INSTITUTE OF ACCOUNTANCY ARUSHA
DEPARTMENT OF ACCOUNTING AND FINANCE
BUSINESS FINANCE (AFT 06207)
ODFB II -2019/2020
SOURCES OF FINANCE
Short term finance
Long term finance
SHORT TERM FINANCE
These are sources of finance used by business to raise finances for meeting short term
requirements of a firm, normally the repayment is less than one year.
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 realisation of sales.
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
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– Loans and advances
– Cash credit
– Overdraft
– Discounting of bills
3. Customers’ advances
4. Instalment credit
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 is 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 instalments 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 upto a specified limit, it is known as overdraft facility. This limit is
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granted purely on the basis of credit-worthiness of the borrower. 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. 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. INSTALMENT CREDIT
Instalment 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 instalments. The supplier charges interest for extending
credit. The amount of interest is included while deciding on the amount of instalment. Another
comparable system is the hire purchase system under which the purchaser becomes owner of the
goods after the payment of last instalment.
Sometimes commercial banks also grant instalment credit if they have suitable arrangements
with the suppliers.
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. Let us examine the merits and
demerits of short-term finance.
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 raising. The amount of interest payable is also affordable. It is, thus,
relatively more economical to raise short-term finance.
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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 retain 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 upto 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.
LONG TERM FINANCE – ITS MEANING AND PURPOSE
A business requires funds to purchase long assets of a business like land and building, plant and
machinery, furniture etc. These assets may be regarded as the foundation of a business. The
capital required for these assets is called fixed capital.
PURPOSE OF LONG TERM FINANCE:
Long term finance is required for the following purposes:
1. To Finance fixed assets :
Business requires fixed assets like machines, Building, furniture etc. Finance required to buy
these assets is for a long period, because such assets can be used for a long period and are not for
resale.
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2. To finance the permanent part of working capital: Business is a continuing activity. It must
have a certain amount of working capital which would be needed again and again. This part of
working capital is of a fixed or permanent nature. This requirement is also met from long term
funds.
3. To finance growth and expansion of business: Expansion of business requires investment of a
huge amount of capital permanently or for a long period.
FACTORS DETERMINING LONG-TERM FINANCIAL REQUIREMENTS
The amount required to meet the long term capital needs of a company depend upon many
factors. These are :
(a) Nature of Business:
The nature and character of a business determines the amount of fixed capital. A manufacturing
company requires land, building, machines etc. So it has to invest a large amount of capital for a
long period. But a trading concern dealing in, say, washing machines will require a smaller
amount of long term fund because it does
not have to buy building or machines.
(b) Nature of goods produced:
If a business is engaged in manufacturing small and simple articles it will require a smaller
amount of fixed capital as compared to one manufacturing heavy machines or heavy consumer
items like cars, refrigerators etc. which will require more fixed capital.
(c) Technology used:
In heavy industries like steel the fixed capital investment is larger than in the case of a business
producing plastic jars using simple technology or producing goods using labour intensive
technique.
SOURCES OF LONG TERM FINANCE
The main sources of long term finance are as follows:
1. Shares:
These are issued to the general public. These may be of two types:
(i) Equity and (ii) Preference. The holders of shares are the owners of the business.
2. Debentures:
These are also issued to the general public. The holders of debentures are the creditors of the
company.
3. Public Deposits:
General public also like to deposit their savings with a popular and well established company
which can pay interest periodically and pay-back the deposit when due.
4. Retained earnings:
The company may not distribute the whole of its profits among its shareholders. It may retain a
part of the profits and utilize it as capital.
5. Term loans from banks:
Many industrial development banks, cooperative banks and commercial banks grant medium
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term loans for a period of three to five years.
6. Loan from financial institutions:
There are many specialized financial institutions established by the Central and State
governments which give long term loans at reasonable rate of interest.