Short Term Financing Loan and Trade Credit

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The financial requirement of the firm may be classified as long-term, intermediate-term, and short-term financing Loan. A requirement of these financing may differ across the firms. For the same firm, it may also differ over time. Understanding sources of financing, major provisions, cost, and other dimensions are the must to select suitable sources. We will take a look at the concept, features, and sources of short-term financing Loan with the special focus on the calculation of the cost of various sources of short-term financing Loan.

Short-Term Financing Loan

Financing requirements of firms may be classified as long-term, intermediate-term and short-term financing. Although every firm requires all these financings, their requirement may differ across the firms. Adequate provision of all these financings is the must for the firms to achieve their goals.

Short-term financing encompasses all those liabilities that are originally scheduled for repayment in one year or less. Firms require short-term financing to cover day to expenses such as the purchase of raw materials, salary, wages taxes, etc. Adequate provision of short-term financing enhances the operating efficiency of the firm. Further, it increases the morale of management, helps to face emergencies and create a better relationship with outside.

So, Every firm requires short-term financing to meet its regular expenses. However, financing requirement may differ across the firms in the industry. For the same firm, short-term financing requirement may be a different time. Therefore, understanding of timing and quantum of short-term financing requirement is the must to make the necessary arrangement for raising of short-term funds. It also facilitates to take a decision about the sources of financing to be used.

Short-term financing has some characteristics. Some of the most important characteristics are the following:

  • Cost of short-term financing may be least costly or most costly. In addition, some sources have cost-free sources. For instance, trade credit may be cost-free or most costly.
  • Although short-term liabilities are repaid within a year, some sources are continuously rolled over. Generally, funds provided by trade credit financing may remain relatively constant. When some accounts are paid, other accounts are created.
  • There are various sources of short-term financing, which are different in terms of their suitability, cost, and availability of fund, etc.

Conceptual Consideration of Short-Term Financing Loan

The financing decision is one of the crucial decision an important aspect of a corporation. This decision involves decision in relation to the amount of financing, types of financing sources of financing and timing of financing. Generally, financing requirement of a firm can be classified as long-term financing, intermediate and short-term financing Loan.

Short-term financing consists of all the liabilities that have a maturity period of one or less than one year. Short-term financing is mainly used to finance the working capital requirement of the organization. Selection of suitable sources of the short-term fund is the must to achieve the financing goal of the firm. Understanding of potential sources, their basic features, and provisions, the cost associated with them, the timing of the requirement and their management, etc, helps to achieve major goals of short-term financing.

Firms may require short-term financing for various purpose. Such financing requirement may vary over time. Generally, all sources are not suitable for all firms. Therefore, estimation of quantum and timing of requirement becomes important to arrange the short-term fund from suitable sources.

In the perfect capital market, both firms and stockholders are indifferent with regards to the use of different types of debt and maturity period. However, it matters in the imperfect capital market because of the selection of types of debt and their maturity effects on the return and risk position of stockholders. Generally, the maturity matching approach, which is also known as a self-liquidating approach, is considered a better approach to finance the working capital requirement of the firm. This approach strikes the balance between the nature of assets to be financed and the sources of financing.

So, like other sources of financing, short-term financing Loan has its own advantages and disadvantages. The major advantages and disadvantages of short-term financing are as follows:

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Advantages 

  • Economical
  • Rapidity
  • Flexibility
  • Limited/no formalities
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Disadvantages 

  • Volatility of Interest
  • Risk of non-extension of facility
  • Limited availability

Sources of Short-Term Financing Loan

Business firms may use different sources of short-term financing. Selection of appropriate sources is the must to achieve the goals of short-term financing. Sources of short-term financing may be classified as an unsecured and secured financing. Unsecured secured sources can further be classified into (1) spontaneous sources (2) non-spontaneous sources. Spontaneous sources arise naturally as part of doing business. On the other hand, non-spontaneous sources must be managed on a formal basis.

Every firm cannot obtain short-term financing from unsecured sources. These sources can be used only by the firms having a high credit rating. Therefore, newly established firms and other firms having no proven credit rating are forced to use secured sources. Secured sources of short-term financing encompass all those sources where lenders require certain assets as collateral.

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Trade Credit

Trade credit is a form of short-term financing common to all business. It is a spontaneous source of financing in the sense that it arises from ordinary business transactions. In fact, it is the largest source of short-term funds for a business. Trade credit simply refers to an arrangement to buy goods or services on account, that is, without making immediate cash payment. Therefore, this debt is recorded on the purchaser’s balance sheet as a liability, which is known as account payable.

Primarily, the amount of trade credit depends upon the per day purchase and credit period extended by the supplier. Thus, it is a product of daily credit purchase and credit period. For example, if a firm’s daily average purchase is $100,000 on a term of net 30, it owes $ 3000,000 times $ 100,000 to its supplier. As the sales increase or decreases, the amount of financing is also changed. Therefore, it is the most flexible source of short-term financing. In the above example, if the business of the purchaser increases, the amount of purchase will also increase and able to generate additional financing. The same happens if the volume of purchase decreases.

In the context of trade credit, the terms of sale are a matter of importance. Along with credit sales, the supplier specifies the credit terms. The credit terms state credit period, size of the discount, the discount period and beginning date of the discount period and credit period. The credit terms vary greatly across the industries. Within the same industry also, credit terms may vary significantly across the firms. Some firms may follow liberal credit terms while others may follow tight terms of sale. In addition, the terms of sale are different over time for the same firm. Generally, credit terms are affected by the economic nature of the product, seller’s circumstances, buyer’s circumstances, size of cash discount, etc.

on the basis of credit terms offered by suppliers and mode of payment used by the buyer, trade credit may be cost-free and costly.

  1. Cost Free Trade Credit: Trade credit is considered as cost-free if there is no discount offer or the firm takes a discount and pay within discount period instead of paying on a due date though there is discount offer in credit terms.
  2.  Costly Trade Credit: Instead of taking a discount, if the firm sacrifices the discount offer and uses the funds for further days, then the trade credit is considered as costly trade credit.

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Evaluation of Trade Credit as a Sources of Short-Term Financing

Trade credit is the most common source of short-term financing to almost all business firms. It represents the largest source of short-term fund for business firms. It has some advantage and disadvantages:

  • Easy Availability
  • Flexibility
  • Informality

However, trade credit has some limitations too. The cost of not taking the discount may be very high. The excessive use of trade credit makes the firm’s financial position very weak. In addition, the firm can fulfill its limited amount of financing requirement through the use of trade credit.

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