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IB DP Business Management Study Notes

3.1.3 Short-term Financing

Short-term financing refers to financial solutions that provide businesses with capital they need to fulfil their immediate requirements, generally within a year. Here, we explore the key short-term financing methods, namely overdrafts, trade credit, and short-term loans. For a comparison with more enduring solutions, see long-term financing.

Overdrafts

An overdraft facility allows businesses to withdraw more money from their bank account than they have, offering a safety net when cash flows are irregular.

Key Features:

  • Flexibility: Overdrafts can be used at any time and are suitable for businesses with fluctuating cash needs.
  • Interest: Interest is only charged on the overdrawn amount and only for the period it is used.
  • Limit: Banks set an overdraft limit based on the company’s creditworthiness.

Advantages:

  • Convenience: Easy to set up and use, especially for managing temporary cash shortfalls.
  • Flexibility: Can be paid back and redrawn as required.

Disadvantages:

  • Higher Interest Rates: Interest rates on overdrafts can be higher than regular loans.
  • Recall: Banks can recall the overdraft at any time, potentially causing cash flow problems.

Trade Credit

Trade credit is a facility offered by suppliers that allows businesses to buy goods or services on account, paying for them later, typically within 30, 60, or 90 days.

Key Features:

  • Credit Terms: Defined by the supplier, indicating the duration and any early payment discounts.
  • Trust-based: Built on the trust between the supplier and business.

Advantages:

  • Cash Flow: Helps in managing cash flow as businesses can receive and sell goods before payment is due.
  • Leverage: Can negotiate better terms with suppliers when there's a long-standing relationship.

Disadvantages:

  • Late Payment Penalties: If not paid on time, suppliers might charge interest or penalties.
  • Strained Relationships: Consistent delays can strain supplier relations, affecting future credit terms.

Short-term Loans

Short-term loans are borrowings that need to be repaid within a year. They’re often used for working capital requirements or to address temporary financial shortfalls.

Key Features:

  • Duration: Typically ranges from a few months to a year.
  • Interest Rates: These can be fixed or variable, but are generally higher than long-term loan rates due to the shorter repayment duration.
  • Collateral: Some short-term loans may require collateral, though unsecured options are also available.

Advantages:

  • Quick Processing: Faster approval and disbursement compared to long-term loans.
  • No Long-term Commitments: Can be repaid quickly, freeing the business from debts faster.

Disadvantages:

  • Higher Interest Rates: As they're typically unsecured, they come with a higher risk for the lender, leading to higher interest rates.
  • Repayment Pressure: The need for rapid repayment can put pressure on the business's finances.

Factors to Consider When Choosing Short-term Financing:

  • Cost: Analyse the interest rates and any other charges associated with the financing option. Understanding the net present value can be crucial in this analysis.
  • Duration: Choose the option that aligns with the business’s short-term financial needs.
  • Relationship with the Lender/Supplier: A good relationship can lead to better terms. Explore how internal and external sources of financing can affect these relationships.
  • Flexibility: Some businesses may prefer flexible solutions like overdrafts which can be used as and when needed.
  • Repayment Terms: Ensure that the business can meet the repayment terms to avoid penalties or strained relationships. For further details on managing these risks, refer to advantages and disadvantages of financial decisions.

In conclusion, while short-term financing can be an excellent tool for businesses to manage their immediate financial needs, it's vital to choose the option that's most aligned with the company's operational requirements and financial health. Proper management and timely repayment of these facilities will ensure that they remain available and beneficial for the business.

FAQ

Trade credit can be preferable in several scenarios. Firstly, businesses that have good relationships with suppliers might secure trade credit more easily than bank financing. It's also beneficial when a company wants to conserve its cash flow. Since trade credit doesn't involve immediate cash outlay, it allows businesses to use funds elsewhere. Moreover, trade credit often doesn't involve interest unless payments are late. This contrasts with overdrafts and short-term loans, which typically accrue interest. Lastly, using trade credit might not require stringent credit checks or collateral, making it simpler and more accessible than some bank products.

Yes, consistently relying on overdrafts can pose several challenges. Over time, this dependence can signal to stakeholders that the business has poor cash management. Overdrafts, by design, are meant for occasional or unexpected shortfalls, not consistent use. Habitual reliance can lead to hefty interest costs over time. Additionally, banks might perceive a business as high-risk if it's continuously in its overdraft, potentially impacting the company's ability to secure other financing types. Furthermore, banks can recall or reduce overdraft facilities at their discretion, so a heavy dependence can jeopardise a firm's operational continuity.

A business's creditworthiness plays a crucial role in its ability to secure short-term loans. Creditworthiness indicates how likely a business is to repay borrowed funds. Lenders assess this through various factors like repayment history, existing debts, business financials, and credit scores. A business deemed creditworthy may access loans with more favourable terms, such as lower interest rates and higher borrowing amounts. In contrast, businesses with poor credit profiles may face challenges in securing loans, and if they do, they might encounter steeper interest rates, stricter repayment terms, or requirements for collateral.

Yes, trade credit can impact a company's credit score. Some suppliers report payment behaviours to business credit bureaus. Consistently paying on time or ahead of the agreed terms can positively influence a company's credit score. Conversely, delinquent payments or defaults on trade credit can negatively impact the score. However, it's essential to note that not all suppliers report to credit bureaus. For businesses looking to build or maintain a robust credit profile, it's wise to understand their suppliers' reporting practices and ensure timely payments when trade credit is utilised.

Short-term loans often have higher interest rates compared to long-term loans. This is due to the perceived higher risk associated with shorter repayment terms. Moreover, short-term loans are usually unsecured, adding to the lender's risk. While these rates might be higher than long-term loans, they could still be competitive when compared to other short-term financing options like overdrafts, which can have even steeper rates. However, it's essential to note that actual rates can vary based on several factors, including the lender's policies, the business's creditworthiness, and prevailing market conditions.

Practice Questions

Evaluate the advantages and disadvantages of using an overdraft as a source of short-term financing for a start-up company.

For a start-up company, an overdraft can provide valuable flexibility in managing its cash flows. The primary advantage of using an overdraft is its convenience; it's easy to set up and use, making it ideal for addressing temporary cash shortfalls. Additionally, a business only pays interest on the amount overdrawn and for the period it is used. However, the interest rates on overdrafts can be significantly higher than other financing methods. There's also the risk of the bank recalling the overdraft at any time, which could severely disrupt a start-up's operations, especially if they heavily rely on this facility.

Describe the main features of trade credit and explain its potential impact on the relationship between a business and its suppliers.

Trade credit is an arrangement allowing businesses to purchase goods or services on account and pay for them at a later specified date, typically within 30, 60, or 90 days. The primary features include the defined credit terms set by the supplier and a trust-based system. The impact of trade credit on the business-supplier relationship can be profound. When a business consistently honours its payment terms, it can foster trust, potentially leading to better credit terms in the future. However, consistent payment delays or defaults can strain the relationship, endangering future trade credit opportunities and possibly leading to stricter terms or even cessation of supplies.

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