Everything you need to know about the short-term sources of finance. Short-term financing is aimed to meet the demand of current assets and pay the current liabilities of the organization.
In other words, it helps in minimizing the gap between current assets and current liabilities. There are different means to raise capital from the market for small duration. Various agencies, such as commercial banks, co-operative banks, financial institutions, and NABARD provide the financial assistance to organizations.
Some of the short-term sources of finance are:- 1. Trade Credit 2. Accruals 3. Deferred Income 4. Commercial Paper (CPs) 5. Public Deposits 6. Inter-Corporate Deposits (ICDs) 7. Commercial Banks 8. Factoring 9. Installment Credit.
Additionally, learn about the features , advantages, merits, disadvantages and demerits of each source of finance.
Short-Term Sources of Finance for a Company, Firm and Business (with merits and demerits)
Short-Term Sources of Finance – Trade Credit, Accruals, Deferred Income, Commercial Papers (CPs), Public Deposits, ICDs, Commercial Banks and Factoring
The various short-term sources of finance are as follows:
Source # 1. Trade Credit:
Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. It occupies a very important position in short-term financing due to the competition. Almost all the traders and manufacturers are required to extend credit facility (a portion), without which there is no business. Trade credit is a spontaneous source of finance that arises in the normal business transactions without specific negotiation, (automatic source of finance).
In order to get this source of finance, the buyer should have acceptable and dependable creditworthiness and reputation in the market. Trade credit is generally extended in the form of open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer and the payment to be received in future as per terms of the sales invoice.
As such trade credit constitutes a very important source of finance, represents 25 per cent to 50 per cent of the total short-term sources for financing working capital requirements.
Getting trade credit may be easy to the well-established, but for a new or a firm with financial problems, will generally face problems in getting trade credit. Generally, suppliers look for earnings record, liquidity position and payment record while extending credit. Building confidence in suppliers is possible only when the buyer discusses his/her financial condition, future plans and payment record. Trade credit involves some benefits and costs.
The main advantages are:
(i) Easy availability when compared to other sources of finance (except financially weak companies)
(ii) Flexibility is another benefit, as the credit increases with the growth of the firm’s sales.
(iii) Informality as stated in the above that it is an automatic finance.
Costs of Trade Credit:
The above discussion on trade credit reveals two things:
(i) Cost of trade credit is very high beyond the cash discount period, company should not have cash discount for prompt payment.
(ii) If the company is not able to avail cash discount it should pay only at the end of the last day of credit period, even it can delay one or two days if it does not affect the credit standing.
Source # 2. Accruals:
Accrued expenses are those expenses which the company owes to the other, but not yet due and not yet paid the amount. Accruals represent a liability that a firm has to pay for the services or goods, it has received. It is spontaneous and interest-free source of financing. Salaries and wages, interest and taxes are the major constituents of accruals. Salaries and wages are usually paid on monthly and weekly base, respectively.
The amounts of salaries and wages are owed but not yet paid and shown them as accrued salaries and wages on the balance sheet at the end of the financial year. The longer the time lag in–payment of these expenses, the greater is the amount of funds provided by the employees. Similarly, interest and tax are accruals, as source of short-term finance. Tax will be paid on earnings.
Income-tax is paid to the government, on quarterly basis and some other taxes may be payable half- yearly or annually. Amount of taxes due as on the date of the balance sheet but not paid till then are shown as accrued taxes on the balance sheet. Like taxes, interest is paid periodically in the year but the funds are used continuously by a firm. All other such items of expenses can be used as a source of short-term finance but shown on the balance sheet.
The amount of accrual varies with the level of activities of a firm. When the level of activity expands, accruals increase and automatically they act a source of finance. Accruals are treated as “cost free” source or finance, since it does not involve any payment of interest.
But in actual terms it may not be true, since payment of salaries and wages is determined by provisions of law and industry practice. Similarly, tax payment is governed by laws and delay in payment of tax leads to penalty. Hence, a firm must note that use of accruals as a source of working capital paying may not be possible.
Source # 3. Deferred Income:
Deferred income is income received in advance by the firm for supply of goods or services in future period. This income increases the firm’s liquidity and constitutes an important source of short-term finance. These payments are not showed as revenue till the supply of goods or services, but showed in the balance sheet as income received in advance.
Advance payment can be demanded by firms which are having monopoly power, great demand for its products and services and if the firm is manufacturing a special product on a special order.
Source # 4. Commercial Papers (CPs):
Commercial paper represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in the USA and it is an important money market instrument. In India, Reserve Bank of India introduced CP on the recommendations of the Vaghul Working Group on Money Market. CP is a source of short-term finance to only large firms with sound financial position.
1. The maturity period of CP ranges from 15 to 365 days (but in India it ranges between 91 to 180 days).
2. It is sold at a discount from its face value and redeemed at its face value.
3. Return on CP is the difference between par value and redeemable value.
4. It may be sold directly to investors or indirectly through dealers.
“Eligibility” Criteria for Issuing CP:
CP is unsecured promissory note, the issue of CP is being regulated by the Reserve Bank of India. RBI has laid down the following conditions to determine the eligibility of a company that wishes to raise funds through the issue of CPs.
1. The tangible net worth (TNW) of the issuing company, as per the latest audited balance sheet should not be less than Rs.4 crore.
2. The company should have been sanctioned a fund based limit from bank(s) finance and/or the all India financial institutions.
3. Company can issue CPs amounting to 75% of the permitted bank (working capital limit) credit.
4. Company’s CPs should have received a minimum rating of (P2 from CRISIL, A-2 form ICRA, etc.).
5. The minimum size of each CP is Rs.5 lakh.
6. The size of any single issue should not be less than Rs.1 crore.
7. The CP is in the form of usance promissory note negotiable by endorsement and delivery.
Advantages of CP:
1. It is an alternative source of finance and proves to be helpful during the period of tight bank credit.
2. It is a cheaper source of short-term finance when compared to the bank credit.
Disadvantages of CP:
1. It is available only for large and financially sound companies.
2. It cannot be redeemed before the maturity date.
Source # 5. Public Deposits:
Public deposits or term deposits are in the nature of unsecured deposits, are solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements.
Fixed deposits accepted by companies are governed by the Companies (Acceptance of Deposits) Amendment Rules, 1978.
The main features of this regulation are:
1. A firm cannot issue public deposits for more than 25 per cent of its share capital and free reserves.
2. The public deposits can be issued for a period ranging from a minimum 6 months to maximum 3 years, only for an amount up to 10% of the company’s share capital and free reserves. Maximum period of 5 years allowed for non-banking financial corporation (NBFC’s).
3. The company that has raised funds by way of issue of public deposits is required to set aside, a deposit and/or investment, by the 30th April each year an amount equal to 10 per cent of the maturity deposits by the 31st March of the next year. The amount, so set aside can be used only for repaying the amount of deposits.
4. Finally, and importantly, a company soliciting and accepting the public deposits from the public is required to disclose true, fair, vital and relevant facts in regard to its financial position and performance.
Advantages of public deposit are:
1. Simple procedure involved in issuing public deposits.
2. No restrictive covenants are involved.
3. No security is offered against public deposits.
4. Cheaper (post-tax cost is fairly reasonable).
1. Limited amount of funds can be raised.
2. Funds available only for a short period.
Source # 6. Inter-Corporate Deposits (ICDs):
A deposit made by one firm with another firm is known as Inter-Corporate Deposit (ICD). Generally, these deposits are made for a period up to six months.
Such deposits may be of three types:
(a) Call Deposits:
These deposits are those expected to be payable on call/on just one day notice. But, in actual practice, the lender has to wait for at least 2 or 3 days to get back the amount. Inter-corporate deposits generally have 12 per cent interest per annum.
(b) Three Months Deposits:
These deposits are more popular among companies for investing the surplus funds. The borrower takes this type of deposits for meeting short-term cash inadequacy. The interest rate on these types of deposits is around 14 per cent per annum.
(c) Six months Deposits:
Inter-corporate deposits are made for a maximum period of six months. These types of deposits are usually given to ‘A’ category borrowers only and they carry an interest rate of around 16 per cent per annum.
i. There are no legal regulations, which make an ICD transaction very convenient.
ii. Inter-corporate deposits are given and taken in secrecy.
iii. Inter-corporate deposits are given based on if the borrower is financial sound, but in practice lender lends money based on personal contacts.
Source # 7. Commercial Banks:
Commercial banks are the major source of working capital finance to industries and commerce. Granting loan to business is one of their primary functions. Getting bank loan is not an easy task since the lending bank may ask a number of questions about the prospective borrower’s financial position and its plans for the future.
At the same time the bank will want to monitor borrower’s business progress. But there is a good side to this, that is borrower’s share price tends to rise, because investor knows that convincing banks is very difficult.
Forms of Bank Finance:
Banks provide different types of tailor- made loans that are suitable for specific needs of a firm.
The different types or forms of loans are:
(iii) Cash credits,
(iv) Purchase or discounting of bills and
(v) Letter of Credit.
Loan is an advance lump sum given to the borrower against some security. Loan is given to the applicant in the form of cash or by credit to his/her account. In practice the loan amount is paid to the customer by crediting his/her account. Interest will be charged on the entire loan amount from the date the loan is sanctioned.
Borrower can repay the loan either in lump sum or in installments depending on conditions. If the loan is repayable in installment basis interest will be calculated on quarterly and on reduced balances. Generally, working capital loans will be granted for one-year period.
Overdraft facility is an agreement between the borrower and the banker, where the borrower is allowed to withdraw funds in excess of the balance in the firm’s current account up to a certain limit during a specified period. It is flexible from the borrower point of view because the borrower can withdraw and repay the cash whenever he/she wants within the given stipulations. Interest is charged on daily over drawn balances and not on the overdraft limit given by the bank. But bank charges some minimum charges.
(iii) Cash Credit:
It is the most popular source of working capital finance in India. A cash credit facility is an arrangement where a bank permits a borrower to withdraw money up to a sanctioned credit limit against tangible security or guarantees.
Borrower does not require to withdraw the total sanctioned credit at a time, rather, he/she can withdraw according to his/ her requirements and he/she can also repay the surplus cash in his/her cash credit account. Interest is chargeable oil actually used amount and there is no commitment charge. Cash credit is a flexible source of working capital from borrower’s point of view.
(iv) Purchasing or Discounting of Bills:
Bills receivable arise out of credit sales transaction, where the seller of goods draws the bill on the buyer. The bill may be documentary or clean bill. Once the bill is accepted by the buyer, then the drawer (seller) of the bill can go to the bank for bill discounting or sale.
The creditworthiness of the drawer (seller) is satisfactory, and then bank purchases or discounts the bill and provides funds by way of crediting to the customer’s account. The credited amount will be less than the bill amount. At the end of the maturity period of the bill bank presents the bill to the drawer (acceptor) for payment.
If the bill is discounted and it is dishonoured by the drawer, then the customer (seller) is liable to pay the bill amount and any other expenses incurred by the bank. If the bill is purchased then bank takes the risk of non-payment.
(v) Letter of Credit [L/C]:
There are two non-fund based sources of working capital, viz., letter of credit (L/Cs) and Bank Guarantees (B/Gs). These are also known as quasi-document issued by the Buyer’s Banker (BB) at the request of the Buyer’s, in favour of the seller, where the Buyer’s Banker gives an undertaking to the seller, that the bank pay the obligations of its customer up to a specified amount, if the customer fails to pay the value of goods purchased.
It helps the bank’s customer to obtain credit from the seller (supplier), which is possible by assurance of the payment. Put it simply, it allows the supplier to extend credit, since the risk of non-payment is transferred to the buyer’s bank. Letter of credit facility is available from banks only for the companies that are financially sound and bank charges the customer for providing this facility.
No doubt bank finance is the most important source of working capital finance. But getting bank finance without giving adequate security is impossible. In how many modes the borrower can give security?
The following are the modes of security required by a bank:
Under this arrangement, the loan applicant is provided money against the security of movable property, usually inventories. The owner/loan applicant does not transfer the possession of the property to the bank. Hypothecation is in the nature of floating charge. It is merely a charge against property for the amount of debt.
This type of security is accepted for granting credit, only to the first class customers with highest liquidity. In other words, banks do not grant credit to new customers and low class customers with hypothecation. If the borrower fails to honour the dues to the bank, the banker may realise his due by sale of the goods hypothecated.
Under this arrangement, the loan applicant/borrower is required to transfer the physical possession of the goods/property to the bank as security. As per section 172 of the Indian Contract Act, pledge is a bailment of goods, as a security, for payment of a debt, or performance of a promise, against some advances. Transfer of possession of goods is a precondition for pledge.
Once the goods are shifted to the lender or bank, bank is expected to take reasonable care of goods pledged with it. The lender has a right of lien and can retain the possession of goods pledged till the debt (including interest and expenses) is cleared. If the borrower defaults in paying his/her dues, the bank has the right to sell goods and recover the dues. But this should be done only after giving due notice to the borrower.
Apart from the hypothecation and pledge sometimes banks ask for mortgage as collateral security. Mortgage is the transfer of legal or equitable interest in a specific immovable property for the payment of a debt. In this arrangement the possession of property remains with the owner/loan applicant, but the full legal title is transferred to the bank. If the borrower fails to pay dues, the bank can get decree from the court to sell the immovable property given as security and it can recover its dues.
Source # 8. Factoring:
Factoring is one of the sources of working capital. Banks have been given more freedom of borrowing and lending both internally and externally and facilitated the free functioning in lending and investment operations. From 1994, banks are allowed to enter directly leasing, hire purchasing and factoring services, instead through their subsidiaries. In other words, banks are free to enter or exit in any field depending on their profitability, but subject to some RBI guidelines.
Banks provide working capital finance through financing receivables, which is known as “factoring”. A “Factor” is a financial institution, which renders services relating to the management and financing of sundry debtors that arises from credit sales.
History of Factoring:
Factoring origin lies in the financing of trade, particularly foreign trade. Factoring as a fact of business life was underway in England prior to 1400. It appears to be closely related to early merchant banking activities. Like all financial instruments factoring evolved over centuries. This was driven by changes in organisation of companies, technology and non-face-to-face communication followed by the telephone and then computer.
By the 20th century in the US factoring became the predominant form of financing working capital for the then high growth rate textile industry. In Canada with its national banks the limitations were less restrictive and thus, did not develop as widely as in the US. Even then factoring also became the dominant form of financing in the Canadian textile industry
Factoring is a popular mechanism of managing, financing and collecting receivables in developed countries like the USA and the UK, and it has spread to a number of countries in the recent past, including India. In India, factoring services started in April 1994, after setting up of subsidiaries. It is yet in the formative stage.
In India there are only four public sector banks that offer factoring related services in the respective regions of the country (authorised by RBI) viz., State Bank of India (subsidiary State Bank of India Factoring and Commercial Services Limited), Canara Bank (Canara Bank Factoring Limited), Allahabad Bank and Punjab National Bank to cater the needs of the Western, Southern, Eastern and Northern regions, respectively.
Features of Factoring:
The following are the salient features of the factoring arrangement:
(i) Factor selects the accounts of the receivables of his client and set up a credit limit, for each account of receivables depending on safety, financial stability and creditworthiness.
(ii) The factor takes the responsibility for collecting the accounts receivables selected by it.
Factor advances to the client against selected accounts that may be not-yet, collected and not-yet- due debts. Generally, the amount of money as advance will be between 70 per cent to 80 per cent of the amount of the bills (debt). But factor charges interest on advances, that usually is equal to or slightly higher than the landing rate of commercial banks.
How factors work?
There are nine simple steps (arbitrary) in mechanics factor.
1. Customer approaches company requesting to provide goods on credit.
2. A company that has factoring option approaches the factor for credit limit, factor fixes credit limit.
3. Once the factor sets limit for credit, then company sends goods and invoice to the customer
4. After receiving invoice from the customer, company sends the same to the factor.
5. Factor pays up to 80% of invoice.
6. Factor sends monthly statements to customers.
7. Factor follows customer for collection of credit.
8. Customer pays amount to the factor.
9. Factor settles factoring dealing with company after paying balance 20% (after deducting commission) to the company.
Short-Term Sources of Finance – Trade Credit, Bank Credit, Public Deposits, Accrual Accounts, Factoring and Advances from Customers
The main sources of short-term finance are as follows:
1. Trade credit
2. Commercial banks or bank credit
3. Public deposits
4. Accrual accounts
6. Advances from customers
Trade credit is the credit extended by the seller of goods to the buyer as incidental to sale. It is also known as merchantile credit. It arises out of transfer of ownership of goods. Trade credit is available in the ordinary course of business without any security. The volume of trade credit available to a firm depends upon the reputation of the buyer, financial position of the seller, volume of purchase, terms of credit, degree of competition in the market, etc.
Trade credit may take two forms – (i) an open account credit arrangement, and (ii) acceptance credit arrangement. In case of open account credit, the buyer has not to sign a formal instrument of debt. Under acceptance credit, on the other hand, the buyer is required to sign a debt instrument e.g. a bill of exchange or a promissory note as an evidence of the amount due by him to the seller. In both the cases, credit is made available to the buyer on an informal basis without creating any charge on assets.
(i) Trade credit is easily and readily availability because no legal formalities are involved.
(ii) Credit is available on a continuing and informal basis. The concern has not to approach anybody and tell that it is short of working capital.
(iii) No charge is created on the assets of the buyer.
(iv) Trade credit is a flexible source of working capital. Wherever necessary, the buyer can delay payment because the seller normally accepts a genuine request. The concern can earn cash discounts by making payments before the expiry of the credit period.
(i) While fixing prices, the seller takes into account the interest, risk and inconvenience involved in selling goods on credit. Therefore, the cost of trade credit may be very high.
(ii) Availability of liberal trade credit facilities may induce a concern to over-trading which can be harmful.
Thus, trade credit is a discretionary source of financing working capital with no explicit costs.
Commercial banks are the single largest source of short-term finance for industry.
They provide working funds in the following forms:
Loan is an advance with or without security. A lump sum is given to the borrower at an agreed rate of interest. The borrower has to pay interest on the total amount whether he withdraws the full amount of the loan or not. The loan may be repaid in lump sum or in instalments.
Loan may be term loan or demand loan. A ‘term loan’ is allowed for a fixed time period whereas a ‘demand loan’ is payable on demand and is, therefore, for a short period.
It is an arrangement under which the borrower is allowed to borrow money up to a specified limit. Cash credit limit is fixed after taking into account the paying capacity and credit worthiness of the client. The credit is given in the form of cash usually against some security or guarantee.
Cash credit is a very flexible source of working capital. The borrower can withdraw money as and when required. He has to pay interest on the amount actually withdrawn rather than on the total unit sanctioned.
It is a facility allowed by a bank to its current account holders. The account holder is allowed to withdraw up to a certain limit over and above the credit balance in his current account. It is for a very short duration, generally a week and is used occasionally.
(iv) Bills Discounted/Purchased:
The customer having a bill of exchange arising out of trade can discount the same with a commercial bank. The term ‘discounting of bills’ is used in case of time bills whereas the term, ‘purchasing the bills’ is used in respect of demand bills.
While sanctioning credit, commercial banks take into account the following factors:
(a) Promoters background, managerial competence, credit-worthiness and integrity.
(b) Technical feasibility of the project in terms of location, size-infrastructure, raw materials, skilled labour, manufacturing process, etc.
(c) Economic viability of the enterprise in terms of future demand and supply position for the product, marketing arrangements, etc.
(d) Financial feasibility and profitability in terms of cost of the project sources of finance, breakeven point, projected profits, cash flow.
(e) Security and guarantee offered.
(f) Role of the enterprise in the nation’s economy—priority sector or otherwise, employment generation, export promotion, etc.
(i) Bank credit is generally a cheaper method of raising working capital.
(ii) Bank credit is flexible because banks offer different schemes of financing working capital.
(iii) Under the directives of Reserve Bank of India, banks provide finance to small scale and cottage industries at concessional rates of interest.
(iv) Commercial banks serve as a friend, philosopher and guide to their clients in respect of the most appropriate method of financing and utilisation of credit.
(i) In order to raise funds from commercial banks several documents have to be submitted and signed. It is a time-consuming and expensive process.
(ii) Commercial banks generally require hypothecation or pledge of assets for granting credit.
(iii) Commercial banks generally take a very serious view of delay in repayment and interest.
Many companies invite and accept deposits for short periods from their directors, shareholders and the general public. This method of raising short term finance is becoming popular due to increasing cost of bank credit Deposits are generally invited for a period ranging from 6 months to five years. Government has prescribed rules and regulations which must be followed by companies inviting public deposits.
(i) It is a very simple method of financing as very little formalities are involved. A company has only to advertise and inform the public that it is interested in and authorised to accept public deposits.
(ii) Public deposits are a relatively less costly source of short-term finance.
(iii) No charge is created against the assets of the company as public deposits are unsecured loans.
(iv) The rate of interest on public deposits is fixed. Therefore, the company can take advantage of trading on equity.
(i) Public deposits are not a reliable source of finance. It is not available during depression and financial stringency. Only well reputed firms can raise public deposits.
(ii) This mode of financing can put the company in serious financial difficulties. Even a rumour that the company is not doing well may lead to a sudden rush of public demanding premature repayments of deposits.
(iii) Widespread use of public deposits may reduce the supply of industrial securities and thereby adversely affect the growth of the capital market.
There is a time lag between receipt of income and making payment for the expenditure incurred in earning that income. During this time lag, the outstanding expenses help an enterprise in meeting some of its working capital needs. For example, wages and taxes become due but are not paid immediately.
Wages and salaries are paid in the first week of the month next to the month in which services were rendered. Similarly, a provision for tax is created at the end of the financial year but tax is paid only after the assessment is finalised.
(i) Accrual accounts are a spontaneous source of finance as these are self-generating.
(ii) Financing through accruals is an interest free method and no charge is created on the assets.
(iii) As the size of business increases the amount of accruals also increase.
(i) An enterprise cannot indefinitely postpone the payment of wages/salaries and taxes. Therefore, it is not a discretionary source of finance.
(ii) This source should be used only as a matter of last resort.
Factoring is an arrangement under which a financial institution (called factor) undertakes the task of collecting the book debts of its client in return for a service charge in the form of discount or rebate. The factoring institution eliminates the client’s risk of bad debts by taking over the responsibility of book debts due to the client. The factoring institution advances a proportion of the value of book debts of the client immediately and the balance on maturity of book debts.
(i) As a result of factoring services, the enterprise can concentrate on manufacturing and selling.
(ii) The risk of bad debts is eliminated.
(iii) The factoring institution also provides advice on business trends and other related matters.
(iv) It helps in avoiding overtrading.
(v) It helps in balancing cash requirements.
(vi) It helps to improve operating margin.
(vii) It helps to reduce overheads involved in credit and collection activities.
(i) A substantial amount of discount or rebate has to be paid to the factoring concern.
(ii) If the factoring institution uses strong arm tactics to collect money it mill spoil the image and relations of the firm with its customers.
a. Factoring is a service whereby the provider, known as the factor, offers to take up the accounts receivable – in the form of invoices – on behalf of a seller, for a fee
b. It’s beneficial for small and medium businesses who may not have adequate working capital to work with large corporate buyers
c. There is absence of clearly defined regulations that recognize factoring. The comfort level of buyers is another issue that factors have to contend with.
Manufacturers and suppliers of goods which are in short supply usually demand advance money from their customers at the time of accepting their orders. For example, a customer has to make an advance at the time of booking a car, a telephone connection, etc. Similarly, contractors constructing buildings, etc. require an advance form the client.
In some businesses it has become customary to receive advance payment from the customers. This is a very cheap source of short term finance because either no interest is payable or the rate of interest payable on advance is nominal.
Sources of Short-Term Finance – Trade Credit, Customer Advance and Installment Credit (With Advantages and Disadvantages)
Short-term financing is aimed to meet the demand of current assets and pay the current liabilities of the organization. In other words, it helps in minimizing the gap between current assets and current liabilities. There are different means to raise capital from the market for small duration. Various agencies, such as commercial banks, co-operative banks, financial institutions, and NABARD provide the financial assistance to organizations.
These agencies provide short-term financing in various forms.
Let us learn about of these sources in detail.
1. Trade Credit:
Trade credit is one of the traditional and common methods of raising short-term capital from the market. It is an arrangement in which the supplier allows the buyer to pay for goods and services at a later date in future. The decision to provide trader credit depends on the mutual understanding of both the buyer and supplier. The supplier takes the decision to extend trade credit after taking into consideration creditworthiness, goodwill, and record of previous transactions of the buyer.
The trade credit transactions are not always done in terms of cash but also in terms of kind. For example- the supplier may provide raw material, machine, finished goods, and services to the buyer instead of cash.
The advantages of trade credit are as follows:
i. Improved Cash Inflows:
Refers to the increased amount of cash inflows in an organization. Trade credit enhances the cash inflows of the organization, which in turn facilitates smoother business operations.
ii. Reduced Capital Requirement:
Specifies that if an organization has trade credit arrangements with its suppliers then it would require less short-term capital to operate the business. In this case, the payments to the suppliers can be made within the pre-decided credit terms, after the receipt of payment from customers. Thus, the business would continue to operate with lower capital requirements. In addition, the organization can effectively use the short-term capital for other activities, such as maintaining inventory.
iii. Increased Focus on Other Business Activities:
Refers to the fact that trade credit facilitates an organization to focus on other business activities, which require immediate funds. Examples of such activities are procurement of raw materials and payment of salaries and wages.
The disadvantages of trade credit are as follows:
i. Increased Borrowing:
Refers to the fact that the ease in availability of trade credit often induces the borrower to raise more credit than required. This results in accumulation of debt, which may hamper the growth of the organization in future.
ii. Delay or Default in the Payment of Trade Credit:
Affects the goodwill of the organization. As a result of this, the organization may face a problem of poor credit rating, which further reduces its creditworthiness.
Customer advances may be defined as the part of payment made in advance by the customer to the organization for the procurement of goods and services in the future. It is also called as Cash before Delivery (CBD). The customers pay the amount of advance, when they place the order of goods and services required by them.
This method of procuring of goods and services depends on the characteristic and value of the product. Customer advances eases the burden of the customer for short term, by deferring the remaining payment for some time.
The advantages of customer advances are as follows:
i. Free from Interest Burden – Implies that the organization does not need to pay any interest on customer advances.
ii. No Security Required – Implies that the organization does not need to keep any security to raise customer advances.
iii. No Repayment Obligation – Refers to the fact that the organization is free to decide whether to refund money, if the order is cancelled by customers.
The disadvantages of customer advances are as follows:
i. Limited to Selected Organization – Refers to the fact that the benefits of customer advances can be availed only by those organizations, which have goodwill in the market.
ii. Limited Period Offer – Implies that the customer advances can be availed only for limited period of time. The allotted time for the advances and delivery of goods and services is fixed and cannot be extended.
iii. Limited Amount of Advance – Refers to the fact that customers made only a part of payment, which may not fulfill the fund requirement of the organization. In addition, the amount of advance is proportional to the value of the product; therefore, it may vary from product to product.
Installment credit is another source of short-term financing, in which the borrowed amount is paid in equal installments with interest. It is also called as installment plan or hire-purchase plan. Installment credit is granted to the organization by the suppliers on the assurance that the repayment would be done in fixed installment at regular intervals of time. It is mostly used to acquire long-term assets used in production processes.
The advantages of installment credit are as follows:
i. Convenient Mode of Payment – Implies that installment credit is an easy mode of payment as it divides the burden of payment in easy installments paid at regular intervals.
ii. Protecting Blockage of Funds – Refers to the fact that installment credit helps the organization in saving capital, which can be used for other productive activities. In helps the organization in purchasing goods and services by making a part of payment.
iii. Facilitating Modernization – Implies that installment credit helps the organization in acquiring new machines and technology even in the absence of sufficient funds for the time being.
iv. Quick possession of Assets – Refers to the installment method, which requires very little paperwork to transfer the ownership of assets from one party to another.
The disadvantages of installment credit are as follows:
i. Influence on Liquidity Position – Refers to the impact of installments on the liquidity position of the organization. The payment of installments is considered as an additional burden on the short-term capital of the organization.
ii. Extra Cost – Refers to the extra amount to be paid by the organization in the procurement of goods through installment credit. If an organization buys goods on installment credit then it needs to pay higher amount as compared to one-time payment. This happens because the installments include the amount of borrowing as well as the interest.
iii. Extra Liability – Refers to the extra burden imposed on the organization in case of default. If the organization fails to pay the installment amount in the allotted time, it may seriously affect the image of the organization. Therefore, it becomes the liability of the organization to pay installment on time.