Sources of Finance - Short-term Finance

An activity that looks at sources of finance for Level 2.

Short term finance

Hopefully you managed to get the right sources of short term finance in the drag and drop activity. Let us have a look in a bit more detail at each of the main types of short term finance.

Bank Overdraft

Most businesses have an account with a bank. The bank deals with all the deposits (money put into the account) and withdrawals (money taken out). Most banks know that businesses do not always receive money from sales straight away. If you run a sandwich bar in a local trading estate then you might get money straight away when you sell your sandwiches. If you are a business selling electrical equipment to an electrical retailer then you may not get paid straight away when you deliver your goods.

When differences occur in the money a business receives from sales (its revenue or turnover) and the money it has to pay out on labour, machinery, equipment, distribution and so on (its costs) the firm can face difficulties. The money flowing into a business from sales and the amount it spends on costs that go out of the business is called its cash flow.

A diagram showing how cash enters and leaves a business
Cash inflows to a business       Cash outflows from a business
(Revenue from sales, loans, interest, sales of assets etc       (Payment for raw materials, stock, labour, insurance, rent, rates etc.)

A business might need to pay a bill on the 28th November for £1,500 but not have enough money in its account to pay the bill. It might know that it is due to receive £3,500 from a customer on the 10th December but in the meantime it has a cash flow problem. This is when it is appropriate to arrange an overdraft with a bank. An overdraft is an agreement with a bank to allow the business to spend money it does not have - it is a form of a loan therefore. In our example, the business might arrange for an overdraft facility of £5,000 with its bank. It can now pay the bill for £1,500 and not worry about the cheque 'bouncing'.

A cheque is said to 'bounce' when the bank refuses to honour the payment. It might be returned to the business and if this happens a charge is made to the business. Not only do bounced cheques cost the business money in bank charges but the relationships with its suppliers can be damaged. Some suppliers might think twice before supplying the business with any more stock in such circumstances!

Arranging an overdraft avoids this problem. The business will get charged interest on the amount they have loaned. In our example, the overdraft facility is £5,000. If the business only uses £1,500 of that limit, they only pay interest on the £1,500, not the whole £5,000. This is a key difference between an overdraft and a loan.

Overdraft facilities do have their disadvantages. The interest rate on an overdraft can be quite high, especially for small firms where the risk to the bank that they might not get their money back is greater. In addition, the business is not allowed to exceed their overdraft limit. If they do the bank might refuse to pay cheques to creditors (people who are owed money) and may hit the business with a hefty charge for exceeding the limit. Overdraft facilities can be re-negotiated but if this is tried too many times, it may be a signal to the bank that a business has not got control over its finances.

Task

A business arranges an overdraft facility for £10,000 with their bank. They use the facility regularly for the first 6 months of the year and on average have an overdraft of £6,000 each month. The interest rate on the overdraft is set at 10%.

How much interest does the business pay over that 6 month period? (Use simple interest - the formula is I = p x r x t where I = the interest, p = the principle (the amount borrowed) and t = the time period)

As a result of a change in the interest rate set by the Bank of England, the business is informed by its bank that the interest rate on its overdraft will rise to 12%. What effect does this have on the cost of servicing the overdraft if the business uses the overdraft in the same way for the next six months?

Trade Credit

This is a period of time given to a business to pay for goods that they have received. It is often 28 days but some businesses might not pay for 6 months and on some occasions even a year after they have received goods.

Hill Farm Furniture is a small business based between Nottingham and Lincoln. The business makes high quality kitchen furniture. The vast majority of the work done by the business is strictly to order and made to suit the specific requirements of the customer. Hill Farm use wood - lots of it! When they receive a delivery from their supplier they do not pay straight away. They will receive a 28 day period before having to settle the bill.

Interior of a farmhouse-style kitchen

For a small business like Hill Farm Furniture, trade credit might be a useful source of short term finance to help them manage their cash flow more effectively. Source: Hill Farm Furniture.

For many small firms, this effectively means they are getting some funds for free. Assume that the bill for a delivery of wood comes to £8,000 for Hill Farm. If they have 28 days before they have to pay they have effectively received a loan of £8,000 from their supplier for 28 days - interest free. This gives the business the time to be able to manage their finances and balance their cash flows more effectively.

If a business did not pay the debt after the 28 days has past then there might be a penalty to pay. The supplier might charge a fee or start charging interest or even take the business to court to get its money back. Non payment of debts like this can cause businesses - especially small businesses - real problems. If they are not receiving money for the goods they have supplied they cannot pay their own debts!

Task

Businesses supplying the motor parts retailer Halfords were very angry at a decision made by the company in December 2005. Halfords announced that they were going to change the trade credit terms with their suppliers from 90 days to 120 days.

Consider the advantages and disadvantages to a small firm supplying Halfords of this decision. (You can get further details of the problem by looking at Biz/ed's Market Power and Cash Flow In The News article.)

Credit Card

A credit card works very much like trade credit. If you buy something using a credit card, you will receive a statement once a month with the details of the amount spent during the last month. You then have a certain period of time to either pay the full amount or a minimum amount.

Example:

James runs a sandwich bar. He gets a lot of his supplies from a cash and carry - bread, cheese, margarine, ham, tuna and so on. He pays for his weekly supplies by credit card. On the 16th of each month he receives his statement. This month it is for £645. He is told that he must pay a minimum sum of £50 or the full amount by the 5th of next month. If he pays the full amount he effectively gets over a month's interest free loan. If he chooses to pay off only part of the full amount he will have to pay interest on the amount still owed. That can be expensive!

Many businesses have a company credit card. It can be a useful way of managing expenses and if paid off in full can be a useful and cheap source of short term finance.

Lease

Most businesses have to buy equipment and machinery of some sort. Many firms have a fleet of company cars which certain staff use or vehicles that they use for distribution. There are a number of ways of buying these things. The business might go to the bank for a loan, arrange some sort of finance deal with the supplier, use cash they have in the business or arrange a lease option.

A large yellow bulldozer in a field

Some machinery or equipment might not be a cost effective proposition to be bought outright. In these cases, leasing may be a more sensible option. Copyright: Adrian Adrian, from stock.xchng.

A lease effectively means that the business is paying for the use of a product but do not own it. It is also called 'hiring'. A lease agreement on a van, for example, might mean that the firm pays out £350 per month for a three year lease. At the end of the three years the vehicle returns to the owner.

Lease agreements can be of benefit to the firm for the following reasons:

  • It can be cheaper to arrange a lease rather than having to buy equipment outright
  • Leases can be very flexible - equipment might only be needed for a short time or for a particular project and so does not warrant being bought outright.
  • The company that owns the equipment, machinery or vehicles is responsible for the maintenance and this can help reduce costs for the business.
  • The payments made are generally fixed and will not therefore change as interest rates change. This helps business plan more effectively.

Bank Loans

Bank loans are very flexible. They can vary in the length of time that the loan has to be repaid. Loans arranged with a bank that are less than one year are regarded as short term finance. As with any other form of loan there are interest payments to be made and this can be expensive and also can vary.

Task

Tyrell worked in a Pizza Hut store for five years before deciding to set up his own pizza delivery store. The business has been going for two years and has been quite successful. The quality of the service and the pizzas themselves has led to an increased demand for his products.

Someone cutting a slice into a large pizza

The pizza business is booming but how should Tyrell finance his plans for expanding his distribution network? Copyright: Jacque Stengel, from stock.xchng.

Tyrell now feels he needs to increase the number of vehicles he has that deliver the pizzas. He did buy two Smart cars initially to make deliveries from a local dealer. He is now contemplating buying two more. He is thinking about the most appropriate way of financing the acquisition of the two cars.

Prepare a 200 word report advising Tyrell of his options and what source of finance you would recommend and why.

| Index | Previous | Next |

Related lesson plan: