Business credit services

Sources of Working Capital Finance One of the important tasks of the finance manager is to select an assortment of appropriate sources to finance the current assets. A business credit services firm has various sources to meet its financial requirements.

Normally, the current assets are supported by a combination of long term and short term sources of financing. In selecting a particular source a firm has to consider the merits and demerits of each source in the context of prevailing constraints.

The long term working capital an be conveniently financed by

a) Owners equity

b) Preferred equity

c) Lenders equity

d) Fixed assets reduction

Sources of short term finance

In choosing a source of short term financing, the business credit services manager is concerned with the following 5 aspects of each financing arrangement.

a) Cost

Generally the finance manager will seek to minimize the cost of financing, which can be usually expressed as an annual interest rate. Therefore, the financing source with the lowest interest rate will be chosen. However, there are other factors which may be important in particular situations.

b) Impact on credit rating

Use of some sources may affect the firms business credit services rating more than use of others. A poor credit rating limits the availability and increases the cost of additional financing.

c) Reliability

Some sources are more reliable than others in that funds are more likely to be available when they are needed.

d) Restrictions

Some creditors are more apt to impose restrictions on the firm than others. Restrictions might include rupee limits on dividends, management salaries, and capital expenditures.

e) Flexibility

Some sources are more flexible than others in that the firm can increase or decrease the amount of funds provided very easily.

All these factors must usually be considered before making the decision as to the sources of financing.

Trade Credit

Trade Credit represents credit granted by manufacturers, wholesalers, etc. as an incident of sale. The usual duration of credit is 30 to 90 days. It is granted to the company on open account, without any security except that of the goodwill and financial standing of purchaser. No interest is expressly charged for this, only the price is a little higher than the cash price.

The use of trade credit depends upon the buyers need for it and the willingness of the supplier to extend it. The willingness of a supplier to grant credit depends upon

a) The financial resources of the supplier

b) His eagerness to dispose of his stock

c) Degree of competition in the market

d) The credit worthiness of the firm

e) Nature of the product

f) Size of discount offered

g) The degree of risk associated with customers

The length of the credit depends upon

a) Customer's marketing period

b) Nature of the product (long credit for new, seasonal goods and short credit for perishable goods and low margin goods)

c) Customer location

Cost of Trade Credit

The trade credit as a source of financing is not without cost. The cost of trade credit is clearly determined by its terms. However, the terms of trade credit vary industry to industry and from company to company. However, regardless of the industry, the two factors that must be considered while analyzing the terms and the cost of trade credit are,

a) The length of time the purchaser of goods has before the bill must be paid

b) The discount, if any that is offered for prompt payment.

Advantages of Trade Credit

Trade Credit, as a form of short term financing has the following advantages.

a) Ready Availability

There is no need to arrange financing formally.

b) Flexible means of financing

Trade credit is a more flexible means of financing. The firm does not have to sign a Promissory Note, pledge collateral, or adhere to a strict payment schedule on the Note.

c) Economic means of financing

Generally, during periods of tight money large firms obtain credit more easily than small firms do. However, trade credit as a source of financing is still more easily accessible by small firms even during the periods of tight money.

Customers Advances

Depending upon the competitive condition of the market and customs of trade, a company can meet its short term requirements at least partly through customer / dealers advances. Such advances represent part of the price and carry no interest. The period of such credit will depend upon the time taken to deliver the goods. This type of finance is available only to those firms which can dictate terms to their customers since their product is in great demand as compared to the products of the other competitive firms.

Commercial Bank: Bill Discounting and Cash Credit

Bank credit is the primary institutional source of working capital finance. Banks offer both unsecured as well as secured loans to business firms. At one time banks confined their lending policies to such loans only. Banks, now, provide a variety of business loans, tailored to the specific needs of the borrowers. Still, short term loans are an important source of business financing such as seasonal build ups in accounts receivable, and inventories. The different forms in which unsecured and secured short term loans may be extended are discounting of bills of exchange, overdraft, cash credit, loans and advances. Banks provide credit on the basis of the security. A loan may either be secured by tangible assets or by personal security. Tangible assets may be charged as security by any one of the following modes, such as, lien, pledge, hypothecation, mortgage, charge, etc.

Discounting and purchase of bills

Under the Bill Market scheme, the Reserve Bank of India envisages the progressive use of bills as an instrument of credit as against the current practice of using the widely prevalent cash credit arrangement for financing working capital. To popularize the scheme, the discount rates are fixed at lower rates than those of cash credit, the difference being about 1 to 1.5 percent.

Cash Credits

Banks in India normally make loans and advances in three forms such as cash credits, overdrafts and loans. Cash credit is an arrangement by which a banker allows the customer to borrow money up to a certain limit (called cash credit limit) against some tangible security or on the basis of a promissory note signed and fixes the limit annually or quarterly after taking into account several material levels. The banker keeps adequate cash balances so as to meet the customer's demand as and when demand arises. Once the cash credit arrangement is made, the customer need not take the whole advance at once but may draw out or utilize the bank credit at any time without keeping a credit balance. Further, the borrower can put back any surplus amount which he may find with him for the time being. The bank can also withdraw the credit at any time in case the financial position of the borrower goes down. Generally the borrower is charged interest on the actual amount utilized by him and for the period of actual utilization only; interest is charged by the bank on daily debit balance.

Overdrafts

When a customer having a current account requires a temporary financial accommodation, he is allowed to overdraw (to draw more than his credit balance) his current account up to an agreed limit. Overdraft accounts can either be secured or unsecured, usually, security is insisted upon for an overdraft arrangement. The customer is allowed to withdraw the amount by cheques as and when he needs it and repays it by means of deposits into his account as and when it is feasible for him. Interest is charged on the daily debit balance i.e. the exact amount overdrawn by the customer and for the period of actual utilization. This is more advantageous to the customer borrower in the sense that the interest is charged only on the amount drawn by him. But the banker is comparatively at a disadvantage because he has to keep himself in readiness with the full amount of the overdraft and he can charge interest on the amount actually drawn. An overdraft, is different from a cash credit in that the former is supposed to be for a comparatively short time whereas the latter is not so.

Loans

When an advance to a customer is made in a lump sum against security or otherwise, without liberty to him of repaying, with a view to making

a subsequent withdrawal it is called a loan. The entire loan amount is paid to the borrower in cash or is credited to his current account and interest is charged on the full amount of the loan from quarterly rests from the date of sanction. Where the loan is repayable in instalments the interest is charged only on the reduced balance. A loan once repaid in full or in part cannot be withdrawn again by the borrower, unless the banker grants a fresh loan which will be treated as a separate transaction. In this respect a loan account differs from a cash credit or an overdraft account. A banker prefers to make an advance in the form of a loan because he can charge interest on the entire amount of the loan sanctioned or disbursed and secondly, loan account involves a smaller operating cost than overdraft or cash credit because in the latter case there is continuity and magnitude of operation.

Critical Evaluation of Bank Finance: Bank credit offers the following advantages to the borrowing companies:

(1) Timely Assistance: Banks assists the borrowing companies by providing timely assistance to meet the working capital requirements. A company a usually rely upon the bank for amounts of loan unto an agreed limit sanctioned by bank in advance.

(2) Flexibility: Bank assistance is flexible to the company. The accommodation an easily be got extended and may be used when it is urgently needed. It helps the company in maintaining goodwill in the market. Also, if the amount of loan or a part of it is no more required it can be repaid and interest on it be saved.

(3) Economy: Bank assistance entails the payment of only interest and does not involve the kind of costs which are to be incurred in the issue of securities such as commission on underwriting etc. Moreover, the rate of interest is not very high. The interest is payable only for the period the loan remains unpaid. Thus it reduces the cost of borrowings.

(4) No Permanent Burden: The borrowings can be repaid if it is no more required. In this way, it is not a permanent burden to the concern.

(5) No interference with company Management: The loan provided by the bank is simply a loan and no string is attached to it. Generally the banks do not interfere with the management of the borrowing companies, till bank is assured of the repayment of loans.

(6) Secrecy: This is by far the greatest advantage of bank finance. Any information supplied to bank regarding financial position of the borrowing company is not made public in any way by the bank.

Drawback of Bank Finance

Bank accommodation and loans suffer from the following draw backs.

(1) Burden of mortgage or Hypothecation

The stock of raw material, finished or semi finished goods are to be kept in godowns under bank control and can be used only with the permission of the bank or after paying the amount of loan.

(2) Short Duration of Assistance

Banks provide only short term assistance generally for the period less than a year and its renewal or its extension is quiet uncertain depending upon the discretion of banks authorities.

(3) Cumbersome Terms

Banks grant assistance generally, to the extent of 50% to 75% of the cost of security pledged or hypothecated, thus having a margin of 25% to 50%. In addition, banks press the borrowing companies to have goods in their godowns. Minimum interest is paid on a certain specific amount whether it is drawn or not and repayment of loan is strictly enforced as per the agreement entered in to between the company and the bank. Thus, the terms of borrowing are too harsh. It also increases the cost of new borrowings and of the production.

Other Articles

most reliable source of finance for this purpose.
carefully planned sales promotions can deliver long-term benefits to your organization.
potential customers about the products and services that you have to offer them.