Short term finance in business usually refers to the additional money a business requires for doing its business for short terms, which is usually a maximum period of one year. These funds are usually used for day to day operations such as payment of wages, inventory ordering, advertisement expenses and so on.
The major sources of short term finance are discussed below:
1. Trade Credit
Trade credit is a common source of short-term finance available to all companies. It refers to the amount payable to the suppliers of raw materials, goods etc. after an agreed period, which is generally less than a year. It is customary for all business firms to allow credit facility to their customers in trade business. Thus, it is an automatic source of finance. With the increase in production and corresponding purchases, the amount due to the creditors also increases. Thereby part of the funds required for increased production is financed by the creditors. The more important advantages of trade credit as a source of short-term finance are the following:
- It is readily available according to the prevailing customs. There are no special efforts to be made to avail of it. Trade credit is a flexible source of finance. It can be easily adjusted to the changing needs for purchases.
- Where there is an open account for any creditor failure to pay the amounts on time due to temporary difficulties does not involve any serious consequence Creditors often adjust the time of payment in view of continued dealings. It is an economical source of finance.
However, the liability on account of trade credit cannot be neglected. Payment has to be made regularly. If the company is required to accept a bill of exchange or to issue a promissory note against the credit, payment must be made on the maturity of the bill or note. It is a legal commitment and must be honored; otherwise legal action will follow to recover the dues.
2. Bank Loans and Advances
Money advanced or granted as loan by commercial banks is known as bank credit. Companies generally secure bank credit to meet their current operating expenses. The most common forms are cash credit and overdraft facilities. Under the cash credit arrangement the maximum limit of credit is fixed in advance on the security of goods and materials in stock or against the personal security of directors. The total amount drawn is not to exceed the limit fixed. Interest is charged on the amount actually drawn and outstanding. During the period of credit, the company can draw, repay and again draw amounts with in the maximum limit. In the case of overdraft, the company is allowed to overdraw its current account up to the sanctioned limit. This facility is also allowed either against personal security or the security of assets. Interest is charged on the amount actually overdrawn, not on the sanctioned limit.
The advantage of bank credit as a source of short-term finance is that the amount can be adjusted according to the changing needs of finance. The rate of interest on bank credit is fairly high. But the burden is no excessive because it is used for short periods and is compensated by profitable use of the funds.
Commercial banks also advance money by discounting bills of exchange. A company having sold goods on credit may draw bills of exchange on the customers for their acceptance. A bill is an order in writing requiring the customer to pay the specified amount after a certain period. After acceptance of the bill, the company can drawn the amount as an advance from many commercial banks on payment of a discount. The amount of discount, which is equal to the interest for the period of the bill, and the balance, is available to the company. Bill discounting is thus another source of short-term finance available from the commercial banks.
3. Short Term Loans from Finance Companies
Short-term funds may be available from finance companies on the security of assets. Some finance companies also provide funds according to the value of bills receivable or amount due from the customers of the borrowing company, which they take over.
4. Bridge Loans
A bridge loan is a type of short-term loan, typically taken out for a period of two weeks to three years pending the arrangement of larger or longer-term financing. It is interim financing for an individual or business until permanent or next-stage financing can be obtained. Money from the new financing is generally used to “take out” (i.e. to pay back) the bridge loan, as well as other capitalization needs.
Bridge loans are typically more expensive than conventional financing to compensate for the additional risk of the loan. Bridge loans typically have a higher interest rate, points and other costs that are amortized over a shorter period, as well as various fees and other “sweeteners” like equity participation by the lender. The lender also may require cross-collateralization and a lower loan-to-value ratio. On the other hand, they are typically arranged quickly with little documentation.