External Financing of Short Term Finance

Cash

If a company is not generating enough cash from trading it may need to borrow. The most common method of borrowing is via a bank overdraft or a bank loan. Bank overdrafts are very flexible. Most major banks will set up an overdraft facility for a business as long as they are sure the business is viable. A bank overdraft is a good way to tackle the fluctuating cash flows experienced by many businesses. An alternative to a bank overdraft is a bank loan. The exact terms of individual bank loans will vary. However, essentially a loan is for a set period of years and this may well be more than two years. The rate of interest on a loan will normally be lower than on a bank overdraft. Loans may be secured on business assets, for example specific assets, such as stock or motor vehicles.

Debtors

Since debtors are an asset, it is possible to raise money against them. This is done by debt
factoring or invoice discounting.

  1. Debt factoring Debt factoring is, in effect, the subcontracting of debtors. Many department stores, for example, find it convenient to subcontract their credit sales to debt factoring companies. The advantage to the business is twofold. First, it does not have to employ staff to chase up the debtors. Second, it receives an advance of money from the factoring organisation. There are, however, potential problems with factoring. The debt factoring company is not a charity and will charge a fee, for example 4 % of sales, for its services. In addition, the debt factoring company will charge interest on any cash advances to the company. Finally, the company will lose the management of its customer database to an external party. As Soundbite 10.1 shows, debt factoring has traditionally been viewed with some suspicion.
  2. Invoice discounting Invoice discounting, in effect, is a loan secured on debtors. The financial institution will grant an advance (for example, 75 %) on outstanding sales invoices (i.e., debtors). Invoice discounting can be a one-off, or a continuing, arrangement. An important advantage of invoice discounting over debt factoring is that the credit control function is not contracted out. The company, therefore, keeps control over its records of debtors. Figure 10.5 compares debt factoring with invoice discounting.

 

Comparison of Dept Factoring and Invoice Discounting

Element Debt Factoring Invoice Discounting
Loan from financial institution Yes Yes
Sales ledger (i.e., keeping records of debtors) Management by financial institution Managed by company
Time period Continuing Usually one-off, but can be continuing

The aim of debtors management is simply to collect money from debtors as soon as possible.
For an optimal cash balance, with no considerations of fairness, a business will benefit if it can accelerate its receipts and delay its payments. Receipts from customers and payments to suppliers are measured using the debtors/creditors collection period ratio.

Stock

As with debtors, it is sometimes possible to borrow against stock. However, the time period is longer. Stock needs to be sold, then the debtors need to pay. Stock is not, therefore, such an attractive basis for lending for the financial institutions. However, in certain circumstances, financial institutions may be prepared to buy the stock now and then sell it back to the company at a later date.