KCB WEEK 6 - Sources of short-term financing

Question 1

```

Main sources of short-term financing?

Answer 1

External
* Overdrafts
* Bills of exchange
* Invoice discounting
* Factoring
* New(er) developments

Internal
* Reduction of working capital
* Sale of redundant (non-current) assets
* Retained profits

Question 2

Advantages and disadvantages of overdrafts

Answer 2

Advantages
* Easy
* Immediate access
* Can be reduced anytime if surplus cash available
* Usually not included in calculation of capital gearing
* Interest payments are tax deductable – cost of borrowing goes down
* Usually not included in calculation of (capital) gearing (uses non-current liabilities)
<br></br>

Disadvantages
* Rate of interest linked to LIBOR – London Interbank Offer Rate (banks interest rate for lending to one another) – not predictable
* Banks charge higher interest than LIBOR when lending to external
* May need to offer a security
* Banks charge annual fee on top of interest – possible one off fee for setup
* Risky - as is repayable on demand

Question 3

Details on / what is invoice discounting

Answer 3

o Company selling on discount – seller borrows from invoice discounter / bank using invoice to customer as collateral
o Uses discount factoring to calculate present value
o Up to 80% of amount receivable immediately
o Bank/discounter will give net amount
o Total less interest of time receivable from total
o But can be used to finance next trade
o Risk - customer can’t pay/company can’t settle if something goes wrong
o Invoice kept – after time period – send to customer and explain are supplier but have sold invoice and customer should settle full amount with the invoice discounter (or bank) – 80% and interest on it are deducted and then fee deducted – balance given to the company (once settled by customer)

o Shouldn’t take just all/any invoice – use a reputable customer – discounter/bank will recognise the name and accept.
o Should take an invoice which makes sense re what you need for next trade in terms of finance

Question 4

Open vs Closed invoice discounting

Answer 4

o Open (disclosed) discount invoicing customer will know invoice sold, won’t mind – some will mind and could change their supplier who can fund from their own financing rather than selling to invoice discounter – can choose closed (undisclosed) invoice discounting . This works the same way but company will send invoice as normal at end of credit period and customer won’t know debt is sold.

Question 5

Advantages and disadvantages of discount invoice discounting

Answer 5

Advantages
* Quick method to give trade finance
* Doesn’t need separate collateral – invoice itself serves as such
* Seller can finance working capital needed for other sales transactions
* Buyer gets interest free credit period
* If necessary- discounting of bill need not be disclosed to customer
* Cheaper than offering cash details
Disadvantages
* Fees charged by discounter reduce profit margin
* Some customers may be uneasy when their bills are discounted with an external party
* Not all invoices meet standard for ‘discount-grade’ bill (
* Over reliance may create poor imagine of seller in trade circles

Question 6

Factoring

Answer 6

o Comes from invoice discounting – ‘whole sale invoice discounting’
o Usually bank will provide – sometimes auditors
o Instead of individual, takeover ALL claims on customer – send a copy each time the customer is billed
 Ex. need £400k for next trade take invoice of £500k, 80% given – need to find a bill which is suitable level – the bill then also must be discount-grade
o Business sells all/selected amount of its receivables as a ‘factor’
o Factor advances around 80% of total value of outstanding invoices
o At end of credit period – money collected by customer by the
 Factor (disclosed factoring)- then fwds the balance after deducting a fee
 Seller (undisclosed factoring) who sends the advance to the factor adding the fee
 WITH (factor asks seller if customer fails for reimbursement) AND WITHOUT RESOURCES (if customer proves to be a bad debt FACTOR WILL BEAR LOSS) – usually ask seller before approving new credit to get additional credit/charge higher fee to avoid

Question 7

Advantages and disadvantages of factoring

Answer 7

Advantages
* Immediate access to funds
* Credit control expertise of the factor will be useful in avoiding bad debts
* Can be arranged by a number of organisations
* Other lines of credit are not affected because factoring is not shown in the SOFP or included in gearing – other creditors won’t know about extent of factors
<br></br>

Disadvantages
* Not cheap
* May not be viewed favourably by ll customers
* Recourse-factoring : risk of bad debt is borne by the company
* Control of customers is lost without recourse factoring

Question 8

Overview - new developments in short-term financing

Answer 8

o Crowd funding
 Web-based platform
 Via internet
 Usually offer higher return to investors than other investment opps
 May not be suitable for large investments
 Associated with high risk
o Peer to peer lending
o Invoice trading third party payment platforms

Question 9

Advantages and disadvantages of ‘new developments’

Answer 9

Advantages
* Quick access to funds
* Borrowers and lenders connected via the internet
* Can be arranged according to finance needs of borrower
* Borrower can avoid unnecessary financial distress
<br></br>

Disadvantages
* High risk often associated with new types of finance
* Expensive from borrowers point of view
* Not suitable for large sums
* Market is still evolving and not all the associated risks are known (court cases needed to lay down guidelines for future cases/for parliament to set future legislations re disputes in court)

Question 10

Reduction of working capital (internal source of short-term financing) overview - advantages and disadvantages

Answer 10

1) Reduction of inventory levels
ADV: Reduce stock holding costs (ex RENT/utilities/assoc. wages)
Minimise obsolescence and damage
Free up money opportunity cost (of carrying inventory). Recommended.

DISADV: Risk of stock-out situation
Loss of production time
Quantity discounts may be lose

Inventory + receivables – payables = amount invested in working capital

<br></br>

2) Tightening of credit control
ADV: Frees up capital
Bad debts reduced
Cost of credit control decreased
Reduces opportunity cost

DISADV: Loss of customers
Reduced sales
Profit loss due to reduced sales
<br></br>

3) Delaying payments to suppliers

ADV: Improves short term cash-flow
Usually no interest on delayed period
Reduces own working capital finance

DISADV: Cannot be used for a long time
Suppliers may refuse credit facility for future purposes
Loss of reputation

Question 11

Sale of redundant non-current assets (internal source of shor-term financing) - advantages and disadvantages

Answer 11

Advantages
* Frees up capital from an unused asset
* Does not dilute ownership control
<br></br>

Disadvantages:
* An asset may not be readily available for sale
* A one off event
* Takes time to find a buyer
* Matching the required amount & the sale value of asset is difficult

Question 12

Retained profits as a source of internal short-term financing

Answer 12

Can be used as and when it is needed (per balance sheet)

Also has a cost (2 WEEKS WHEN LOOKING AT COST OF CAPITAL)