Short term finance | Examples and types

This post gives a detailed information on what is short term finance, examples and types.

Corporate business organisations make use of short term finance arrangement in one form or another.

Consequently, the relevance of short term financing to corporate business organisation cannot be overemphasized.

They determine short-term finance will be discussed under the following

  • General features
  • Types of short term finance
  • Interest rates

What is short term finance

Short term finance definition: This is the type of finish that is provided for periods not exceeding one year

General, firms seek this type of finance to enable them provide fund for their current needs.

In looking for this type of finance the financial manager seeks specific answers to the following questions.

What is short term finance, examples and types.

What is the cost of such finance, how flexible is the finance and finally how restrictive are the provisions of the contractual terms.

Cost

Every aspect of finance has a sort of cost attached to it. That is to say that fund are not provided free of charge.

The financial manager must evaluate this cost against the benefits he expect for utilising the facility.

He must also compare this cost with that of other institutions that are willing to provide a similar facility.

This is necessary to ensure that he obtain the best again for his organisation.

What is short term finance, examples and types.

Flexibility

The financial manager will want to know whether it is possible to increase the volume of credit or whether his organisation is stuck with that level of credit.

He will as a rule prefer those forms of credit that provides for flexibility.

However, this issue of flexibility have to be carefully watched.

This is because he has to match the benefit from flexibility vice versa the decline in the credit rating of the film.

If a firm takes a lot of credit is credit rating will drop because subsequent creditors will be unwilling to extend credit to that organisation.

Credit rating thus measures the ability of a firm to obtain further credit and general terms.

What is short term finance, examples and types.

Restrictions

The financial manager must evaluate the amount of restriction which the credit has imposed on his organisation.

Some creditors place stringent restrictions on management with a view to enhancing their safety positions.

There could be restriction on a emolument of management, procurement of for the credit and even on the use of certain assets.

What is short term finance, examples and types.

Types of short term finance

Types of short term finance

There are various types of short term finance and they can be subdivided into three sub units namely, Trade Credit, bank loans and commercial paper.

1. Trade credit in short term finance

What is short term finance, examples and types.

The first type of short term finance is the trade credit.

This is the type of credit that is extended in the course of normally trading activity.

Trade Credit are allowed in most cases to create Goodwill between trading partners.

Trade credit normally cover periods from when the customer takes physical possession of the goods, to when he is required by the creditor to pay for them.

Text credit can be extended for periods ranging from 15 days to 30 days or even months.

Trade credit are expressed in periods such as;

  • 2/10 net 40
  • 2/10 60
  • 2/10 net 90

The expression 2/10 net 40, simply means that if the purchaser (debtor) pays for goods within 10 days, he enjoys two percent discount on the invoice price.

However, if on the other hand he pays for the goods after 10th that day but before the 40th day, he does not enjoy the discount.

In any event the debtor must make good his debt within 40 days.

If a debtor persistently pays his debt within the upper limit of the credit period, that is 40th day, he will obviously be enjoying free financing to the extent that he pays no interest for holding the goods until he makes good his debt.

However, he is bearing some implicit cost for not making good his debt within the lower limit of the credit period.

The implicit cost results in the form of discount income or cash discount which he has lost.

The implicit cost is computed with the following equation.

r = r / 1 – i × 365 days / u – l

Where r =annual discount lost

i = discount rate

u = upper limit

l = lower limit

Please kindly note that when periods are expressed in weeks or month, the 365 days is replaced by 52 or 12 as the case may be.

Short term finance examples in terms of trade credit are below;

Example: Company Ltd purchase equipment from a dealer who allowed them the following condition, 3/7 net 30 days.

However, AB Coy Ltd persistently makes good his debt on the last date of the credit period. Calculate the cost of delayed payment.

Calculation: r = i / 1 – i × 365 / u – l

r = 0.03 / 1 – 0.03 × 360 / 30 – 7

r= 0.03 / 0.97 × 360 / 23

r = .43 or 48%

2. Bank Loan in short term financing

What is short term finance, examples and types.

Another types of short term finance is the bank loan, and it can be classified according to securities pledged.

Also they can be classified according to their maturity pattern and method of payment.

In this regard, we have seasonal and interim loans.

What is short term finance, examples and types.

Secured Loans

This is that form of loans for which securities are pledge as collateral.

Demanding such securities are not unreasonable, hence the securities must be valuable so that in the event of default in repayment of loan, the bank can dispose of the collateral and protect it self.

Unsecured Loan

This is that type of loan for which there’s no securities pledged.

However, they are made after listening to the applicant and evaluating his statement.

The caution here is that people are quite unreliable when it comes to debts.

There should be no sentiments about whether the applicant is good or not.

It is question of getting him to demonstrate the ability to repay the loan.

In making unsecured loans, the banker seeks answers to two questions.

Can he pay?

If he can pay will he pay?

These answers are most necessary because most of those in default of loan repayment are not destitutes.

Rather they are affluent member of the society who believe that loans from banks are their fair share of the national cake.

Seasonal Loan

These are the loans given out to people to enable them cope with their economic activities during a particular season.

In this country, seasonal loans are given out in respect of agriculture.

During the planting season which starts with rain at the early part of the year, there’s lot’s of loan demand to help farmers plough and grow crops.

Farmers demand the loan with view of repaying loans from the proceeds received by from their crop 🌾 during harvest.

By their nature therefore, agriculture loans are self liquidating.

Thus between January and March, there is large demand for agricultural loans, while the banks expects farmers to start repaying the loans from August to November when they must have harvested and sold their crops.

Loans are demanded by firms to enable them hold inventories are also liquidating.

This is because such inventories will be converted to receivable and finally cash.

Interim Loan

This type of loan is given to enable a firm tide over temporary cash deficiencies.

It is peculiar to construction industry.

Usually when a firm obtains a government contract, the firm is expected to go into operation before the funds are released to it.

During this initial stage, the firm can apply to the bank for financial accommodation.

Usually, the financial accommodation given by banks follow a line of credit.

After an application have been made to the bank to grant some credit, the bank studies the application carefully with a view to determine whether or not it should extend the facility to the firm.

The bank may give a favourable response to the firm, stating the amount of accommodation that the bank is willing to extend, the interest rate on the facility and the regularity of drawing on the facility.

Thr firm can then draw the facility but never exceeding to the limit granted by the bank.

The loans granted by the bank can be for a specific period of time.

Generally, commercial banks look favorable at extending short term loan to it’s clients.

These loans can however, be made revolving thus extending it to several years.

A banker’s commitment could be to the maximum amount demanded.

Usually, interest is charged on the amount drawn and of course a fee less than the interest rate is charged on the unused facility.

However, to qualify for a bank loan, the firm must be a customer to the bank.

That is the firm must maintain at least a current account with the bank.

It is not unusual therfore for a bank to insist that for it to extend loan, there must be a minimum amount standing on the current account of the firm.

This amount is called compensation balance.

A bank can therefore insist that the amount standing on the current account must be a percentage of the facility being demanded.

For instance, a bank insist on 20% compensation balance.

A firm demanding a loan of 25 million to meet it’s current needs must of necessity have 5 million on it’s current account with the bank.

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