Chapter 3. Contd..... Sources of Finance ( short Term Sources)

Sources of Short Term Finance

1. Public Deposits:

·         It refers to the deposits accepted from the public on which a fixed rate of interest is paid. The rate of interest is higher than rate of interest paid by banks on their deposits.

·         Only Public Companies and non-banking companies are allowed to  accept public deposits. A private company is not allowed to accept deposits.

·         The time period of such deposits may range from 6 months to 3 years.

·         Such deposits are unsecured and no assets are required to be pledged.

Advantages

1.  No legal formalities : It is a simple method, where public make deposits at their free will. It involves no legal formalities which are required in the issue of shares and debentures.

2.   No charge on assets :      Public deposits do not involve any charge on the assets of the company. The company can use its fixed assets for raising funds from other sources.

3.   No interference in management:          Depositors do not have any voting rights. They can not take part in management and do not interfere in the matters of the company.

4.  Flexibility in capital structure: The capital structure of the company can be kept flexible by this method of finance. Fixed deposits can be returned if the company is overcapitalized. On the other hand, additional finance can be raised without much difficulty, in case of need.

5.  Economical : It is economical because the rate of interest allowed on deposits is usually less than the interest rate charged by banks and other financial intuitions on loans.

6.   Trading on equity:  Interest on Deposts is paid at a fixed rate. In case the earnings of the company good, the rate of dividend on equity shares can be increased. 

Disadvatages:-

1.   Unsuitable for new concerns: This method is not suitable for new companies as the public may be hesitant to invest for fear of loss of money.

2.   Uncertainty of getting deposits:            Public deposits are called “fair weather friends”. There is no certainty of getting a good response from public particularly in period of depression.

3.   Unsecured:           Depositors face high risk as public deposits are secured on the assets of the company.

4.   Restrict growth of capital market:        Public deposit hamper the grown the healthy capital market in the country. Widespread use such a source may create shortage of industrial security. It may also pose a threat to the credit planning and plan priorities of the Govt.

5.  Possibility of cheating( speculations):           It is possible that a company may project a good picture to attract public deposits. The funds procured may be misused and thereby innocent investors may be cheated.

6.   Loss of creditworthiness:     If the deposit money is not paid on maturity on account of shortage of liquid resources, the goodwill of the company may be adversely affected.

2. Commercial Banks:

Lending is an important function of commercial banks. Banks provide finance to business enterprises in the following ways:

1.  Loans and Advances:  the key features are as follows:

a.      It is lump sum money advanced by way loan to the borrower for which a bank opens a separate account in the name of the borrower in which the amount is credited.

b.      Interest : the borrower is required to pay interest on the whole amount from the date the loan was sanctioned.

c.       Repayment: The loan may be repaid either in instalments at regular interval or in one time at the expiry of a fixed term of loan.

d.      Withdrawal: the borrower can withdraw the whole of the amount or a part of it but interest is charged on the whole amount of loan.

e.      Security: The loan may be secured or unsecured. However in most cases the banks ask for sufficient security from the borrower before sanctioning the loan.

2.  Cash Credit: Its key features are as follows:

a.      Cash credit is a kind of agreement with the bank under which a bank fixes a maximum limit up to which the borrower can withdraw money. It is a running account from which the amount can be withdrawn and paid back as per the needs of the customer.

b.      The limit is usually fixed based on the reputation and security offered by the borrower.

c.       Interest is charged only on the actual amount withdrawn.

The main advantage is flexibility in the use of money and the convenience. The customer does not have to approach the bank again and again in case of need of funds.
The disadvantage is the high rate of interest.

  3.  Bank Overdraft: Main points are:

a.      Overdraft is facility of withdrawing/making payment more than the balance in the bank.

b.      Overdraft facility is granted to customers having a current account with the bank.

c.       A maximum limit of overdraft is fixed based on the reputation ( credit worthiness) of the customer and the security offered by him.

d.      Interest is charged on the actual amount of overdraft.

This is a very convenient and flexible one time form of short term financial arrangement with the bank and the customer does not have to ask bank if the payment exceeds the balance in the bank.

4.  Discounting of Bills: Main points are:

a.      Discounting of bills means getting cash from a bank in exchange of Bills of exchange ,promissory note etc.

b.      Bank charge some commission/interest for this service by paying amount lower than the face value of the bill. The charges are for the unexpired time period of the bill. These are called discounting charges.

c.       On maturity date of the bills, the bank will collect full amount of the bill from the drawee ( debtor).

d.      The borrower/customer remains liable to the bank, if the drawee fails to honour the bill on its due date.

Advantages of funds from Commercial Banks:

Bank Credit has several advantages:

1.      Flexible: Bank credit is highly flexible. There are many options for raising short term funds. The money can be repaid whenever desired.

2.      No interference in management: Commercial banks do not interfere in the working of the company. Only financial statements are to be submitted at the specified time.

3.      Easy repayment option : In all the lending options, the banks provides easy repayment option to the borrower, which is not available in any other forms of borrowing.

4.      Economical: short term funds from banks prove to cheaper. This reduces interest burden on the borrower.

Disadvantages:

1.      Legal formalities:

2.       Shorter period of funds: Funds from commercial banks are mostly for shorter periods.

3.      Charge on assets: Banks generally require a charge on the assets of company before funds are sanctioned.

4.      High rate of interest: The rate of interest charged by the banks is higher than interest on debentures or public deposits.

Trade Credit :

·         Trade credit is a credit extended on purchase of raw material or finished goods on credit. The payment for purchased is to be made later on. Trade credit does not include purchase of assets on credit.

·         The credit period range from 15 days to three months.

·         Trade credit is unsecured and the credit is allowed by sellers to buyer based on the financial reputation of the buyer or trade practice in the industry, financial strength of the buyer, nature of products etc.

Advantages

1.      Simple : Trade credit is convenient source of short term credit and does not involve much formalities.

2.      No interest: No interest is payable for the period of credit.

3.      No security : The buyer is not required to give any security or pledge assets.

4.      Flexible : The payment system is quite flexible and depends upon mutual agreement between the seller and the buyer.

Advantages

1.      Higher prices: The prices of goods sold is generally higher when trade credit is allowed.

2.      Available for short term : the maximum period of credit is only 3 months.

3.      Possibility of Bad Debts: The seller may have to bear the bad debts if the buyer is unable to pay the amount.

4.      Large working capital: the sellers need to keep large amount of working capital when he sells the goods on credit and allows longer credit period.

Installment Credit:

·         It refers to purchase of durable items like plant and machinery, furniture etc. on credit.

·         The buyer has to pay part of the price at the time of taking delivery of goods, known as down payment. The balance of the amount is to be paid in installments.

·         The seller/supplier charges interest on the balance due and interest is included in the installment. In some cases, the credit is allowed through finance company or commercial banks.

·         The physical possession of the asset is given to the buyer immediately on signing of agreement and down payment but the ownership of the asset is transferred only on payment of final installment.

Customer Advance:

•           It refers to that part of the price which is taken in advance from customers at the time of booking or before the delivery of goods.
•          A nominal interest may be paid on such advance.
•          When delivery of goods is given to the buyer, the advance money is adjusted against the price of the article.
•          Advance can only be taken from customers when the advance booking of the product is done or the product is in high demand.
•          The advance received provide working capital to the firm.

Factoring : (Accounts Receivable Financing)

 Accounts Receivable finance is defined as raising of funds through mortgage or sale of Trade Receivables.

In case of mortgage of receivables, finance companies (factors) provide loans on the security of these receivable, generally upto 60% of amount of such security. The debtors of the firm may directly make payment to the finance company or to the firm, which in turn will use that money to return the loan amount. Bad debt, if any will be borne by the firm and not the finance company. The rate of interest on such loans is quite high.

In case of outright sale of receivable, the finance company purchase debtors and receivable at a heavy discount. The finance company, in turn will take the entire responsibility of collecting the money and will be bad debts, if any.

Inter-Corporate Deposits:

  It refers to deposits by one company with another company  In other words, Inter corporate deposit is the process of borrowing of money by one company from another company. A company having surplus money may lend to other companies which may need financial assistance.

       Period of Deposit: Maximum six month

    The rate of interest on such deposits is not fixed. It depends upon the amount involved and the tenure of lending.

Types of inter-corporate deposits:

Inter corporate deposits are of three types:

1. Call Deposit:

Such a type of deposit is withdrawn by the lender by giving a notice of one day. However, in practice, a lender has to wait for at least 3 days.

2. Three-month Deposit:

As the name suggests, such type of a deposit provides funds for three months to meet up short-term cash inadequacy.

3. Six-month Deposit:

The lending company provides funds to another company for a period of six months.

Advantages of inter-corporate deposits are:

i. Surplus funds can be effectively utilized by the lender company.

ii. Such deposits are secured in nature.

iii.  Inter-corporate deposits can be easily procured.

Disadvantages:

i.   Such deposits are available only for short period.

ii. These deposits can usually be availed by reputed companies