Sources of Short term and long term finance

The business requires two types of finance namely:

1. Short term finance

2. Long term finance

Short term finance is concerned with decisions relating to current assets and current liabilities and is
also called as working capital finance.
Short term financial decisions typically involve cash flows within a year or within the operating
cycle of the firm. Normally short term finance is for a period upto 3 years.

The main sources of short term finance are:

1. Cash credit
2. Short term loans from financial institutions
3. Bill Discounting
4. Letter of credit
5. Inter-corporate deposits
6. Commercial papers
7. Factoring
8. Working capital advance by commercial banks

1. Cash Credit:
Cash Credit facility is taken basically for financing the working capital requirements of the
organization. Interest is charged the moment cash credit is credited to the Bank A/C irrespective of
the usage of the Cash Credit.

2. Short term loans from financial institutions:

Bank overdraft

3. Bill Discounting:
Bill Discounting is a short term source of finance, whereby Bills Receivable received from debtors
are in cashed from the bank at a discounted rate.

4. Letter of credit
Letter of credit is an indirect form of working capital financing and banks assume only the risk,
the credit being provided by the supplier himself.
A letter of credit is issued by a bank on behalf of its customer to the seller. As per this document, the
bank agrees to honor drafts drawn on it for the supplies made to the customer. I f the seller fulfills
the condition laid down in the letter of credit.

5.Inter- corporate Deposits

A deposit made by one company with another, normally for a period of six months is referred to as
an ICD ie. Short-term deposits with other companies are a fairly attractive form of investment of
short term funds in terms of rate of return.
These deposits are usually of three types:
a. Call deposits: A call deposit is withdraw able by the lender on a given days notice.
b. Three-months Deposits: These deposits are taken by the borrowers to tied over a short term
cash inadequacy
 c. Six-month Deposits: Normally lending companies do not extend deposits beyond this time
frame. Such deposits are usually made with first-class borrowers.

6. Commercial papers
A company can use commercial papers to raise funds. It is a promissory note carrying the
undertaking to repay the amount or/ on after a particular date.

7. Factoring
A factor is a financial institution which offers services relating to management and financing
of debts arising form credit sales. Factoring provides resources to finance receivables as well as
facilitates the collection of receivables.
There are 2 banks, sponsored organizations which provide such services:
a. SBI factos and commercial services LTD
b. Canbank factors LTD, started operations since the beginning of 1997.

8.Working capital advance by commercial banks

Since the above sources do not permit the use of funds, for a longer period of time, the business has
to seek further sources, if the need is for a longer period of time , ie. which extends to 3 years and
above.
When a firm wants to invest in long term assets, it must find the needs to finance them. The firm can
rely to some extent on funds generated internally. However, in most cases internal resources are not
enough to support investment plans. When that happens the firm may have to curtail investment plan
or seek external funding. Most firms choose to take external funding. They supplement internal
funding with external funding raise from a variety of sources.

The main sources of long term finance can broadly divided into:
1. Internal
2. External

Internal sources include:

a. Share capital (Equity shares and preference shares)
b. Reserves and Surplus
c. Personal loans and advances from owners called as ‘Quasi Capital’

External sources include:

a. Term loan from banks, financial institutions and international bodies like International
Monetary Funds, World Bank, Asian Development Bank.
b. Debentures
c. Loans and advances from friends and relatives
d. Inter- Corporate Deposits
e. Asian Depository Receipts / Global Depository Receipts
f. Commercial Papers
The short term or long term finance is a function of financial management. The good and efficient
management is that which can raise the funds whenever required and at the most competitive terms
and conditions. Raising of funds either internally or externally requires a professional approach and
also complying with so many legal, technical and statutory requirements prescribed by the
Companies Act, Securities Exchange Board Of India, Stock Exchanges Authorities and also allied
laws like Income Tax, Foreign Exchange Management Act, Banking Regulations Act, etc.

Sources of Finance

Sale of Assets

Business balance sheets usually have several fixed assets on them. A fixed asset is anything that is
not used up in the production of the good or service concerned - land, buildings, fixtures and fittings,
machinery, vehicles and so on. At times, one or more of these fixed assets may be surplus to
requirements and can be sold.

Alternatively, a business may desperately need to find some cash so it decides to stop offering
certain products or services and because of that can sell some of its fixed assets. Hence, by selling
fixed assets, business can use them as a source of finance. Selling its fixed assets, therefore, has an
effect on the potential capacity of the business - the amount it can produce.

Ordinary Shares

Ordinary shares are also known as equity shares and they are the most common form of share in the
UK. An ordinary share gives the right to its owner to share in the profits of the company (dividends)
and to vote at general meetings of the company.

Since the profits of companies can vary wildly from year to year, so can the dividends paid to
ordinary shareholders. In bad years, dividends may be nothing whereas in good years they may be
substantial. Some businesses may choose to pay out a dividend even if it has had a difficult trading
year and has made a loss! (How do you think this is possible and why might a business choose to do
this?)

Ordinary shareholders can vote on all of the issues raised at a general meeting of the company
including:
Appointment of directors and auditors
Whether to accept the dividend proposed
Changes to the company's constitution (memorandum and articles of association)

The nominal value of a share is the issue value of the share - it is the value written on the share
certificate that all shareholders will be given by the company in which they own shares.

The market value of a share is the amount at which a share is being sold on the stock exchange and
may be radically different from the nominal value.

Don't forget that the stock market is actually just a second hand share market so even though no
company ever wants its share price to collapse in the ways that we have just seen, these share price
catastrophes do not directly affect the business. However, with such a depressed share price,
companies might find it vey difficult to raise additional finance or reassure existing creditors that
they are a worthwhile risk.

Preference Shares

Preference shares offer their owners preferences over ordinary shareholders. There are two major
differences between ordinary and preference shares:
Preference shareholders are often entitled to a fixed dividend even when ordinary shareholders are
not.
Preference shareholders cannot normally vote at general meetings.

Note, that if by any chance a company cannot pay its preference share dividend then it cannot pay
any ordinary share dividend since the preference shareholders have the right to receive their dividend
before the ordinary shareholders under all circumstances - hence the term 'preference'.

Preference shares are usually cumulative and this means that if this year's dividend wasn't paid, then
it will be carried forward to next year.

Debentures

Debentures are loans that are usually secured and are said to have either fixed or floating charges
with them.

A secured debenture is one that is specifically tied to the financing of a particular asset such as a
building or a machine. Then, just like a mortgage for a private house, the debenture holder has a
legal interest in that asset and the company cannot dispose of it unless the debenture holder agrees. If
the debenture is for land and/or buildings it can be called a mortgage debenture.

Debenture holders have the right to receive their interest payments before any dividend is payable to
shareholders and, most importantly, even if a company makes a loss, it still has to pay its interest
charges.

If the business fails, the debenture holders will be preferential creditors and will be entitled to the
repayment of some or all of their money before the shareholders receive anything.

Other Loans

The term debenture is a strictly legal term but there are other forms of loan or loan stock. A loan is
for a fixed amount with a fixed repayment schedule and may appear on a balance sheet with a
specific name telling the reader exactly what the loan is and its main details.

Overdraft Facilities

Many companies have the need for external finance but not necessarily on a long-term basis. A
company might have small cash flow problems from time to time but such problems don't call for
the need for a formal long-term loan. Under these circumstances, a company will often go to its bank
and arrange an overdraft. Bank overdrafts are given on current accounts and the good point is that
the interest payable on them is calculated on a daily basis. So if the company borrows only a small
amount, it only pays a little bit of interest.

Hire Purchase

Hire Purchase is a method of acquiring assets without having to invest the full amount in buying
them. Typically, a hire purchase agreement allows the hire purchaser sole use of an asset for a period
after which they have the right to buy them, often for a small or nominal amount. The benefit of this
system is that companies gain immediate use of the asset without having to pay a large amount for it
or without having to borrow a large amount.

Lines of Credit from Creditors

This source of finance really belongs under the heading of working capital management since it
refers to short term credit. By a 'line of credit' we mean that a creditor, such as a supplier of raw
materials, will allow us to buy goods now and pay for them later. Why do we include lines of credit
as a source of finance? Well, if we manage our creditors carefully we can use the line of credit they
provide for us to finance other parts of our business.

Grants

Grants can be an attractive aspect of a company's financing structure. If a company has a specific
issue that it wants or needs to deal with then it could find that there are grants available from local
councils and other bodies that will help to pay for it.

Venture Capital

Venture Capital has become a vital aspect of the source of finance market over the last 10 to 15
years. Venture Capital can be defined as capital contributed at an early stage in the development of a
new enterprise, which may have a significant chance of failure but also a significant chance of
providing above average returns and especially where the provider of the capital expects to have
some influence over the direction of the enterprise. Venture Capital can be a high risk strategy.

Factoring

Factoring allows you to raise finance based on the value of your outstanding invoices. Factoring also
gives you the opportunity to outsource your sales ledger operations and to use more sophisticated
credit rating systems. Once you have set up a factoring arrangement with a Factor, it works this way:

Once you make a sale, you invoice your customer and send a copy of the invoice to the factor and
most factoring arrangements require you to factor all your sales. The factor pays you a set proportion
of the invoice value within a pre-arranged time - typically, most factors offer you 80-85% of an
invoice's value within 24 hours.

The major advantage of factoring is that you receive the majority of the cash from debtors within 24
hours rather than a week, three weeks or even longer.
Invoice Discounting

Invoice discounting enables you to retain the control and confidentiality of your own sales ledger
operations.

The client company collects its own debts. 'Confidential invoice discounting' ensures that customers
do not know you are using invoice discounting as the client company sends out invoices and
statements as usual. The invoice discounter makes a proportion of the invoice available to you once
it receives a copy of an invoice sent.

Once the client receives payment, it must deposit the funds in a bank account controlled by the
invoice discounter. The invoice discounter will then pay the remainder of the invoice, less any
charges.

The requirements are more stringent than for factoring. Different invoice discounters will impose
different requirements.