Sources of Short-term Finance

Introduction
The need for finance may be for long-term, medium-term or for short-term. Financial
requirements with regard to fixed and working capital vary from one organization to other. To
meet out these requirements, funds need to be raised from various sources. Some sources like
issue of shares and debentures provide money for a longer period. These are therefore, known as
sources of long-term finance. On the other hand sources like trade credit, cash credit, overdraft,
bank loan etc. which make money available for a shorter period of time are called sources of
short-term finance. In this lesson you will study about the various sources of short-term finance
and their relative merits and demerits.
18.2 Objectives
After studying this lesson, you will be able to:
discuss the purpose served by short-term finance;
identify and explain the various sources of short-term finance;
outline the merits and demerits of short-term finance.
describe the relative merits of trade credit and bank credit;
explain the advantages and disadvantages of bill discounting;
distinguish between bank over-draft and bank loans;
differentiate between bank overdraft and cash credit.
identify the types of securities required for bank credit.
state the merits and demerits of customers advances as a source of short-term finance.
enumerate advantages and disadvantages of installment credit as a source of short-term
finance.
explains the benefits and drawbacks of finance from co-operative banks.
Purpose of Short-term Finance
After establishment of a business, funds are required to meet its day to day expenses. For
example raw materials must be purchased at regular intervals, workers must be paid wages
regularly, water and power charges have to be paid regularly. Thus there is a continuous
necessity of liquid cash to be available for meeting these expenses. For financing such
requirements short-term funds are needed. The availability of short-term funds is essential.
Inadequacy of short-term funds may even lead to closure of business.
Short-term finance serves following purposes
1. It facilitates the smooth running of business operations by meeting day to day financial
requirements.
2. It enables firms to hold stock of raw materials and finished product.
3. With the availability of short-term finance goods can be sold on credit. Sales are for a certain
period and collection of money from debtors takes time. During this time gap, production
continues and money will be needed to finance various operations of the business.
4. Short-term finance becomes more essential when it is necessary to increase the volume of
production at a short notice.
5. Short-term funds are also required to allow flow of cash during the operating cycle. Operating
cycle refers to the time gap between commencement of production and realization of sales.
18.4 Sources of Short-term Finance
There are a number of sources of short-term finance which are listed below:
1. Trade credit
2. Bank credit
– Loans and advances
– Cash credit
– Overdraft
– Discounting of bills
3. Customers’ advances
4. Installment credit
5. Loans from co-operatives
1. Trade Credit
Trade credit refers to credit granted to manufactures and traders by the suppliers of raw material,
finished goods, components, etc. Usually business enterprises buy supplies on a 30 to 90 days
credit. This means
That the goods are delivered but payments are not made until the expiry of period of credit. This
type of credit does not make the funds available in cash but it facilitates purchases without
making immediate payment. This is quite a popular source of finance.
2. Bank Credit
Commercial banks grant short-term finance to business firms which are known as bank credit.
When bank credit is granted, the borrower gets a right to draw the amount of credit at one time or
in installments as and when needed. Bank credit may be granted by way of loans, cash credit,
overdraft and discounted bills.
(i) Loans
When a certain amount is advanced by a bank repayable after a specified period, it is known as
bank loan. Such advance is credited to a separate loan account and the borrower has to pay
interest on the whole amount of loan irrespective of the amount of loan actually drawn. Usually
loans are granted against security of assets.
(ii) Cash Credit
It is an arrangement whereby banks allow the borrower to withdraw money up to a specified
limit. This limit is known as cash credit limit. Initially this limit is granted for one year. This
limit can be extended after review for another year. However, if the borrower still desires to
continue the limit, it must be renewed after three years. Rate of interest varies depending upon
the amount of limit. Banks ask for collateral security for the grant of cash credit. In this
arrangement, the borrower can draw, repay and again draw the amount within the sanctioned
limit. Interest is charged only on the amount actually withdrawn and not on the amount of entire
limit.
(iii) Overdraft
When a bank allows its depositors or account holders to withdraw money in excess of the
balance in his account up to a specified limit, it is known as overdraft facility. This limit is
granted purely on the basis of credit-worthiness of the borrower. Banks generally give the limit
up to Rs.20, 000. In this system, the borrower has to show a positive balance in his account on
the last Friday of every month. Interest is charged only on the overdrawn money. Rate of interest
in case of overdraft is less than the rate charged under cash credit.
(iv) Discounting of Bill
Banks also advance money by discounting bills of exchange, promissory notes and handiest.
When these documents are presented before the bank for discounting, banks credit the amount to
customer’s account after deducting discount. The amount of discount is equal to the amount of
interest for the period of bill.
3. Customers’ Advances
Sometimes businessmen insist on their customers to make some advance payment. It is generally
asked when the value of order is quite large or things ordered are very costly. Customers’
advance represents a part of the payment towards price on the product (s) which will be delivered
at a later date. Customers generally agree to make advances when such goods are not easily
available in the market or there is an urgent need of goods. A firm can meet its short-term
requirements with the help of customers’ advances.
4. Installment credit
Installment credit is now-a-days a popular source of finance for consumer goods like television,
refrigerators as well as for industrial goods. You might be aware of this system. Only a small
amount of money is paid at the time of delivery of such articles. The balance is paid in a number
of installments. The supplier charges interest for extending credit. The amount of interest is
included while deciding on the amount of installment. Another comparable system is the hire
purchase system under which the purchaser
becomes owner of the goods after the payment of last installment. Sometimes commercial banks
also grant installment credit if they have suitable arrangements with the suppliers.

5. Loans from Co-operative Banks

Co-operative banks are a good source to procure short-term finance. Such banks have been
established at local, district and state levels. District Cooperative Banks are the federation of
primary credit societies. The State Cooperative Bank finances and controls the District
Cooperative Banks in the state. They are also governed by Reserve Bank of India regulations.
Some of these banks like the Vanish Co-operative Bank was initially established as a co-
operative society and later converted into a bank. These banks
grant loans for personal as well as business purposes. Membership is the primary condition for
securing loan. The functions of these banks are largely comparable to the functions of
commercial banks.
18.5 Merits and Demerits of Short-term Finance
Short-term loans help business concerns to meet their temporary requirements of money. They
do not create a heavy burden of interest on the organization. But sometimes organizations keep
away from such loans because of uncertainty and other reasons.
Merits of short-term finance
a) Economical: Finance for short-term purposes can be arranged at a short notice and does not
involve any cost of rising. The amount of interest payable is also affordable. It is, thus, relatively
more
economical to raise short-term finance.
b) Flexibility: Loans to meet short-term financial need can be raised as and when required.
These can be paid back if not required. This provides flexibility.
c) No interference in management: The lenders of short-term finance cannot interfere with the
management of the borrowing concern. The management retains their freedom in decision
making.
d) May also serve long-term purposes : Generally business firms keep on renewing short-term
credit, e.g., cash credit is granted for one year but it can be extended up to 3 years with annual
review. After three years it can be renewed. Thus, sources of short-term finance may sometimes
provide funds for long-term purposes.
Demerits of short-term finance
Short-term finance suffers from a few demerits which are listed below:
a) Fixed Burden: Like all borrowings interest has to be paid on short-term loans irrespective of
profit or loss earned by the organization. That is why business firms use short-term finance only
for temporary purposes.
b) Charge on assets: Generally short-term finance is raised on the basis of security of moveable
assets. In such a case the borrowing concern cannot raise further loans against the security of
these assets nor can these be sold until the loan is cleared (repaid).
c) Difficulty of raising finance: When business firms suffer intermittent losses of huge amount
or market demand is declining or industry is in recession, it loses its creditworthiness. In such
circumstances they find it difficult to borrow from banks or other sources of short-term finance.
d) Uncertainty: In cases of crisis business firms always face the uncertainty of securing funds
from sources of short-term finance. If the amount of finance required is large, it is also more
uncertain to get the finance.
e) Legal formalities: Sometimes certain legal formalities are to be complied with for raising
finance from short-term sources. If shares are to be deposited as security, then transfer deed must
be prepared.
Such formalities take lot of time and create lot of complications.

Advantages of Bill discounting

a) Immediate availability of cash: By discounting the bill, the drawer gets cash immediately.
He does not have to wait for the payment until the expiry of credit period stated on the bill.
b) No extra security is to be offered: Banks generally do not ask for any other security while
making payment against the bill discounted. However, if a customer is interested, banks also
grant him limit for discounting of bills. This limit is known as ‘limit against discounted bills’.
Usually banks ask for certain security while extending this limit. Such limit is obtained when
drawing of bills of exchange is almost a regular feature in business.
c) Nature of liability for repayment: Repayment of money advanced against discounted bill is
the responsibility of the drawer of bills of exchange. Banks therefore approach the drawer, who
is generally the acceptor of the bill, for payment after the due date on the bill. In case the drawer
does not pay or refuses to pay, the drawer or the person who got payment after discounting the
bill is held responsible for payment.
Disadvantages of Bill discounting
(a) Payment of interest in advance: While discounting a bill, bank deducts the discount and
balance is credited in customer’s account. This discount is equal to the amount of interest for the
remaining period of payment against the bill. Thus, a person receiving money through
discounting of bill has to offer advance interest on the amount of the bill.
(b) Facility is subjected to the creditworthiness of parties involved: Banks generally extend
this facility after being satisfied with the creditworthiness of different parties involved. In case of
doubt, the bank may ask for some security. Thus, it is not a very easily available facility.
(c) Additional burden in case of non-payment: Bills not paid upon maturity are to be certified
by Notary Public and a certain amount in the form of noting charges is paid. Thus, it becomes an
additional
burden.
18.8 Distinction between Bank Overdraft and Bank Loan
a) Charge of interest: Interest is charged only on the overdrawn amount in the case of bank
overdraft, but in the case of bank loan, interest is charged on the entire amount of loan.
b) Amount of borrowing: The amount of borrowing is limited in case of bank overdraft, but
bank loan may be for any amount depending upon the securities offered by the borrower against
the loan.
c) Renewal procedure: The renewal procedure is very simple in the case of overdraft. Banks
require positive balance to be shown in the customer’s account on the last Friday of every month.
But loans are to be paid back after the expiry of credit period. For renewal, fresh negotiations are
to be made.
d) Security: Overdraft facility is generally granted by banks purely on the basis of credit
worthiness of the customer, but for bank loan security of tangible assets is an essential
requirement besides the personal security of the borrower.
e) Rate of interest: Rate of interest is generally higher in case of bank loan.
f) Flexibility: Bank overdraft is more flexible than bank loan. Money can be withdrawn,
deposited and again withdrawn within the limits. But in case of bank loan the amount sanctioned
is fixed.
g) Economical: Bank overdraft is more economical because interest is paid only on the amount
drawn in excess of the balance. However in case of bank loan interest is paid on the whole
amount of loan, whether it is withdrawn or not.
h) Repayment: Bank overdraft can be repaid conveniently by the customer. But the amount of
entire bank loan has to be repaid on the expiry of credit period. It appears to be more
burdensome.
18.9 Distinction between Bank Overdraft and Cash Credit
a) Cash credit is a separate arrangement of credit granted by a bank to a firm. The firm may or
may not have an account with the bank. Overdraft is granted to an account holder purely on the
basis of his credit-worthiness. Credit worthiness is decided by the financial soundness of past
dealings of the customer with the bank.
b) In case of cash credit, the amount of credit is placed in a separate account of the borrower.
Overdraft limit is generally granted to an existing account of the customer.
c) The amount of credit in case of cash credit depends upon the value of securities offered. But
overdraft limit is decided on the average balance of the customer in his account.
d) Overdraft is granted without the security of tangible assets. But for cash credit security of
tangible assets is an essential requirement.
18.10 Types of Securities required for Bank credit
Loans and advances are granted by bank on personal security of the borrower as well as on the
security of some tangible assets, besides the standing of the firm. Thus securities against bank
credit may be of two
types:
(i) Personal security
(ii) Security of tangible assets.
Personal security means the credit-worthiness of the borrower. Banks judge the credit-worthiness
of the borrower on the basis of his financial soundness and past dealings with the bank.
The following tangible assets are accepted by banks for extending short term finance:
a) Moveable goods: Stock of raw materials and finished goods are accepted by banks as security
against bank credit. In case of nonpayment, these goods are sold and money is recovered by
banks.
b) Shares and stock: Shares and stock that are quoted on a recognized stock exchange are
accepted as security against bank credit. The borrower is required to deposit the share certificate
along with a transfer deed signed by him.
c) Documents of title to goods: Bill of lading, Railway Receipts (RR), Goods Receipt (GR),
Warehouse warrant are various documents which are recognized as documents of title to goods.
To secure credit from bank, the borrower may deposit any of these documents with bank after
duly endorsing the same in favor of the bank. This enables the bank to deal with the goods in
case of default in repayment.
d) Fixed deposit receipts: It is a receipt issued by bank as evidence of fixed deposit made by the
customer. Banks grant loan on the security of this receipt. The interest charged on loan is higher
than the interest allowed on deposit. Banks normally grant loan up to 90% of the value of such
receipts.
e) Life insurance policies: Banks extend credit on the basis of life insurance policy up to the
amount of surrender value of such receipts.
f) Jeweler or precious metals: This type of security may be offered to borrow money for private
as well as for business purposes. Proprietary concerns sometimes offer jeweler or other precious
metals to obtain credit.
g) Other securities : Besides the assets and documents mentioned above, banks also accept
National Savings Certificate (NSC), India Vikas Patra (IVP), Kisan Vikas Patra (KVP) to grant
short-term credit.
18.11 Merits and Demerits of Customers’ advances as a source of Short-term Finance
Customers’ advance refers to advance made by the customer against the value of order placed. It
is, thus, a part payment of the value of goods to be supplied later.
Merits
(a) Interest free: Amount offered as advance is interest free. Hence funds are available without
involving financial burden.
(b) No tangible security : The seller is not required to deposit any tangible security while
seeking advance from the customer. Thus assets remain free of charge.
(c) No repayment obligation : Money received as advance is not to be refunded. Hence there
are no repayment obligations.
Demerits
(a) Limited amount : The amount advanced by the customer is subject to the value of the order.
Borrowers’ need may be more than the ad amount of advance.
(b) Limited period : The period of customers’ advance is only up to the delivery goods. It
cannot be reviewed or renewed.
(c) Penalty in case of non-delivery of goods : Generally advances are subject to the condition
that in case goods are not delivered on time, the order would be cancelled and the advance would
have to be refunded along with interest.
18.12 Advantages and Disadvantages of Installment credit as a source of Short-term
Finance
As you have already studied in this chapter, installment credit is a system under which a small
payment is made at the time of taking possession of the goods and the remaining amount is paid
in installments. Installment money is inclusive of interest. Advantages and disadvantages of this
system are given below:
Advantages
(i) Immediate possession of assets : Delivery of assets is assured immediately on payment of
initial installment (down payment).
(ii) Convenient payment for assets and equipments : Costly assets and equipments which
cannot be purchased due to inadequacy of long-term funds can be conveniently purchased on
payment by installments.
(iii) Saving of one time investment : If the value of asset or equipment is very high, funds of the
business are likely to be blocked if lump sum payment is made. Installment credit leads to saving
on one time investment.
(iv) Facilitates expansion and modernization of business and office Business firms can afford
to buy necessary equipments and machines when the facility of payment in installments is
available. Thus, expansion and modernization of business and office are facilitated by
installment credit.
Disadvantages
(i) Committed expenditure : Payment of installment is a commitment to pay irrespective of
profit or loss in the business.
(ii) Obligation to pay interest : Under installment credit system payment of interest of
obligatory. Generally sellers charge a high rate of interest.
(iii) Additional burden in case of default : Sellers sometimes impose stringent conditions in the
form of penalty or additional interest, if the buyer fails to pay the installment amount.
(iv) Cash does not flow : Like trade credit, installment credit facilitates the purchase of asset or
equipment. It does not make cash available which can be utilized for all needful purposes.
18.13 Benefits and Drawbacks of Finance from Cooperative Banks
Benefits
(i) Loans from co-operative banks are easily available to farmers and small businessmen
involving minimum formalities.
(ii) Co-operative banks provide a convenient means of borrowing. Loans are generally granted at
a lower rate of interest.
(iii) Sometimes co-operative banks organize training programmers for members to familiarize
them with the various avenues of business and regarding proper utilization of loan money.
(iv) Being a member of a cooperative bank, the borrower can participate in the management and
also share in the profits of the society.
(v) Co-operative loans create a sense of thrift and self-reliance among the low income group.
(vi) Loans are generally given for productive purposes and that helps to develop the financial and
social status of the people.
Drawbacks
i) Loan from co-operative banks is available only to members.
ii) Co-operative banks find it difficult to ensure repayment of loan money due to inadequate
information about the need and utilization of funds by the borrower. There is little scrutiny of the
repaying capacity of the loan seeker at the time of granting loan.
iii) Inadequate resources and lack of trained personnel for management have restricted the spread
of co-operative banking facilities.
iv) Co-operative banks depend largely on the support of the Government. Therefore Government
rules and regulations sometime create hurdles for the borrowers.
v) Credit from co-operative banks is available only for limited purposes.