Introduction
Short-term financing is of key importance for the firm’s short-term continued establishment because if they are not available in the short run, it means the firm’s long-term existence will be put into question. Short-term financing is finances from sources whose obligations are expected to mature within one year or less. These funds are required in order to support the current assets like cash, marketable securities, accounts receivable and inventory (McLaney E., 2003).
There exist unsecured and secured sources of short term financing for firms. The unsecured sources of finance are always limited considering the riskiness involved especially to small and growing businesses that are not financially stable. This means that the suppliers of finance are confident to a certain level on which they can offer secured form of financing and beyond this level businesses are required to pledge some security so that they can be given funds (Westerfield R., Jaffe, and Jordan, 2007).
The unsecured sources are normally cheaper than secured and easy to obtain them than long term finance hence it is advisable for businesses to use them to finance seasonal needs like inventories and accounts receivable. This will improve the overall profitability thus reducing the risk position of the firm (Brealey R. Myres, S. and Marcus, J., 2001).
Unsecured short-term finances can also be obtained from banks in form of loans. These loans are normally self liquidating by creating a process to repay itself depending on the use it was taken for. The major ways in banks offer unsecured short-term loans are notes, line of credit and revolving credit agreements (McLaney E., 2003). The advantages and disadvantages of short term financing are;
Advantages
- Short term finances are risky since they can be paid on demand or within the stated period and normally the duration is short whereas others can be terminated any period depending on the financial position of the company.
- During winding up of the company, they are given last priority.
- They have no voting rights in the company’s general control.
- Flexibility – they can be used any time it is required for instance bank overdrafts can be used so long as the company does not exceed the required limit. In addition, credit period can be extended depending on the goods or services supplied.
- Reliable – any company can easily access this facility so long as it meets the requirements.
- Not expensive – interest rates are usually above the base rate and are tax deductible (Westerfield R., Jaffe, and Jordan, 2007).
Disadvantages
- Short term finances are risky since they are legally repayable on demand or within a certain stated period depending on the financial position of the company.
- Security is usually required by way of fixed or floating charges on assets or sometimes in private companies by personal guarantees from owners.
- Interest costs vary with bank base rates (Schlosser M., 2002).
Accounts Payable
This is a short term form of financing which is created by the purchase of raw materials on credit. Here the transaction is between the buyer and the seller. The buyer purchaser is under obligation to pay the seller the amount required by the seller’s terms of sale upon accepting the goods. The seller issues the invoice during delivery of the goods which states the credit terms that is extended in such delivery (Westerfield R., Jaffe, and Jordan, 2007).
Even if the supplier has no written contract except to prove that he actually supplied goods to the purchaser, under law, he has a legal claim for the assets of the firm if the firm becomes bankruptcy (Schlosser M., 2002).
Accruals
These are liabilities for services received whose payment has not yet been made. To most firms, wages and taxes are the most accrued items. Accruals can be manipulated by the firm so as to act as a source of short term financing. Employees wages can be accrued so as to increase finances for the firm if the decision of paying employees is at the discretion of the managers but it impossible to manipulate the taxes because the taxes are paid to the government. Therefore a firm can save a greater amount from wages since employees are paid for the services provided at a later period of time (Westerfield R., Jaffe, and Jordan, 2007).
This source of financing is free cost since no has no interest associated with. This therefore calls for the firm to utilize it well since it can completely damage the firms trust worthy. It means that the bills will be paid as late as possible which may damage the credit standing of the company. Also employee motivation will reduce if they will work with delayed pay hence reduced profitability of the firm. The firm can often use this method of it uses it with precautionary care (Westerfield R., Jaffe, and Jordan, 2007).
Notes
It a negotiated unsecure loan and can be obtained from commercial bank by a credit worthy business firm. This type of short term note generally has a maturity period of 30 to 90 days. The interest charges on the note are general stated as a fixed percentage tied to the prime interest rate (McLaney E., 2003). The prime interest rate is the lowest rate of interest charged on business loans to the best borrowers of the leading banks.
The prime rate fluctuates with changing of supply and demand relationships for short term funds. Banks typically determine to the prime rate on loans to various borrowers by adding some type of risk premium to the prime rate to adjust it for the borrower’s riskiness (Brealey R. Myres, S. and Marcus, J., 2001). This riskiness is a composite of the perceived business and financial riskiness of the borrower. The premium may be anything from 0 percent to 4 percent, although most unsecured short-term notes carry premiums of less than 2 percent. In general commercial banks do not make short-term unsecured loans to businesses that are believed to be questionable risks (McLaney E., 2003).
Line of credit
This is an agreement between a commercial bank and a business firm by stating the amount of unsecured short term borrowing the bank will make available to the borrower. A line of credit agreement is typically made for a period of one year and often places certain constraints on the borrower. A line of credit agreement is not a guaranteed loan, but indicates that if the bank has sufficient funds available it will allow the borrower to owe it up to a certain amount of money. The major attraction of line of credit from the banks point of view is that it eliminates the need to examine the credit worthiness of a customer each time it borrows money (Brealey R. Myres, S. and Marcus, J., 2001).
Commercial paper
This consists of short term, unsecured promissory notes issued by firms with a high credit standing. Generally only large firms of unquestionable financial soundness are able to issue the commercial paper. Most commercial paper has maturities between 30 days and nine months. A large portion of the commercial paper is issued today by finance companies and manufacturing firms account for a smaller portion of this type of financing (McLaney E., 2003).
The interest paid by the issuer of the commercial paper is determines by the size of the discount and the length of the time to maturity. Commercial paper is sold at a discount from its face value and the actual interest earned is determined by certain calculations. An interesting characteristic of commercials paper is that is normally has a yield below the prime bank lending rate. This is because many suppliers of short term funds do not have the option of making business loans at the prime rate; they can invest only in marketable securities such as treasury bills and commercial paper. Since commercial paper is an extremely safe marketable securities (Brealey R. Myres, S. and Marcus, J., 2001).
Customer advances
A firm may be able to obtain short term unsecured funds through customer advances. In other words, customers may pay for all or a portion of what they intend to purchase in advance of their receipt of the goods. In many situations, where a large expensive item is being custom manufactured, the customer may be more than wiling to make an advance against the merchandise to finance a portion of the cost of production (Sterling, Robert R, 1970).
In other instances a customer may be highly dependent on supplier for a key competent and may therefore find it to his advantage to assure the suppliers success by providing financing in the form of an advance. In most instances the supplier must request the advance from the customer (Westerfield R., Jaffe, and Jordan, 2007).
Private loans
Short term in secured loans may be obtained from stockholders of the firm. Wealthy stockholder in smaller corporations may be quite willing to lend money to the firm to get it through a period of crisis. The type of arrangement makes sense from the viewpoint of the shareholder, who has vested interest in survival of the firm. Another form of private loan can be obtained by temporarily foregoing commissions for salesmen. Each of these types of loans involves the extension of unsecured credit to the firm by an interested or a concerned party (Brealey R. Myres, S. and Marcus, J., 2001).
References
Brealey R. Myres, S. and Marcus, J.(2001) Fundamentals of corporate Finance, Irwin series in finance, Boston, MA: Irwin/ McGraw – Hill.
McLaney E., (2003); Business finance theory and practice; Prentice Hall. Web.
Schlosser M.;(2002); Business finance: application, Models and cases, prentice hall. Web.
Sterling, Robert R, (1970) Theory of the Measurement of Enterprise Income. Lawrence, KS: University Press of Kansas.
Westerfield R., Jaffe, and Jordan (2007); Corporate finance core principles and applications by McGraw-Hill. Web.