Funds required for efficient and effective operations in corporations are obtained from two main sources; internal and external.
These include funds generated through retained earnings or profits and sales of company assets. Retained earnings refer to part of the company’s profit that is not distributed to shareholders in a form of dividend, but withheld for present and future expansion projects. In some cases, management may deem it necessary to dispose of or sell some of the company’s assets due to wear and tear; the introduction of more sophisticated machinery than previous or existing ones; or the need to pay off debts. Proceeds from the sales serve as source of internal funds to the organisation.
These comprise funds raised through borrowing and sale of shares in the primary markets. Borrowing includes contracting of loans from financial institutions and sale of financial securities on short-term and long-term basis.
Common forms of corporate financing
The instruments used to finance the activities of an organisation can be broadly categorised into short-term borrowing instruments and long-term borrowing instruments.
Short-term borrowing instruments include commercial paper, trade credit, overdraft facility, acceptance credit, short-term bank credit, among other instruments.
Commercial paper is a short-term marketable, unsecured promissory note often issued by credible organisations, including finance companies, bank holding companies and others purchased directly by companies. The involvement of secondary markets in this transaction is relatively low.
Trade credit explains a mutually arranged commodity credit between manufacturing companies and wholesale firms; and sellers and buyers outside the initial control of the banking system. Trade credit serves as a source of short-term working capital to buyers who obtain goods and services on account from suppliers. It is drawn by the seller and accepted by the buyer. Trade credit transactions are manifested in commercial bills of exchange. The buyer agrees to pay the amount incurred at a specified future date. Through the arrangement, the buyer holds on to an “IOU” during the term of contract. Where the seller is in dire need of funds and cannot wait till the maturity date, he or she can discount the bill of exchange and sell to raise funds.
Merits of trade credit
To begin with, loan repayments and trade turnover tend to increase when trade credit is used. Also, it is convenient since it provides suppliers the needed security to contract bank loans prior to the maturity of trade bills. Finally, trade credit helps firms to increase their working capital in times of credit restrictions.
Demerits of trade credit
First, trade credit minimises the effectiveness of credit control and sanctions imposed by the Bank of Ghana (BoG). Second, lack of settlement discounter or payment delay may render trade credit transactions costly. Finally, trade credit may contribute to inflation by increasing total credit in the economy beyond the expected limit.
The foregoing demerits notwithstanding, banking experts stress the need for trade credit to be encouraged during periods of recession to ensure faster economic recovery.
Overdraft facility is where a bank allows its corporate customers to withdraw in excess of the total balances in their respective accounts, preferably current deposit accounts. An overdraft fee is usually charged by the bank when an overdrawn amount is not repaid within 24 hours. A bank may provide protection for its customers for a year; the overdraft agreement may be renewed after one year. It is arguably the most common form of borrowing initiated by organisations.
Advantages of an overdraft facility
An overdraft is usually not tied to a specific transaction. This makes it flexible and suitable for financing daily working capital requirements of businesses. Interest charges on overdrafts may be lower compared with interest charges on other loan facilities.The documentation process for the award of overdraft to bank customers is simple and fast. Risks associated with secured overdrafts are usually low. This enables banks to charge lower interest rates on secured overdrafts.
Disadvantages of an overdraft facility
The borrower may be exposed to interest rate fluctuations, especially when the rate is tied to the base rate. Fluctuations in this case may not be as volatile as the inter-bank rates. An overdraft is usually repayable on demand. This makes it an unsafe form of borrowing; even in difficult economic times, the borrower is compelled to repay the overdraft. Sometimes, base rates are higher than inter-bank rates. In such a situation, overdrafts attract higher charges than loan facilities.
This is a bill of exchange guaranteed by a credit insurance company or bank for a commission. Under the acceptance credit, a bank is approached by a corporate customer and the former permits the latter to draw a bill of exchange after an agreement has been reached. A credit limit is placed on the bill of exchange by the bank. It may be easy for the customer to find a third party in the financial market to discount the bill after its acceptance by the bank.
Discounted bill of exchange means the buyer purchases it at a price below its face value.
Acceptance commission refers to the difference between the price paid by the discounting bank and the face value of the bill; it represents the interest rate. A commercial bill is termed as a bank bill if it is accepted by the bank. An eligible commercial bill accepted by an eligible bank is called an eligible bank bill. An eligible bank meets the minimum requirements of the central bank, namely reciprocal treatment of local and foreign banks, quality of acceptance business and market standing.
Merits of acceptance credit
The discount rate of an acceptable credit is often below the inter-bank rate. The discount rate associated with an acceptance credit is an eligible bill rate, meaning the discount rate is a fine rate. Cost of borrowing is not affected by subsequent changes in interest rate since the effective interest rate or discount rate is determined at the beginning of operations. Acceptance credit is considered flexible because it can be drawn for various amounts of different maturities up to 187 days. When the borrowing company pays the credit and the main transaction is carried out successfully, the acceptance credit is said to be self-liquidating.
The acceptance credit policy is in tandem with the real bill doctrine; an acceptance credit is often guaranteed. This facilitates removal of the commitment fee charged on short-term bank credit. Corporate customers sometimes arrange for acceptance credits in bulk. The issuing company is not obliged to be tied only to the accepting bank. This makes it possible for the issuing firm to discount its credit bill with another discounter with better terms and conditions. Removal of the commitment fee allows for individual bills to be drawn without negotiation after an agreement has been reached on bulk credits.
Demerits of acceptance credit
The issuing firm may discount the credit acceptance bill. The discounting firm or bank may, again, rediscount or
Author: Ebenezer M. Ashley (PHD)