External sources of short term finance
Bank and Institutional Loans
Generally a quick and straightforward way for raising short term business finance
Usually provided over a fixed period of time and can be short term or long term depending on the purpose of the loan
Secured vs unsecured loans
Secured loans
Banks and other finance companies often require security for a short term loan just as they do for a long term loan
Security for short term loas usually consist of trade receivables, inventories of both
If the business fails to repay the lender may take action to seize the security and take legal proceedings against the company
Company directors may also be personally liable, depending on how the loan was arranged
Unsecured
Unsecured loans are usually taken for smaller amounts and take place over a shorter period of tiem
Businesses vernally pay more interest with unsecured loans as the are not backed up by an asset
There is a higher risk for the lender as they have no guarantee of getting their money back
Firms who use short term bank loans often arrange a line of credit, an agreement between a bank and a customer that establishes a maximum loan balance that the lender permits the borrower to access or maintain
To ensure that the line is used for short term purposes, ti works as a resolving acocunt
Loan Covenant
A loan covenant places a restrictive clause in a loan agrement that places certain constraints on the borrower with reference to
Financial reporting
Requiring lenders to submit management reporting with cash flows and forecasts on a regular basis
Financial ratios
Getting debt or liquidity ratios within an agreed range or requiring WC to be maintained at a minimum level
Regulatory Reporting
Requiring the statutory financial statements to be audited annually
Debt covenants
Restricting the borrower's ability to take on more debt without prior consent of the lender or forbidding it from undertaking certain activites
Advanatages
Loans can be set up in a short space of time, providing access to money quickly
Businesses normally prefer unsecured loans as they are considered less risky than loans with longer terms
Good for budgeting was they require set repayments speed over a period of time
Loans have more flexible terms than some other sources of short term finance
Banks do not put as much emphasis on the credit history of the business as they do for longer term loans
Loans do not require giving up control of a or share of the business
Interest and arrangement fees are usually tax deductible
Not usually repayable on demand unless defaulted
Disadvanatges
Short term loans usually have higher interest rates than long term loans
Loans can compound debt problems if a business cannot obtain cheaper long term finance
Defaulting on repayment can damage credit status
A term loan is conditional on a loan covenant, the bank can demand repayment of the loan if the business defaults
There is normally an extra charge for early repayment
Overdrafts
An overdraft is a pre agreed facility provided by banks and financial institutions that allows a withdrawal of money in excess of the accounts credit balance
Often used as a back up form of financing to ease pressure on WC
Ideal for those with fluctuating finance requirements particuarly when a company has to provide for uuexpcetc expenditure such as repairs and maintenance
Provided over a fixed period of time or as a rolling facility with n end date
No penalty for repayment
Normally provided at a cost of an annual arrangement r maintenance fee plus interest
Interest rates are charged on a daily basis on the overdrawn amount and are usually high but they vary depending on the risk of default
Interest rate is normally variable ( a margin over base rate of the BoE base rate)
Advantages
Overdrafts are easy and quick to arrange with immediate access to funds
Unlike many loans, an overdraft can normally be cleared anytime without an early repayment penalty
They serve as backup against unexpected expenditure
The bank normally allows an interest free period with interest paid only on the overdrawn balance
Do not require giving up control of or a share of the business
Interest and arrangement fees are normally tax deductible
Due to its short term nature, an overdraft balance is not normally included in the calculation of the business's financial gearing
Disadvantages
Interest is unpredictable as it depends on a variable interest rate and on the amount overdrawn on each day of the charging period
Overdrafts are repayable on demand without prior notice although this is unlikely unless the business experiences financial diffulties
A higher rate of interest is charged for using the unauthorised facility
Banks often charge an annual arrangement or maintenance fee for providing an overdraft facility
Larger facilities will often need to be secured, depending on the lender and the business level of risk
Failure to pay interest charges or gong back into credit ona. regular basis will lead to a fall in credit score
Debt factoring
A financial arrangement whereby a business sells all or selected trade receivables at a price lower than the realisable value to a third party, known as a factor, who takes responsibility for collecting money from the customers
Two types
With recourse
The borrower maintains control over the trade receivables and collects from customers
The factor assumes no responsibility for bad debts
Credit risk of non payment by the debtor is borne by the borrower and trade receivables are essentially used as collateral
This approach is least visible to customers and allows borrowers to keep customers form knowing about any factoring arrangements
Without recourse
The factor maintains control and bears the responsibility for bad debts and any risk of non payment subject to the payment of additional fee
The lender advances a certain % normally around 80% of the debt within 2 or 3 days of the factoring arrangement
Besides the assured csh flow, the administrative burden of the supervision of trade credit is reduced which may be important for small and growing businesses
The lender monitors all trade receivables due from the customers of the borrower and has payments sent to the lenders designated location
Advantages
Debt factoring provides an immediate source of finance
Useful for companies that are expanding rapidly as it will leave other lines of credit open for use elsewhere in the business
Start up businesses and SMEs can benefit from factoring when they cannot gain access to other forms of cheaper finance
Debt collection, when outsourced can increase cash by providing savings in credit management and certain in cash flows
The factors credit control system can be used to assess the creditworthiness of both new and existing customers
Reduces the probability of bad debts for the company
Non-recourse facing allows for insurance against bad debts
Disadvanatages
Factoring xan be expensive with costs running at between 2% and 4% of sales revenue
Debt collection when outsourced raises fears about its viability. This may endanger the company's trading relationships with customers who may not wish to dead with a factor
The company risks losing control over its trade receivables and granting credit to its customers
The company still bears the risk of non payment in factoring (with recourse) where credit risk of non payment tis borne by the business
Invoice discounting
Does not use the sales ledger administration services of a factor
Short term borrowing arrangement whereby a company can borrow cash from financial instutitons against invoices raised with customers
The company uses unpaid trade receivables as collateral
A company can use up to 80% of he value of all invoices which are at less than 90 days to borrow within 24 hours
The finance company relies ona. spread of trade receivables among many customers
The actual percentage and duration may vary
While specialist invoice discounting providers exist, this is a service also provided by a factoring company
Quick way to improve cash flow but may cause management to lose focus from the administrative and compliance aspect
Advantages
Quicker method to procure cash than through loans and overdrafts
Provides significantly more cash than a traditional bank
Accelerates cash flow from customers since up to 80% of the invoices can be converted into cash
No non current assets are required as collateral
Allows more room for credit sales by making such sales more liquid
Borrower maintain control over the trade receviables
Confidentiality of the arrangement can be maintained
The company can obtain the cash it needs while also allowing the normal credit period to its customers
Disadvantages
The additional fees charged by the discounting providers decrease the company's profit margin
Excessive reliance on invoice discounting may not be taken very positively by all stakeholders
Can give the appearance of the borrower struggling with finances
Available only on commercial invoices, payments owed from the general public may not be eligible for invoice discounting
When a business relies heavily on invoice discounting, it may cause management to lose focus from strengthening its credit terms
Alternative finance and online innovations
Alternative finance provides financial channels that are not as rigid as the traditional finance ystem
New rules came into force in 2014 for the regulation of alternative finance activities such as equity crowdfunding and P2P ledning, the regulations require that platforms operating in the sector must be licensed and conform to standards set out by the FCA
Crowdfunding
A practice of raising money to support a business venture, project or local intitiative
The investors will sometimes receive shares in the business or receive a reward such as early receipt of a product and.or a discount on the price of the product
As the market is still evolving, new types of platform that carry a different level of risk will continue to emerge
Campaigns and projects funded can fail
Investors face a high risk of losing their principal or sometimes being exposed to scams
Peer to peer lending
A business borrowing froma. collection of private investors usually through an online platofrm
P2P lending business facilitates the arrangement by matching lenders with borrowers and credit checking the borrowers
P2P lending is debt finance that generally operates online, therefore operating with lower overheads and providing a lower cost service than traditional lenders
Both the lenders and borrowers expect to get a better rate than they would through banks
Businesses or individuals needing to borrow money apply online and the software determines the credit risk and the rate of interest to be charged
Normally unsecured, secured loans are sometimes offered by using luxury assets and other business assets as collateral
Invoice trading third party payment
Peer to peer invoice trading is a new type of invoice finance where businesses auction their outstanding invoices via centralised online platforms to obtain immediate cash to boost their WC
It provides an online solution that connects businesses selling invoices with investors lending against those invoices for an attractive return
The platform charges a fee from both the business and the investors for the service provided
Provides finance more cheaply and quickly than from traditional providers
Like factoring, businesses receive funds against invoices without having to wait for the invoices to be settled
Invoice trading platforms provide finance giant individual invoices rather than signing clients up for the long term contracts
Advanatges
Provides quick access to money with online applications
Provides new and innovative ways to connect borrowers and investors via the interest
Can save businesses from unexpected financing distress
Provides access to funds previously unavailable by use of non traditional forms of determining credit worthiness
Disadvanatges
Not subject to regulatory reporting requirements in many jurisdictions
Costs significantly more than annualised rates associated with conventional financing - anywhere from 30% to 50%
Amount of money that can be borrowed is quite limited
Small businesses may prefer working with more established well recognised instutituons
The market is still evolving with new platforms carrying the different level of risk for both lenders and borrowers