This article throws light upon the ten main sources of short-term fund. The sources are: 1. Indigenous Bankers 2. Trade Credit 3. Installment Credit 4. Advances 5. Factoring 6. Accrued Expenses 7. Deferred Incomes 8. Commercial Paper 9. Commercial Banks 10. Public Deposits.
Short-Term Funds: Source # 1. Indigenous Bankers:
Private money-leaders and other country bankers used to be the only sources of finance prior to the establishment of commercial banks. They used to charge very high rates of interest and exploited the customers to the largest extent possible.
Now-a-days with the development of commercial banks they have lost their monopoly. But even today some business houses have to depend upon indigenous bankers for obtaining loans to meet their working capital requirements.
Short-Term Funds: Source # 2. Trade Credit:
Trade credit refers to the credit extended by the suppliers of goods in the normal course of business. As present day commerce is built upon credit, the trade credit arrangement of a firm with its suppliers is an important source of short-term finance. The credit-worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit.
It is mostly granted on an open account basis whereby supplier sends goods to the buyer for the payment to be received in future as per terms of the sales invoice. It may also take the form of bills payable whereby the buyer signs a bill of exchange payable on a specified future date.
When a firm delays the payment beyond the due date as per the terms of sales invoice, it is called stretching accounts payable. A firm may generate additional short-term finances by stretching accounts payable, but it may have to pay penal interest charges as well as to forgo cash discount.
If a firm delays the payment frequently, it adversely affects the creditworthiness of the firm and it may not be allowed such credit facilities in future.
The main advantages of trade credit as a source of short-term finance include:
(i) It is easy and convenient method of finance.
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is informal and spontaneous source of finance.
However, the biggest disadvantage of this method of finance is charging of higher prices by the suppliers and loss of cash discount.
Short-Term Funds: Source # 3. Installment Credit:
This is another method by which the assets are purchased and the possession of goods is taken immediately but the payment is made in Installment over a pre-determined period of time. Generally, interest is charged on the unpaid price or it may be adjusted in the price.
But, in any case, it provides funds for sometimes and is used as a source of short-term working capital by many business houses which have difficult funds position.
Short-Term Funds: Source # 4. Advances:
Some business houses get advances from their customers and agents against orders and this source is a short-term source of finance for them. It is a cheap source of finance and in order to minimise their investment in working capital, some firms having long production cycle, especially the firms manufacturing industrial products prefer to take advance from their customers.
Short-Term Funds: Source # 5. Factoring:
Another method of raising short-term finance is through account receivable credit offered by commercial banks and factors. A commercial bank may provide finance by discounting the bills or invoices of its customers. Thus, a firm gets immediate payment for sales made on credit.
A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales. Factoring is becoming popular all over the world on account of various services offered by the institutions engaged in it.
Factors render services varying from bill discounting facilities offered by commercial banks to a total take-over of administration of credit sales including maintenance of sales ledger, collection of accounts receivables, credit control and protection from bad debts, provision of finance and rendering of advisory services to their clients.
Factoring may be on a recourse basis, where the risk of bad debts is borne by the client, or on a non-recourse basis, where the risk of credit is borne by the factor.
At present, factoring in India is rendered by only a few financial institutions on a recourse basis. However, the Report of the Working Group on Money Market (Vaghul Committee) constituted by the Reserve Bank of India has recommended that banks should be encouraged to set up factoring divisions to provide speedy finance to the corporate entities.
Short-Term Funds: Source # 6. Accrued Expenses:
Accrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also. These simply represent a liability that a firm has to pay for the services already received by it. The most important items of accruals are wages and salaries, interest, and taxes.
Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services already rendered by employees. The longer the payment- period, the greater is the amount liability towards employees or the funds provided by them.
In the same manner, accrued interest and taxes also constitute a short-term source of finance. Taxes are paid after collection and in the intervening period serve as a good source of finance. Even income-tax is paid periodically much after the profits have been earned. Like taxes, interest is also paid periodically while the funds are used continuously by a firm. Thus, all accrued expenses can be used as a source of finance.
The amount of accruals varies with the change in the level of activity of a firm. When the activity level expands, accruals also increase and hence they provide a spontaneous source of finance. Further, as no interest is payable on accrued expenses, they represent a free source of financing. However, it must be noted that it may not be desirable or even possible to postpone these expenses for a long period.
The payment period of wages and salaries is determined by provisions of law and practice in industry. Similarly, the payment dates of taxes are governed by law and delays may attract penalties. Thus, we may conclude that frequency and magnitude of accruals is beyond the control of managements. Even then, they serve as a spontaneous, interest free, limited source of short-term financing.
Short-Term Funds: Source # 7. Deferred Incomes:
Deferred incomes are incomes received in advance before supplying goods or services. They represent funds received by a firm for which it has to supply goods or services in future. These funds increase the liquidity of a firm and constitute an important source of short-term finance.
However, firms having great demand for its products and services, and those having good reputation in the market can demand deferred incomes.
Short-Term Funds: Source # 8. Commercial Paper:
Commercial paper represents unsecured promissory notes issued by firms to raise short-term funds. It is an important money market instrument in advanced countries like U.S.A. In India, the Reserve Bank of India introduced commercial paper in the Indian money market on the recommendations of the Working Group on Money Market (Vaghul Committee).
But only large companies enjoying high credit rating and sound financial health can issue commercial paper to raise short-term funds. The Reserve Bank of India has laid down a number of conditions of determine eligibility of a company for the issue of commercial paper.
Only a company which is listed on the stock exchange has a net worth of at least Rs. 10 crores and a maximum permissible bank finance of Rs. 25 crores can issue commercial paper not exceeding 30 per cent of its working capital limit.
The maturity period of commercial paper, in India, mostly ranges from 91 to 180 days. It is sold at a discount from its face value and redeemed at face value on its maturity. Hence, the cost of raising funds through these sources is a function of the amount of discount and the period of maturity and no interest rate is provided by the Reserve Bank of India for this purpose.
Commercial paper is usually bought by investors including banks, insurance companies, unit trusts and firms to invest surplus funds for a short-period., A credit rating agency, called CRISIL, has been set up in India by ICICI and UTI to rate commercial papers.
Commercial paper is a cheaper source of raising short-term finance as compared to the bank credit and proves to be effective even during period of tight bank credit. However, it can be used as a source of finance only by large companies enjoying high credit rating and sound financial health.
Another disadvantage of commercial paper is that is cannot be redeemed before the maturity date even if the issuing firm has surplus funds to pay back.
Short-Term Funds: Source # 9. Commercial Banks:
Commercial banks are the most important source of short-term capital. The major portion of working capital loans are provided by commercial banks. They provide a wide variety of loans tailored to meet the specific requirements of a concern.
The different forms in which the banks normally provide loans and advances are as follows:
(b) Cash Credits
(c) Overdrafts, and
(d) Purchasing and discounting of bills.
When a bank makes an advance in lump-sum against some security it is called a loan. In case of a loan, a specified amount is sanctioned by the bank to the customer. The entire loan amount is paid to the borrower either in cash or by credit to his account. The borrower is required to pay interest on the entire amount of the loan from the date of the sanction.
A loan may be repayable in lump sum or installments. Interest on loans is calculated at quarterly rests and where repayments are stipulated in installments, the interest is calculated at quarterly rests on the reduced balances.
Commercial banks generally provide short-term loans up to one year for meeting working capital requirements. But, now-a-days, term loans exceeding one year are also provided by banks. The term loans may be either medium-term or long-term loans.
(b) Cash Credits:
A cash credit is an arrangement by which a bank allows his customer to borrow money up to a certain limit against some tangible securities or guarantees. The customer can withdraw from his cash credit limit according to his needs and he can also deposit any surplus amount with him. The interest in case of cash credit is charged on the daily balance and not on the entire amount of the account.
For these reasons, it is the most favourite mode of borrowing by industrial and commercial concerns. The Reserve Bank of India issued directive to all scheduled commercial banks on 28th March 1970, prescribing a commitment charge which banks should levy on the unutilised portion of the credit limits.
Overdraft means an agreement with a bank by which a current account-holder is allowed to withdraw more than the balance to his credit up to a certain limit. There are no restrictions for operation of overdraft limits.
The interest is charged on daily overdrawn balances. The main difference between cash credit and overdraft is that overdraft is allowed for a short period and is a temporary accommodation whereas the cash credit is allowed for a longer period. Overdraft accounts can either be clean overdrafts, partly secured or fully secured.
(d) Purchasing and Discounting of Bills:
Purchasing and discounting of bills is the most important from in which a bank lends without any collateral security. Present day commerce is built upon credit. The seller draws a bill of exchange on the buyer of goods on credit. Such a bill may be either a clean bill or a documentary bill which is accompanied by documents of title to goods such as a railway receipt.
The bank purchases the bills payable on demand and credits the customer’s account with the amount of bills less discount. At the maturity of the bills, bank presents the bill to its acceptor for payment. In case the bill discounted is dishonoured by non-payment, the bank recovers the full amount of the bill from the customer along with expenses in that connection.
In addition to the above mentioned forms of direct finance, commercial banks help their customers in obtaining credit from their suppliers through the letter of credit arrangement.
Letter of Credit:
A letter of credit popularly known as L/C is an undertaking by a bank to honour the obligation of its customer up to a specified amount, should the customer fail to do so. It helps its customers to obtain credit from suppliers because it ensures that there is no risk of non-payment.
L/C is simply a guarantee by the bank to the suppliers that their bills up to a specified amount would be honoured. In case the customer fails to pay the amount, on the due date, to its suppliers, the bank assumes the liabilities of its customer for the purchases made under the letter of credit arrangement.
A letter of credit may be of many types, such as:
(i) Clean Letter of Credit:
It is a guarantee for the acceptance and payment of bills without any conditions.
(ii) Documentary Letter of Credit:
It requires that the exporter’s bill of exchange be accompanied by certain documents evidencing title to the goods.
(iii) Revocable Letter of Credit:
It is one which can be withdrawn by the issuing bank without the prior consent of the exporter.
(iv) Irrevocable Letter of Credit:
It cannot be withdrawn without the consent of the beneficiary.
(v) Revolving Letter of Credit:
In such type of letter of credit the amount of credit is automatically reversed to the original amount after such an amount has once been paid as per defined conditions of the business transaction. There is no deed for further application for another letter of credit to be issued provided the conditions specified in the first credit are fulfilled.
(vi) Fixed Letter of Credit:
It fixes the amount of financial obligation of the issuing bank either in one bill or in several bills put together.
Security Required in Bank Finance:
Banks usually do not provide working capital finance without obtaining adequate security.
The following are the most important modes of security required by a bank:
Under this arrangement, bank provides working capital finance against the security of movable property, usually inventories. The borrower does not give possession of the property to the bank. It remains with the borrower and hypothecation is merely a charge against property for the amount of debt. If the borrower fails to pay his dues to the bank, the banker may file a case to realise his dues by sale of the goods/property hypothecated.
Under this arrangement, the borrower is required to transfer the physical possession of the property of goods to the bank as security. The bank will have the right of lien and can retain the possession of goods unless the claim of the bank is met. In case of default. The bank can even sell the goods after giving due notice.
In addition to the hypothecation or pledge, banks usually ask for mortgages as collateral or additional security. Mortgage is transfer of a legal or equitable interest in a specific immovable property for the payment of a debt.
Although, the possession of the property remains with the borrower, the full legal title is transferred to the lender. In case of default, the bank can obtain decree from the Court to sell the immovable property mortgaged so as to realise its dues.
Short-Term Funds: Source # 10. Public Deposits:
Acceptance of fixed deposits from the public by all type of manufacturing and non-bank financial companies in the private sector has been a unique feature of Indian financial system. The importance of such deposits in financing of Indian industries was recognised as early as in 1931 by the Indian Central Banking Enquiry Committee.
It has been most common in the financing of cotton textile industry in Bombay and Ahmedabad, but in the recent years many companies have accepted deposits from the public to finance their working capital requirements.
The manifold increase in demand for public deposits from the corporate sector in India has been on account of restrictive credit policy of the Govt. of India and a substantial credit gap existing in the market.
As a result, companies have been accepting deposits directly from the public by offering higher rates of interest as compared to banks and post offices to meet their requirements of funds. But even by offering higher rates of interest to the investors, the cost of funds raised through public deposits to the companies has been lower than the minimum rate of interest on bank advances.
In spite of the fact that public deposits are unsecured, more risky, less liquid and without any tax advantage, there has been a tremendous growth both in the amount of public deposits as well in the number of companies accepting such deposits. The number of people making investment in public deposits has also increased manifold.
The public sector (Government Companies) has also started accepting public deposits since June, 1980. According to an estimate, over Rs. 3,000 crores have been invested by way of public deposits in the corporate sector. The study of the tenure of public deposits in various companies shows that about 80 per cent of the deposits were of short nature during 1960s.
But since then the maturity period of the such deposits has been lengthening and about 90 per cent of the deposits were for maximum period of 36 months during the latter half of 1980s. If an industry wise analysis is made, we find that companies engaged in heavy engineering, iron and steels, cotton textiles, cement and chemicals accounted for a large share of public deposits.
Acceptance of public deposits by the corporate sector, in many cases, has been found to encourage non-priority sectors of production and defeat the very purpose of the restrictive credit policy of the Reserve Bank of India.
The growth of public deposits in companies has also been viewed as diversion of people’s savings in the non-banking sector. However, this view has been disputed by many thinkers who think that “eventually these company deposits would find their way into the banking system via tax payments, payments to creditors”, etc.
Since January 1967, the Government of India has tried to restrict the growth of company deposits through various measures. The primary objective of exercising control over public deposits has been to regulate the growth of deposits outside the banking sector as well as to provide some protection to the investors in such deposits.
But, in spite of the restrictive measures, public deposits with the non-banking corporate sector have become a significant part of corporate financing.