From time to time it is necessary to finance short term operations. This may occur due to seasonal or temporary fluctuations with funding for the business. Short term financing covers one year or less and it tends to be less complicated than formal long term financing. The draw back to short term financing is the high interest costs. Sources of short term financing include Trade Credit, Bank Loans, Lines of Credit, and Borrowing against assets such as receivables and inventory.
Trade Credit – This is a spontaneous source of working capital by extending your payment terms for Accounts Payable. We previously noted that you want to pay your suppliers and vendors only when the amount is due. Even though your payments are made on the due date, you can also take into account some float time such as mail delivery time and time it takes the payment to clear the bank.
The amount of trade credit is simply a function of how much accounts payable you can carry over time. For the most part, you will have 30 days to pay for services and products or you may have progress billings as work is completed. You can also factor in some time for mail float or checks clearing the bank. For example, if you historically average $ 1,000 per day in accounts payable and the entire time when cash clears the bank for payment is 35 days, then you have $ 35,000 of trade credit.
In addition to Accounts Payable, spontaneous sources of funds can also be recognized by other current liabilities, such as accrued taxes or accrued payroll. For example, every other Friday you need to meet your payroll. You can distribute and credit payroll after 2:00 p.m. on Friday’s to gain some additional float time as opposed to paying employees early.
Bank Loans (Unsecured) – If a company has strong liquidity and a solid credit rating, then a company may be able to borrow funds without collateral. Unsecured loans are appropriate when immediate cash is needed and the entire amount can be paid back as a lump sum within a very short period of time. Banks lend unsecured loans to company’s that have good cash flows as opposed to large physical assets on the Balance Sheet. Likewise, companies tend to prefer unsecured loans since they do not have to pledge other assets and if a company does have other assets, these assets remain free and available for borrowing under secured arrangements should the need arise.
One of the costs associated with borrowing is interest. Interest represents the financing costs of the loan. If interest is paid at maturity for a one-year loan, then the annual financing cost is the stated interest rate of the loan. The stated interest rate is sometimes referred to as the nominal rate. The true rate that you pay may be somewhat different. This is referred to as the effective rate. For example, the total interest and financing costs you pay over one year divided by the funds that were made available to you represents the effective interest rate.