HARAMBEE UNIVERSITY

FACULTY OF BUSINESS AND ECONOMIS

ACCOUNTING AND FINANCE DEPARTMENT
FINANCIAL MANAGEMENT II
CHAPTER FIVE
FINANACING CURRENT ASSETS

5.1 ALTERNATIVE CURRENT ASSET FINANCING POLICIES

Financing current assets is the process of using a company’s short-term assets, such as inventory
and accounts receivable, to borrow money or get a loan. The lender will have a security interest
in the assets as a guarantee of repayment. Current assets can be financed by either short-term or
long-term sources, such as shares, debentures, banks, and financial institutions.

There are three approaches of financing current assets that are popularly used. They are;

Most businesses experience seasonal and/or cyclical fluctuations. For example, construction
firms have peaked in the spring and summer, retailer’s peak around Christmas and the
manufactures who supply both construction companies and retailers follow similar patterns.
Similarly, virtually all businesses must build up current assets when the economy is strong, but
they then see off inventories and reduce receivables when the economy slacks off, still, current
assets rarely drop to zero-companies have some permanent current assets, which are the current
assets on hand at the low point of the cycle. Then, as sales increase during the upswing, current
assets must be increased and these additional current assets are defined as temporary current
assets. The manner in which the permanent and temporary current assets are financed is called
the firm’s current asset financing policy.

(a) Maturity Matching, or “Self-Liquidating”, Approach

The maturity matching, or “self-liquidating”, approach calls for matching asset and liability
maturities. This strategy minimizes the risk that the firm will be unable to pay off its maturing
obligations. To illustrate, suppose a company borrows on a one-year basis and uses the funds
obtained to build and equip a plant. Cash flows from the plant (profits plus depreciation) would
not be sufficient to pay off the loan at the end of only one year, so the loan would have to be
renewed. If for some reason the lender refused to renew the loan, then the company would have
problems. Had the plant been financed with long-term debt, however, the required loan payments
would have been better matched with cash flows from profits and depreciation, and the problem
of renewal would not have arisen.

(b) Aggressive Approach

The situation for a relatively aggressive firm which finances all of its fixed assets with long-term
capital and part of its permanent current assets with short-term, no spontaneous credit. Note that
we used the term “relatively” in the title for panel b because there can be different degrees of
aggressiveness. For example, the dashed line in panel b could have been drawn below the line
designating fixed assets, indicating that all of the permanent current assets and part of the fixed
assets were financed with short-term credit; this would be a highly aggressive, extremely no
conservative position and the firm would be very much subject to dangers from rising interest
rates as well as to loan renewal problems. However, short-term debt is often cheaper than long-
term debt, and some firms are willing to sacrifice safety for the chance of higher profits.
(c) Conservative Approach

The dashed line above the line designating permanent current assets indicating that permanent
capital is being used to finance all permanent asset requirements and also to meet some of the
seasonal needs. In this situation, the firm uses a small amount of short-term, non-spontaneous
credit to meet its peak requirements, but it also meets a part of its seasonal needs by “storing
liquidity” in the form of marketable securities.

5.2ADVANTAGE AND DISADVANTAGE OF SHORT-TERM FINANCING

Short-term Financing refers to financing needs for a small period normally less than a year. It is
also know as working capital financing.

• The main agenda of opting for short term finance for a business is to get funds for
working capital so that the cycle runs efficiently and the fund does not become the hurdle
in the day to day business.

• If the person is unable to repay the loan then it will affect its credit score as well

Advantages of the Short Term Loans

1. Fast disbursement: The short-term loan has a comparatively lesser risk probability than a long-
term loan. This is because long-term loans have an extended maturity date. Therefore,
defaulting on the loan payment in the short term is easier. Very little time is needed for the
sanctioning because of the short maturity date. This is why the short-term loan is sanctioned
and disbursed at a very fast rate.
2. Less interest Expenses: Because short-term loans have to be repaid in lesser time, usually less
than a year, the sum of the interest cost becomes very less. As opposed to long-term loans, they
are easy. The interest rate on a long-term loan can sometimes be higher than the loan itself.
3. Less Documentation (Best in Class): As it is less risky, the documents required for the
same will also be not too much making it an option for all to approach for short term
loans
Disadvantages of the Short Term Loans

1. Higher Interest Rates. Short-term finance requires higher interest rates, making it more
expensive than long-term financing.
2. Not Ideal for Long-Term Projects or Investments. Short-term financing is unsuitable for
any long-term investments or projects and may not cover the labor and materials needed
during a more extended period.
3. It limited Financial Capability. With short-term financing, businesses do not have access
to enough capital to cover more significant investments and transactions that occur over a
more extended period.
4. Less Flexibility with Terms and Conditions. As short-term financing usually comes from
commercial lenders, they tend to impose stricter conditions compared to other types of
financing, leaving little room for negotiation on the terms of repayment and interest
payments.
5. Riskier Loans. Since short-term loans are riskier than long-term loans, lenders typically
require collateral before handing out the loan, meaning businesses need to put up assets
as security against the loan they take out in case of default on payments later on down the
line.
 6. More Documentation is Required For Loan Approval Processes. The approval process for
short-term finance can be more complicated than other forms due to the additional
documents that need to be submitted to prove eligibility for the loan, such as financial
statements and tax returns.
7. Poor Credit Rating May Lead To the Rejection Of Loan Requests. A business’s credit
score plays a role in determining whether or not its request for short-term finance will be
approved by lenders, which can lead to difficulty in getting a loan if these factors aren’t
ideal.
8. Lack Of Collateral May Prevent Loan Approval. Without collateral as security against a
loan, many banks and commercial lending institutions may refuse requests for short-term
finance as there is no assurance that the debt will be paid back without having some
guarantee first.
9. High Fees Associated with Short-Term Finance Options. Fees associated with traditional
banking services, such as processing fees, application fees, early repayment fees, etc., can
add up quickly when taking out loans from banks, making using bank loans an expensive
option compared to alternative sources like peer–to–peer lending.
10. Limited Capital Availability For Businesses With Poor Financial History Or Bad Credit
Scores. Businesses with poor financial history or bad credit scores may find it difficult or
even impossible to get access to sufficient capital via traditional banking services, putting
them at a disadvantage when trying to implement sound business strategies which rely on
some level of access to quick funding solutions like those offered by banks.

5.3 SOURCES OF SHORT-TERM FINANCING

The following are the sources of the Short-Term Financing which the formers refer to in the
ordinary course of business:

 Trade Credit

 Bank Finance

 Accrued expenses

 Deferred Revenues

 Commercial Papers

 Letter of Credit

1. Trade Credit

Trade Credit is also known as accounts payable; it is a credit drawn out by one seller to another
when a credit purchase has been made, it helps in supplying goods without immediate payment
of cash. It provides a floating time of 28 days to manage the cash flow of the business. Thus, it is
widely used by business firms as a source of short-term finance, the amount of trade credit relies
upon the purchase units for which credit is available.

Although it may be risky for the supplier if the buyer does not pay the sum in due course, and to
avoid such losses the other set of trade credit is required in which instruments such as promissory
notes, bills of exchange are needed. So that in case the supplier needs money, he can discount
such bills from the banks. The bills of purchase having a high credit rating can be sold. These
instruments minimize the risk of bad debts.
2. Bank Finance

Corporate sector is very much dependent on the commercial bank for fulfilling their short-term
financial needs, a limited portion of this need gets fulfilled by the trade credit, and the excess
requirement over it gets fulfilled by a commercial bank. Bank credit has two forms, i.e.,
unsecured and secured credit. Unsecured credits are those that are not covered by collateral
securities, and collateral securities cover secured Credits.

Here loan can be provided with either for a specific purpose known as a single loan for which the
company signs a promissory note to avoid deficiencies and repays this loan within a specific
period of time. On the contrary, the other way of granting a loan is a line of credit which is more
common; the bank fixes a limit for the borrower to avoid the cumbersome process of going
through essential formalities every time the borrower reaches a bank for a loan.

The ways of borrowing a sum from the bank are as follows:

 Working capital loan

 Discounting of bill
 Overdraft
 Letter of credit
 Cash credit

3. Accrued Expenses

The expenses which have already been acknowledged in the books before it has been paid are
known as accrued expenses.

4. Deferred Revenues

Deferred revenue refers to a part of the firm’s income that has not been acquired, but pre-
payment has already received by the customers.

5. Commercial Papers

Issuing of commercial papers is also one of the most used sources of financing now-a-days.
These are the short-term notes describing that if a company needs money, they can issue
commercial papers. It is used for financing of Trade credits, payroll and meeting additional
short-term liabilities and commercial paper ranges from 15 days to 1 year.6. Letter of Credit

The Letter of Credit shows the pledge of the buyer to the seller for making the payment. This
document is issued by the bank, safeguarding the prompt and full payment to the seller. If the
buyer fails to do so, the bank becomes liable to pay the amount to the seller, for issuing a letter of
credit bank charges a percentage of the amount from the buyer and is delivered against the
pledge of securities.