Short-term and Long-term Sources of Finance

Characteristics of Short-term Financing: A major portion of a firm’s financing normally is derived

from short-term sources, that is, from sources that require repayment in a year and less. Several
characteristics of short-term financing are important:
1. Cost of funds: Short- term financing can provide both the highest and the lowest cost funds in
the firm’s capital structure. Some forms of short-term financing are most costly than intermediate-
or long- term funds. On the other hand, some short- term sources provide funds at no cost at all to
the firm. Payables and accruals fall into this category.

2. Roll-over effect: This occurs when short term liabilities are continually refinanced from period to
period. Even though short-term financing must be repaid in less than one year, some sources
provide funds that are continuously rolled over. The funds provided by payables, for example,
may remain relatively constant, because as some accountants are paid, other accountants are
created.

3. Clean- up: This occurs when commercial banks or other lenders require the firm to pay off its
short-term obligation. Just as some sources are rolled over some must be reduced to zero, or
cleaned up, at one point in the year. This is frequently a requirement of bank credit where the
clean up offers proof that the short term financing is being used to meet the short-term or cyclical
need only.

Goals of Short-term Financing: The firm can use short-term sources to achieve a number of goals.
1. Flexibility: Short-term financing allows the firm to match its funds against its needs over an
annual, seasonal or other cyclical period.
2. Low-cost financing: The interest free sources provide low- cost financing for the firm by
reducing its borrowing need from interest bearing sources.
3. Secure additional funds: In some cases, a firm may not be able to issue equity and may be
meaning its borrowing capacity from intermediate and long-term lenders. Short-term sources may
be the only means for raising additional funds to finance inventories of receivables during a peak
period.

Sources of short term financing:

1. Interest free sources: Two interest free sources of short-term financing arise spontaneously from
the daily activities of the firm. These accounts payable and accruals.
a. Accounts Payable: Accounts payable are created when the firm purchases raw materials,
supplies or goods for resale on credit terms without signing a formal note for the liability.
These purchases on open account are, for most firms, the largest single source of short-term
financing. Payables represent an unsecured form of financing since no specific assets are
pledged as collateral for the liability.
Even though no formal note is signed, an accounts payable is a legally binding obligation of
a firm. By accepting the merchandise, the purchaser agrees to pay the supplier the invoice amount under
the terms of trade required by the supplier.
b. Accruals: Accruals short term liabilities that arise when services are received but payment
has not yet not made. The two primary accruals are wages payable and taxes payable.
Employees work for a week, 2 weeks or even a month before receiving a pay cheque. The
 salaries or wages, plus the taxes paid by the firm on those wages, offer a form of unsecured
short-term financing for the firm.
The government provides strict rules and procedures for the payment of withholding or
social security taxes, so that the accrual of taxes cannot be readily manipulated. It is, however, possible to
change the frequency of paydays to increase or decrease the amount of financing through wages accrual.

2. Unsecured Interest-Bearing Sources: A stable and profitable firm can borrow funds from short-
term sources at competitive rates of interest. This section includes some of the unsecured sources
of interest bearing loans.
Self-liquidating bank loans: The most common commercial bank borrowing for a firm is the
unsecured, self-liquidating short-term loan. Self-liquidating means that the bank is providing funds for a
seasonal or cyclical business peak and the money will be used to finance an activity that will generate
cash to pay off the loan.
Three kinds of unsecured short-term bank loans are commonly used.
a. Single payment Note: A commercial bank will lend a strong business customer a lump sum
repayable with interest in a single payment and at a specified maturity, usually 30 to 90 days.
b. Line of credit: It is an agreement between a commercial bank and a firm whereby the bank
agrees to make available upon demand up to a stipulated amount of unsecured short-term funds, if
the bank has the funds available.
c. Revolving Credit Agreement: It is a guaranteed line of credit. The bank guarantees that the firm
can borrow up to a specific limit regardless of the degree of tightness of money.

Unsecured Non-bank Short-term Sources: Three non-bank sources of short-term financing are
commonly used-
a. Commercial Paper: This consists of promissory notes with maturities of a few days to 270 days.
It can only be used by large well-known corporations because they are unsecured obligations by
the firm.
b. Private Loans: A short-term unsecured loan may be obtainable from a wealthy shareholder, a
major supplier, or other party interested in assisting the firm through a short-term difficulty.
c. Cash advances for customers: A customer may pay for all or a portion of future purchase before
receiving the goods. This form of unsecured financing provides funds to purchase the raw
materials and produce the final goods.

Long Term Sources of Finance: Long term sources of finance are those that are needed over a longer
period of time - generally over a year. The reasons for needing long term finance are generally different to
those relating to short term finance. It is important to remember that in most cases, a firm will not use
just one source of finance but a number of sources.

Main sources of long term finance are:

Shares: A share is a part ownership of a company. Shares relate to companies set up as private limited
companies or public limited companies (places). There are many small firms who decide to set
themselves up as private limited companies; there are advantages and disadvantages of doing so. It is
possible, therefore, that a small business might start up and have just two shareholders in the business.
If the business wants to expand, they can issue more shares but there are limitations on who they can sell
shares to - any share issue has to have the full backing of the existing shareholders. PLCs are different.
They sell shares to the general public. This means that anyone could buy the shares in the business.

Some firms might have started out as a private limited company and have expanded over time. There
might come a time when they cannot issue any more shares to friends or family and need more funds to
continue expanding. They might then decide to become a public limited company. This is called 'floating
the business'. It means that the business will have to go through a number of administrative and legal
procedures to allow it to be able to offer shares to the general public.

Venture Capital: Venture capital is becoming an increasingly important source of finance for growing
companies. Venture capitalists are groups of (generally very wealthy) individuals or companies
specifically set up to invest in developing companies. Venture capitalists are on the lookout for
companies with potential. They are prepared to offer capital (money) to help the business grow. In return
the venture capitalist gets some say in the running of the company as well as a share in the profits made.

Bank Loans: As with short term finance, banks are an important source of longer term finance. Banks
may lend sums over long periods of time - possibly up to 25 years or even more in some cases. The loans
have a rate of interest attached to them. This can vary according to the way in which the Central Bank sets
interest rates. For businesses, using bank loans might be relatively easy but the cost of servicing the loan
(paying the money and interest back) can be high. If interest rates rise then it can add to a business’s costs
and this has to be taken into account in the planning stage before the loan is taken out.

Mortgage: A mortgage is a loan specifically for the purchase of property. Some businesses might buy
property through a mortgage. In many cases, mortgages are used as a security for a loan. This tends to
occur with smaller businesses. To raise this sort of money, the bank will want some sort of security - a
guarantee that if the borrower cannot pay the money back the bank will be able to get their money back
somehow.

The borrower can use their own property as security for the loan - it is often called taking out a second
mortgage. If the business does not work out and the borrower could not pay the bank the loan then the
bank has the right to take the home of the borrower and sell it to recover their money. Using a mortgage
in this way is a very popular way of raising finance for small businesses but as you can see carries with it
a big risk.

Owner’s Capital: Some people are in a fortunate position of having some money which they can use to
help set up their business. The money may be the result of savings, money left to them by a relative in a
will or money received as the result of a redundancy payment. This has the advantage that it does not
carry with it any interest. It might not, however, be a large enough sum to finance the business fully but
will be one of the contributions to the overall finance of the business.

Retained profit: This is a source of finance that would only be available to a business that was already
in existence. Profits from a business can be used by the owners for their own personal use or can be used
to put back into the business. This is often called 'ploughing back the profits'.

The owners of a business will have to decide what the best option for their particular business is. In the
early stages of business growth, it may be necessary to put back a lot of the profits into the business. This
finance can be used to buy new equipment and machinery as well as more stock or raw materials and
hopefully make the business more efficient and profitable in the future.

Selling Assets: As firms grow they build up assets. These assets could be in the form of property,
machinery, equipment, other companies or even logos. In some cases it may be appropriate for a business
to sell off some of these assets to finance other projects.