Corporate Financial Management (4th Edition). Harlow: FT Prentice Hall. Arnold, G., 2005. Essentials of Corporate Financial Management (3rdedition). Harlow: Pearson education limited. Brealey, R., Myers, S., Marcus, A., 2008. Fundamentals of Corporate Finance (6th Edition). NY: McGraw-Hill. Davies, T., & Boczko, T., 2005. Business accounting finance (2nd edition). Maidenhead: McGraw-Hill education (UK) Limited. Levy, H., 2002. Fundamentals of Investments. Harlow: FT Prentice-H. Pike, R., & Neale, B., 2008. Corporate Finance and Investment (6th edition).

Harlow: FT Prentice Hall. Stutely, R., 2003. The definitive guide to managing the numbers (1st edition). Harlow: Pearson education limited.