Short-Term External Financing: Options and Strategies
Short-Term External Financing
Short-term external financing includes all funds raised by a company from external sources, with a maturity of one year or less. Common instruments include:
- Commercial loans and supplier credit
- Short-term bank loans
- Discounts on commercial paper
- Sales of receivables (factoring)
Trade and Supplier Credit
Also known as trade credit, this type of financing arises from the payment terms offered by suppliers after a sale. These terms typically range from 30 to 90 days, allowing the customer time to generate revenue from the purchased goods before payment is due.
Loans and Short-Term Bank Loans
A short-term bank loan involves providing capital to a borrower who agrees to repay the principal plus interest within one year. There are several categories:
- Seasonal Loans: These loans are used by companies with seasonal activities, such as agricultural businesses. Funds are typically used to purchase raw materials or pay wages during production periods before sales occur.
- Loans On Demand: These loans allow the borrower to use funds with the agreement to repay the full amount plus interest at a specified time.
- Secured Loans: These loans are backed by collateral, such as securities, commodities, or livestock. The value of the collateral is considered in addition to the borrower’s creditworthiness.
Details of Short-Term Bank Loans
Two common modes of short-term bank loans are:
- Bank Overdraft: This involves using an amount exceeding the available balance in a checking account. The company must repay the overdrawn amount plus interest. The advantage is immediate availability.
- Credit Account: This involves a financial institution granting a credit limit, allowing the company to draw funds as needed without using the maximum available. The company pays interest on the funds used, along with fees for the credit line and for any unused portion of the credit line. A credit account provides a maximum amount of funds available to the company for a given period, with interest only charged on the amount and time used. The company can deposit and withdraw funds at any time.
Discounts of Commercial Paper
Discounting commercial paper involves selling accounts receivable to a financial institution to receive an advance on the funds. The financial institution deducts fees and interest from the face value of the receivables.
The interest charged by the institution for advancing the funds before maturity is called a discount. If the bill is not paid, the bank charges the company the amount plus return shipping fees. The bank advances the face amount less the discount and costs. The client’s debt is included in the company’s current assets and short-term debt on the balance sheet.