The two major sources of short-term financing are

A constant flow of working capital is an intrinsic component of a successful business. This is especially true considering the outflow that is a part and parcel of every cycle: salaries and wages need to be paid; raw materials need to be purchased and equipment needs to be serviced; funds are needed for marketing, advertising, and other general overhead costs; reserves are required till the customers make their payment. Working capital is truly the lifeline for any company.

Related Reading: Best Ways to Improve Working Capital

The question arises as to how does a business acquires funds for working capital. There are two types of financing: short term and long term.

Types of Short Term Financing

Banks can be an invaluable source of short term working capital finance.

1. Overdraft Agreement

By entering into an overdraft agreement with the bank, the bank will allow the business to borrow up to a certain limit without the need for further discussion. The bank might ask for security in the form of collateral and they might charge daily interest at a variable rate on the outstanding debt. However, if the business is confident of making the repayments quickly, then an overdraft agreement is a valuable source of financing and one that many companies resort to.

2. Accounts Receivable Financing

Many banks and non-banking financial institutions provide invoice discounting facilities. The company takes the commercial bills to the bank which makes the payment minus a small fee. Then, on the due date, the bank collects the money from the customer. This is another popular method of financing, especially among small traders. Businesses that offer large terms of credit can carry on their operations without having to wait for the customers to settle their bills.

3. Customer Advances

There are many companies that insist on the customer making an advance payment before selling them goods or providing a service. This is especially true while dealing with large orders that take a long time to fulfill. This method also ensures that the company has some funds to channelize into its operations for fulfilling those orders.

4. Selling Goods on Installment

Many companies, especially those that sell television sets, fans, radios, refrigerators, vehicles, and so on, allow customers to make their payments in installments. Since many of these items have become modern-day essentials, their customers might not come from well-to-do backgrounds or the cost of the product might be too prohibitive for immediate payment. In such a case, instead of waiting for a large payment at the end, they allow the customers to make regular monthly payments. This ensures that there is a constant flow of funds coming into the business that does not choke up the accounts receivable numbers.

Types of Long-Term Financing

Relying purely on short-term funds to meet working capital needs is not always prudent, especially for industries where the manufacture of the product itself takes a long time: automobiles, aircraft, refrigerators, and computers. Such companies need their working capital to last for a long time, and hence they have to think about long term financing.

1. Long-Term Loan from a Bank

Many companies opt for a full-fledged long term loan from a bank that allows them to meet all their working capital needs for two, three, or more years.

2. Retain Profits

Rather than making dividend payments to shareholders or investing in new ventures, many businesses retain a portion of their profits so that they may use it for working capital. This way they do not have to take loans, pay interest, incur losses on discounted bills, and they can be self-sufficient in their financing.

3. Issue Equities and Debentures

In extreme cases when the business is really short of funds, or when the company is investing in a large-scale venture, they might decide to issue debentures or bonds to the general public or in some cases even equity stock. Of course, this will be done only by conglomerates and only in cases when there is a need for a huge quantum of funds.

Final Thought

Companies cannot rely only on limited sources for their working capital needs. They need to tap multiple avenues. They also need to constantly evaluate what their needs are, through analysis of financial statements and financial ratios, and choose their working capital channels judiciously. This is an ongoing process, and different routes are appropriate at different points in time. The trick is to choose the right alternative as per the situation.

Companies can also partner with a Financial Service provider to implement more effective ways of improving their working capital.

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1. What are the main sources and costs of unsecured and secured short-term financing?

How do firms raise the funding they need? They borrow money (debt), sell ownership shares (equity), and retain earnings (profits). The financial manager must assess all these sources and choose the one most likely to help maximize the firm’s value.

Like expenses, borrowed funds can be divided into short- and long-term loans. A short-term loan comes due within one year; a long-term loan has a maturity greater than one year. Short-term financing is shown as a current liability on the balance sheet and is used to finance current assets and support operations. Short-term loans can be unsecured or secured.

Unsecured loans are made on the basis of the firm’s creditworthiness and the lender’s previous experience with the firm. An unsecured borrower does not have to pledge specific assets as security. The three main types of unsecured short-term loans are trade credit, bank loans, and commercial paper.

When Goodyear sells tires to General Motors, GM does not have to pay cash on delivery. Instead, Goodyear regularly bills GM for its tire purchases, and GM pays at a later date. This is an example of trade credit: the seller extends credit to the buyer between the time the buyer receives the goods or services and when it pays for them. Trade credit is a major source of short-term business financing. The buyer enters the credit on its books as an account payable. In effect, the credit is a short-term loan from the seller to the buyer of the goods and services. Until GM pays Goodyear, Goodyear has an account receivable from GM, and GM has an account payable to Goodyear.

Unsecured bank loans are another source of short-term business financing. Companies often use these loans to finance seasonal (cyclical) businesses. Unsecured bank loans include lines of credit and revolving credit agreements. A line of credit specifies the maximum amount of unsecured short-term borrowing the bank will allow the firm over a given period, typically one year. The firm either pays a fee or keeps a certain percentage of the loan amount (generally 10 to 20 percent) in a checking account at the bank. Another bank loan, the revolving credit agreement, is basically a guaranteed line of credit that carries an extra fee in addition to interest. Revolving credit agreements are often arranged for a period of two to five years.

As noted earlier, commercial paper is an unsecured short-term debt—an IOU—issued by a financially strong corporation. Thus, it is both a short-term investment and a financing option for major corporations. Corporations issue commercial paper in multiples of $100,000 for periods ranging from 3 to 270 days. Many big companies use commercial paper instead of short-term bank loans because the interest rate on commercial paper is usually 1 to 3 percent below bank rates.

Secured loans require the borrower to pledge specific assets as collateral, or security. The secured lender can legally take the collateral if the borrower doesn’t repay the loan. Commercial banks and commercial finance companies are the main sources of secured short-term loans to business. Borrowers whose credit is not strong enough to qualify for unsecured loans use these loans. Typically, the collateral for secured short-term loans is accounts receivable or inventory. Because accounts receivable are normally quite liquid (easily converted to cash), they are an attractive form of collateral. The appeal of inventory—raw materials or finished goods—as collateral depends on how easily it can be sold at a fair price.

Another form of short-term financing using accounts receivable is factoring. A firm sells its accounts receivable outright to a factor, a financial institution (often a commercial bank or commercial finance company) that buys accounts receivable at a discount. Factoring is widely used in the clothing, furniture, and appliance industries. Factoring is more expensive than a bank loan, however, because the factor buys the receivables at a discount from their actual value.

For businesses with steady orders but a lack of cash to make payroll or other immediate payments, factoring is a popular way to obtain financing. In factoring, a company sells its invoices to a third-party funding source for cash. The factor purchasing the invoices then collects on the due payments over time. Trucking companies with voluminous accounts receivable in the form of freight bills are good candidates for the use of short-term financing such as factoring. Why might firms choose factoring instead of loans? (Credit: Mike’s Photos/ flickr/ Creative Commons Zero (CC0) license)

1. Distinguish between unsecured and secured short-term loans.
2. Briefly describe the three main types of unsecured short-term loans.
3. Discuss the two ways that accounts receivable can be used to obtain short-term financing.

accounts payable Purchases for which a buyer has not yet paid the seller. factoring A form of short-term financing in which a firm sells its accounts receivable outright at a discount to a factor. line of credit An agreement between a bank and a business that specifies the maximum amount of unsecured short-term borrowing the bank will allow the firm over a given period, typically one year. revolving credit agreement A guaranteed line of credit whereby a bank agrees that a certain amount of funds will be available for a business to borrow over a given period, typically two to five years. secured loans Loans for which the borrower is required to pledge specific assets as collateral, or security. trade credit The extension of credit by the seller to the buyer between the time the buyer receives the goods or services and when it pays for them. unsecured loans Loans for which the borrower does not have to pledge specific assets as security.