Discuss working capital as a source of short term finance.

1. Accrued expenses
Accrued expenses represent expenses incurred but not paid. The most common accrued expenses are wages and taxes. The business entity defers immediate payment of these expenses and so gets access to the funds that could have been used to pay these expenses. In a sense accrued expenses represent costless financing. Services are rendered for wages, but employees are not paid and do not expect to be paid until the end of the pay period. Similarly taxes are not paid and do not expect to be paid until their due date. Accrued expenses represent an interest free source of finance.
Unfortunately for the business entity, accrued expenses do not truly represent discretionary financing since there is a specified date when these expenses have to be paid and postponement can be an issue. For taxes, the government is the creditor, and it likes to be paid on time. A business entity in extreme financial problems can postpone payment of taxes but there are penalties and interest charges. Postponement of wages can affect staff morale and reduce efficiency. However for wages a business entity can alter the frequency of payment (e.g. they can decide to pay wages every two weeks instead of every week) and so get access to accrued expenses financing for longer.

2. Inventory loans
Inventories are liquid assets and therefore attractive as a security for a loan. The lender determines a percentage advance against the market value of the collateral. For example the lender may loan the business entity 90% of the value of the inventories charged as collateral. Not every inventory can be charged as collateral. The best collateral is inventory that is relatively standard and for which a ready market exists.
Lenders consider;
a) Marketability
b) Perishability
c) Market price stability of the inventory
d) The difficulty and the expense of selling the inventory to satisfy the loan.

Consequently the lenders may charge a high interest if the inventory is not as marketable, if it is prone to price changes or if the inventory is perishable.

3. Assignment of Accounts receivable( pledging )
Accounts receivables can form an attractive form of collateral. The lender bears the risk of fraud and may incur the cost of processing the collateral. A business entity may seek a receivable loan from either a commercial bank or finance business entity but a bank usually charges lower rates. The lender will analyze the quality of the business entity’s receivables and also the size to determine how much to lend against them. If the receivables are of high quality then he can offer more.
A receivable loan can either be on non notification or notification basis. For non notification; the customers are not notified that the receivables are pledged as collateral while for notification basis the customer is notified that the receivables are security.
Receivables as collateral have advantages as a source of finance. An accounts receivable loan is a more or less continuous financing arrangement. As the business entity generates new receivables that are accepted to the lender, they are assigned, adding to the security base against which the business entity is able to borrow. With increased receivables, they can get more loans. The business entity doesn’t have to first pay all its receivable loans it owes the lender before the same lender can lend the business entity more funds. With the additional receivables, the business entity can get additional loans. Since in a normal business entity receivables are always increasing, receivables loans may form a more or less permanent source of financing.

4. Factoring Accounts receivable
In receivables loan, the business entity retains title to the receivables. When a business entity factors its receivables, it actually sells them to a factor. The sale may either be with or without recourse.
Non recourse factoring is where the supplier sells its receivables to a factor in order to obtain cash payment of the accounts before their actual due date. The factor takes over all responsibility for credit analysis of new accounts, payment collection and credit losses
The factoring house pays over a fixed amount, for example 85% of the value of receivables. The 15% discount will reflect:
1) Interest on the money advanced: The borrowing business entity gets immediate access to the funds from the factor while the factor has to wait until the receivables are due before he can access the funds from payment of the receivables. Therefore the factor is compensated for the time he has to wait to get the funds from receivables.
2) Administration costs of the factoring house: the factor will incur costs in chasing the customers to pay up.
3) Credit risk: if the customer never pays up, it is the factoring business entity that loses out.
Using a factor gives the borrowing business entity money earlier than if it had to wait to be paid, it transfers the problem of bad debts to the factor since the factor now owns the receivable. However, the factor will want to get the customers to pay up as soon as possible, so may put excessive pressure on the borrowing business entity’s customers. This could have a negative effect on the supplier’s future business with these customers. The interest cost is relatively high.
The typical non recourse factoring is continuous. As new receivables are acquired they are sold to the factor that then avails the funds to the borrowing business entity. Since receivables are continuously increasing, the business entity gets access to funds from factoring continuously. Sometimes the factor will allow the business entity to overdraw its account during peak periods of peak needs i.e. borrow more than the value of the receivables.
For recourse factoring the borrowing business entity is still responsible for collecting its debts. The factor has no control over the debt collection process so it charges interest on the borrowed amount. I.e. if the loan was on 85% of the receivables then the interest charged is on the amount loaned. The borrowing business entity will use the money it collects from receivables to pay the principal money borrowed (i.e. the 85% of the receivable) and the interest.

5. Trade credit
This is the largest short term financing. Most buyers are not required to pay for goods immediately after delivery. A typical trade credit agreement will appear as follows: 2/10, net 30. This indicates that the seller offers a 2% discount if the bill is paid within 10 days; otherwise the buyer must pay the full amount within 30 days. A cash discount is offered as an incentive to the buyer to pay early.
There are several advantages of trade credit as a form of financing. The major advantage is its ready availability. The trade credit (accounts payable) represents a continuous form of credit. There is no need to arrange financing formally; it is already there. The business entity can stretch the period by paying at a date later than the stipulated date. However this will lead to deterioration of the credit relationship between the supplier and the buyer. There is also no need for collateral to get the credit.

6. Discounting of Bill of Exchange
Banks also advance money by discounting bills of exchange, promissory notes etc. 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.

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Lellah answered the question on November 8, 2021 at 07:16