Short-term finance is needed to fulfill the current needs of the business. The current needs may include payment of taxes, salaries or wages, repair expenses, payment to creditors, etc. The need for short-term finance arises because sales revenues and purchase payments are not perfectly the same at all the time. Sometimes sales can be low as compared to purchases. Further sales may be on credit while purchases are on cash. So, short-term finance is needed to match this disequilibrium.
Sources of short term finance are as follows:
(i) Bank Overdraft: Bank overdraft is a very widely used source of business finance. Under this client can draw a certain sum of money over and above his original account balance. Thus it is easier for the businessman to meet short-term unexpected expenses.
(ii) Bill Discounting: Bills of exchange can be discounted at the banks. This provides cash to the holder of the bill, which can be used to finance immediate needs.
(iii) Advances from Customers: Advances are primarily demanded and received for the confirmation of orders. However, these are also used to finance the operations necessary to execute the job order.
(iv) Installment Purchases: Purchasing on installment gives more time to make payments. The deferred payments are used to finance small expenses, which are to be paid immediately.
(v) Bill of Lading: Bill of lading and other export and import documents are used as a guarantee to take a loan from banks, and that loan amount can be used as finance for a short time period.
(vi) Financial Institutions: Different financial institutions also help people in business get out of financial difficulties by providing short-term loans. Certain co-operative societies can arrange short-term financial assistance for people in business.
(vii) Trade Credit: It is the usual business practice to buy raw material, store, and spares on credit. Such transactions result in increasing accounts payable of the business, which are paid after a certain time period. Therefore, goods are sold in cash, and payment is made after 30, 60, or 90 days. This allows some freedom to people in business in meeting financial difficulties.
(2) Medium Term Finance:
This finance is required to meet the medium-term (1-5 years) requirements of the business. Such finances are basically required for the balancing, modernization, and replacement of machinery and plant. These are also needed for the re-engineering of the organization. In addition, they aid the management in completing medium term capital projects within planned time. Following are the sources of medium-term finance:
(i) Commercial Banks: Commercial banks are the major source of medium-term finance. They provide loans for different time-period against appropriate securities. At the termination of terms, the loan can be re-negotiated if required.
(ii) Hire Purchase: Hire purchase means buying on installments. It allows the business house to have the required goods with payments to be made in the agreed installment. Needless to say that some interest is always charged on outstanding amounts.
(iii) Financial Institutions: Several financial institutions such as SME Bank, Industrial Development Bank, etc., also provide medium and long-term finances. Besides providing finance, they also provide technical and managerial assistance on different matters.
(iv) Debentures and TFCs: Debentures and TFCs (Terms Finance Certificates) are also used as a source of medium-term finances. Debentures are an acknowledgment of a loan from the company. It can be of any duration as agreed among the parties. The debenture holder enjoys a return at a fixed rate of interest. Under the Islamic mode of financing, debentures have been replaced by TFCs.
(v) Insurance Companies: Insurance companies have a large pool of funds contributed by their policyholders. Insurance companies grant loans and make investments out of this pool. Such loans are the source of medium-term financing for various businesses.
(3) Long Term Finance:
Long-term finances are required permanently or for more than five years of tenure. They are basically desired to meet structural changes in business or for heavy modernization expenses. These are also needed to initiate a new business plan or for long-term developmental projects. Following are its sources:
(i) Equity Shares: This method is most widely used worldwide to raise long-term finance. The public subscribes to equity shares to generate the capital base of large-scale businesses. The equity shareholders share the profit and loss of the business. This method is safe and secured, in a sense that amount once received is only paid back at the time of wounding up of the company.
(ii) Retained Earnings: Retained earnings are the reserves that are generated from the excess profits. In times of need, they can be used to finance the business project. This is also called plowing back of profits.
(iii) Leasing: Leasing is also a source of long-term finance. With the help of leasing, new equipment can be acquired without any heavy outflow of cash.
(iv) Financial Institutions: Different financial institutions such as former PICIC also provide long-term loans to business houses.
(v) Debentures: Debentures and Participation Term Certificates are also used as a source of long-term financing.
These are various sources of finance. In fact, there is no hard and fast rule to differentiate between short and medium-term sources or medium and long term sources. A source, for example, a commercial bank, can provide both a short-term or a long-term loan according to the client’s needs. However, all these sources are frequently used in the modern business world for raising finances.