Q. Discuss any two Sources of Short-term Finance, other than Bank Credit and Trade Credit, that are used by firms to meet their Working Capital needs.
Commercial Paper:
Commercial Paper (CP) is a widely
used instrument for short-term borrowing by corporations. It is a type of
unsecured promissory note that allows companies to raise funds quickly to meet
their short-term obligations. CP is typically issued by large, creditworthy
firms and is traded in the money market. Discuss any two Sources of Short-term Finance, other than Bank Credit and Trade Credit, that are used by firms to meet their Working Capital needs.
Features of Commercial Paper:
Commercial Paper has several
distinctive features that make it attractive to both issuers and investors.
Firstly, it has a short maturity period, usually ranging from 1 to 270 days,
making it a convenient option for companies with temporary cash flow needs.
Secondly, CP is usually issued at a discount to its face value, and the
difference represents the interest earned by the investor upon maturity.
Issuers of Commercial Paper:
Large, creditworthy corporations
with a strong credit rating are the primary issuers of commercial paper. These
companies utilize CP to finance their working capital requirements, such as
accounts payable, inventory, and other short-term liabilities. By opting for
CP, firms can access quick funds without resorting to traditional bank loans.
Investors in Commercial Paper:
Investors in commercial paper are
often institutional entities such as money market funds, mutual funds, and
corporate treasuries. They are attracted to commercial paper due to its
relatively higher yield compared to other short-term investments like Treasury
bills. The short maturity period and the low credit risk associated with
reputable issuers make CP an appealing investment choice for these entities.
Advantages of Commercial Paper:
Commercial Paper offers several
advantages to both issuers and investors. For issuers, it provides a
cost-effective alternative to traditional loans, especially when interest rates
in the money market are favorable. Additionally, CP allows companies to
diversify their sources of short-term funding. Investors benefit from the
relatively higher yields compared to other short-term instruments, and the
flexibility to choose from a range of creditworthy issuers.
Challenges and Risks:
While commercial paper is a popular
source of short-term finance, it is not without challenges. The primary risk is
the credit risk associated with the issuer. If the issuing company faces
financial difficulties or defaults, investors may incur losses. To mitigate
this risk, investors often conduct thorough credit analysis before investing in
commercial paper.
Factoring:
Factoring is a financial
arrangement where a company sells its accounts receivable (invoices) to a third
party, known as a factor, at a discount. This allows the company to receive
immediate cash instead of waiting for customers to settle their invoices.
Factoring is a common practice in industries where lengthy credit terms are
prevalent, such as manufacturing and distribution. Discuss any two Sources of Short-term Finance, other than Bank Credit and Trade Credit, that are used by firms to meet their Working Capital needs.
Types of Factoring:
There are two main types of
factoring: recourse factoring and non-recourse factoring. In recourse
factoring, the selling company retains the risk of non-payment by its
customers. If a customer fails to pay, the selling company must buy back the
receivable from the factor. Non-recourse factoring, on the other hand,
transfers the credit risk to the factor. If the customer doesn't pay due to
insolvency, the factor bears the loss.
Working Mechanism:
The factoring process involves
several steps. First, the selling company delivers goods or services to its
customers and generates invoices. Instead of waiting for the customers to pay,
the company sells these invoices to a factor at a discount. The factor then
advances a significant portion of the invoice amount to the company, typically
around 70-90%. Once the customer pays the full invoice amount, the factor
releases the remaining balance to the company, deducting its fees.
Benefits of Factoring:
Factoring provides several advantages
for companies seeking short-term financing. The immediate influx of cash helps
improve liquidity and enables the company to meet its working capital needs
promptly. Moreover, factoring allows businesses to transfer the credit risk
associated with customer non-payment to the factor, providing a degree of
protection against bad debts.
Factors as Financial Intermediaries:
Factors, the entities that purchase
receivables, act as financial intermediaries in the factoring process. They
provide a valuable service by advancing funds to the selling company and
assuming the credit risk. In return, factors charge fees, which may include a
discount on the face value of the receivables and other service charges. The
fees are determined based on factors such as the creditworthiness of the
customers, the industry, and the volume of receivables.
Considerations for Companies Using Factoring:
While factoring offers benefits,
companies should carefully consider certain aspects before opting for this form
of short-term financing. Factors charge fees for their services, which can
impact the overall cost of financing. Additionally, the decision to factor
receivables may influence the relationship between the selling company and its
customers, as the factor typically communicates directly with the customers for
payment collection.
Conclusion:
In conclusion, Commercial Paper and
Factoring are two viable sources of short-term finance that companies utilize
to address their working capital needs. Commercial Paper offers a direct
capital market solution, allowing creditworthy corporations to raise funds
quickly, while Factoring provides a means for companies to accelerate cash flow
by selling their receivables. Both sources come with their unique features,
advantages, and considerations, offering flexibility for firms to choose the
most suitable option based on their specific circumstances and financial
objectives. Discuss any two Sources of Short-term Finance, other than Bank Credit and Trade Credit, that are used by firms to meet their Working Capital needs.
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