Commercial Paper, Trade & Bank Credit, Factoring Homework Help & Tutoring
Commercial Paper, Trade & Bank Credit, Factoring Assignment Help, Tutor Help:
Working Capital Financing
There are many sources for financing of working capital. There are both external
and internal sources. The external sources are both short-term and long-term. Trade
credit, commercial banks, finance companies, indigenous bankers, public deposits,
advances from customers, accrual accounts, loans and advances from directors and
group companies etc., are external short-term sources. Companies can also issue
debentures and invite public deposits for working capital which are external long-term
sources. Equity funds may also be used for working capital.
Commercial Paper:
Commercial paper is a short-term unsecured obligation with a maturity ranging from
2 to 270 days, issued by companies to investors with temporarily idle cash.
It can be issued only if the company possesses a very high credit rating.
So, the interest rate is less than that of a bank-loan. Commercial paper is usually
sold at a discount with the interest immediately deducted from the face of the note
by the creditor and the company pays the full face value upon maturity. But it can
also be issued in interest-bearing form. It may be issued through a dealer or directly
placed to an institutional investor.
The benefits of commercial paper are that no security is required, the interest
rate is typically less than required by banks or finance companies, and the commercial
paper dealer often offers financial advice. The drawbacks are that commercial paper
can be issued only by large, financially sound companies and that its dealings are
impersonal.
Trade credit and terms:
Trade credit is a short-term credit facility extended by suppliers of raw materials
and other suppliers in the normal course of business. It is a common and important
source of financing. Either open account credit or acceptance credit may be adopted.
In the former as per business custom credit is extended to the buyer, the buyer
is not signing any debt instrument as such. The invoice is the basic document. In
the acceptance credit system, a bill of exchange is drawn on the buyer who accepts
and returns the same. The bill of exchange evidences the debt. Trade credit is an
informal and readily available credit facility. It is unsecured. It is also flexible
in the sense that advance retirement or extension of credit period can be negotiated.
But trade credit may be costlier as the supplier may inflate the price to account
for the loss of interest for delayed payments, although this method of credit does
not involve explicit interest charge. If the company has liquidity difficulties,
it may be able to stretch accounts payable; however the company will be required
to give up any cash discount offered and accept a lower credit rating.
Example:
A company buys $2,000 merchandise on terms of 2/10, net/30. It fails to take the
discount and pays the bill on the last due date. The cost of discount is:
Discount X 360 days
(1-Discount) (credit period – discount period)
= 0.02 X 360 = 0.367 or 36.7%
(1 - 0.02) (30 - 10)
Discount X 360 days
(1-Discount) (credit period – discount period)
= 0.02 X 360 = 0.367 or 36.7%
(1 - 0.02) (30 - 10)
The company would be better off taking the discount even if it needed to borrow
the money from the bank, since the opportunity cost is 36.7%. The interest rate
on a bank loan would be far less.
The smaller the difference between the payment day and the end of the discount period,
the larger is the annual interest/cost of trade credit. To sum up, as the cost
of trade credit is generally very high beyond the discount period, firms should
avail of the discount on prompt payment. If, however, they are unable
to avail of the discount, the payment of trade credit should be delayed till the
last due date.
Bank Credit
Bank credit is one of the most important sources for financing of current assets.
Various forms of bank credit include cash credit/overdrafts, bills purchased/discounted,
short-term loans, letter of credit, straight loans, hypothecation loans, pledge
loans, mortgage loans etc. Even though other institutions such as savings
and loan associations and credit unions provide banking services, most banking activities
are conducted by commercial banks. They allow the company to operate with minimal
cash and still be confident of planning activities even in uncertain conditions.
Commercial banks favor short-term loans since they like to get their money back
within one year.
Factoring
Factoring provides resources to finance receivables as well as facilitates the collection
of receivables. Factoring involves the outright sale of receivables at a discount
to a factor to obtain funds. Customers are notified of the arrangement.
The factor provides more services than is the case with pledging.
Functions of a Factor:
- Financing facility/trade debts
- Maintenance and administration of sales ledger
- Collection facility(of accounts receivables)
- Assumption of credit risk – credit control and restriction and
- Provision of advisory services.
The purchaser of the accounts receivables takes all credit and collection risks.
The proceeds received by the seller are equal to the face value of the receivables
less the commission charge, which is usually 2% to 4% higher than the prime interest
rate. The cost of factoring arrangement is the factor’s commission for credit investigation,
interest on the unpaid balance of advanced funds and a discount from the face value
of the receivables if there is high credit risk. Remissions by customers are made
directly to the factor.
Finance Companies:
Finance companies provide similar credit and loan facilities like banks, though
they are not banks. They provide need based loans and sometimes arrange loans from
others for customers. Interest rates are usually higher than banks. But timely assistance
may be obtained.
Public deposits:
They are unsecured deposits raised by businesses for periods normally exceeding
a year. These are another good source of finance for the working capital requirements.
Other sources of financing:
Advance from customers, accrual accounts like outstanding expense, loans from directors
etc., are some of the other sources of financing working capital requirements.
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