Key Takeaways:
- Understand major short-term sources of finance and how they support business operations.
- Learn the unique mechanisms, features, and practical applications of trade credit, commercial paper, and bill discounting.
- Develop the ability to distinguish between short-term and long-term financing options for exam and real-world decision-making.
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Every business whether a manufacturing giant or a small trader must manage its finances wisely. Day-to-day operations, purchases, wage payments, and inventory management all require funds that are often needed for short periods. This is where Short-term Financing Options take center stage. These instruments are crucial for maintaining liquidity, flexibility, and confidence among suppliers and customers. Let's examine the core short-term sources: working capital financing, commercial paper, trade credit, and bill discounting, all of which are directly relevant for UGC NET Commerce aspirants and, indeed, any future business leader.
Short-Term vs Long-Term Sources of Finance
| Short-Term Sources | Long-Term Sources |
|---|---|
| Typically used for day-to-day operations; repayment period is less than one year. | Used for capital expenditures such as plant, machinery, or expansion; repayment period exceeds one year. |
| Examples: trade credit, commercial paper, bill discounting, bank overdrafts. | Examples: equity shares, debentures, term loans, retained earnings. |
| Helps manage working capital requirements and seasonal fluctuations. | Supports long-term growth, modernization, and asset acquisition. |
Working Capital Financing
Definition and Role
Working capital financing refers to the funds sourced for meeting short-term operational needs—like paying suppliers, utility bills, and managing inventory. It's the backbone of smooth business functioning. These funds ensure that a firm's current assets (like receivables and stock) can be quickly converted to cash to meet its current liabilities.
Banks are the most common providers, offering cash credit, overdrafts, and short-term loans. The choice depends on the firm's creditworthiness, collateral, and business cycle requirements. Efficient management here prevents liquidity crunches and costly disruptions.
Trade Credit
a. Meaning and Mechanism
Trade credit is a spontaneous, informal source of finance where suppliers allow a business to purchase goods or services now and pay for them later—usually within 30 to 90 days. No formal agreement is signed, yet it is built on trust and business relationships. The amount of credit extended often depends on the buyer's reputation, previous dealings, and industry practice.
b. Importance in Supply Chains
Why is trade credit so vital? Picture a retailer who needs to stock shelves ahead of a festival season. Immediate cash might not be available, but suppliers willing to offer trade credit keep the supply chain fluid. This arrangement:
- Reduces the need for immediate cash outflow.
- Strengthens relationships between buyers and suppliers.
- Enables businesses to maintain higher inventory levels during peak seasons.
- Acts as a source of competitive advantage for both parties.
Trade credit is often considered the largest single source of short-term finance for business enterprises, especially in trading and manufacturing sectors.
However, excessive reliance on trade credit can strain supplier relationships and sometimes lead to higher costs if prompt payment discounts are ignored or late fees accrue.
Commercial Paper
a. Eligibility and Issue Process
Commercial paper (CP) is an unsecured, short-term debt instrument issued by large, creditworthy firms to raise funds directly from the money market. Only companies with strong credit ratings and a solid financial history can issue CP. The instrument usually has a maturity period ranging from 7 days up to one year.
CP is typically issued at a discount to face value and is redeemed at par. It is regulated by the Reserve Bank of India (RBI) in India, and requirements include:
- Minimum tangible net worth (often specified by RBI guidelines).
- Good credit rating from approved rating agencies.
- Listing with recognized depositories for dematerialized trading.
b. Advantages for Top-Rated Firms
- Lower cost of funds: Interest rates are generally below those of bank loans for top-rated companies.
- No collateral required: Because only financially strong firms can issue CP, it's unsecured.
- Quick access: Firms can tap into funds rapidly to meet short-term needs, such as inventory buildup or seasonal working capital requirements.
- Flexible maturity: Issuers can choose maturities to match anticipated cash inflows.
For investors, commercial paper offers a relatively safe, liquid, and higher-yielding alternative to traditional savings products, provided the issuer's credit rating is sound.
Bill Discounting
a. Mechanism
Bill discounting is a process where a business sells its accounts receivable (bills of exchange) to a bank at a discount before they are due. The bank pays the business an amount less than the bill's face value, and collects the full amount from the debtor at maturity. This provides immediate funds to the business, enhancing its liquidity.
The typical steps are:
- Seller draws a bill of exchange on the buyer for goods supplied.
- Buyer accepts the bill, confirming liability to pay on the due date.
- Seller submits the accepted bill to a bank for discounting.
- Bank deducts a discount (interest) and credits the seller with the balance.
- On maturity, the bank collects the full amount from the buyer.
b. Role of Banks
- Banks act as intermediaries, providing liquidity to sellers before the actual payment date.
- Through bill discounting, banks help businesses bridge cash flow gaps and manage working capital efficiently.
- Banks assess the creditworthiness of both the drawer and drawee before discounting bills, reducing credit risk.
Bill discounting is widely used in sectors where goods are sold on credit, such as textiles, chemicals, and engineering goods.
Example
Consider a supplier, XYZ Ltd., who sells goods worth ₹5,00,000 to a retailer on 60 days credit. XYZ Ltd. draws a bill of exchange, which is accepted by the retailer. Ten days later, XYZ Ltd. approaches its bank to discount the bill, as it needs cash for new inventory. The bank discounts the bill at 10% per annum. Let's calculate how much XYZ Ltd. receives:
- Calculate discount period: 50 days left (60 - 10)
- Calculate discount amount:
- Discount = ₹5,00,000 × 10% × (50/365) = ₹6,849 (rounded)
- Amount received by XYZ Ltd.:
- ₹5,00,000 - ₹6,849 = ₹4,93,151
- On maturity, the bank collects ₹5,00,000 from the retailer.
Key Features of Short-Term Financing Options
| Source | Nature | Typical Users | Cost | Collateral |
|---|---|---|---|---|
| Trade Credit | Supplier-provided credit for purchases | All businesses | Usually nil or implicit | None |
| Commercial Paper | Unsecured promissory note | Large, top-rated firms | Lower than bank loans | None |
| Bill Discounting | Bank discounts bills of exchange | Firms selling on credit | Discount rate charged | Bill itself serves as security |
| Working Capital Loans | Loans/overdrafts from banks | All businesses | Interest charged | Often required |
Short-term financing options are the lifeblood of business operations, supporting everything from inventory purchases to payroll. Trade credit fosters trust and supply chain efficiency. Commercial paper empowers large enterprises to tap into the money market, while bill discounting and working capital loans keep the wheels turning for all types of firms.