Internal and External Sources of Short Term Finance
All businesses need finances to support their operations and investing activities. Firms should have a clear understanding of the purpose for which they need the loan for them to make lucrative loan decisions. The main purpose why businesses need temporary lending is to raise working capital to cover the short-term shortage of funds. There are two types of short term financing sources which include the internal and external sources.
Internal Financing Sources.
Refers to the businesses’ source of finance, which is generated within the business from its activities and assets. Some of these sources include:
Retained Earnings: Retained profits or earnings refers to the results generated from an operating business after dividend payout to the stakeholders. Businesses utilize these profits as a source of financing by re-investing back into the business instead of seeking loans from lending institutions such as banks. There are several advantages associated with ploughing back retained earnings such as no cost of capital, they act as a long-term source of finance since they are not repayable, and is cost-effective since there is no issue cost involved.
Reduction in working capital: Working capital is comprised of accounts payables and accounts receivables. A business can strategize on how to use working capital reduction as a source of financing by either; extending the accounts payable cycle through negotiating favourable terms with the creditors which will aid in financing part of trade finance needed by customers, or by speeding up accounts receivables cycle. Benefits accrued by reducing working capital are include saving on the cost of interest on bank overdraft, cash credit, and working capital loans.
Sale of assets: Proceeds from the sale of assets by a business are a source of internal financing and is advantageous to the firm in that the business gets a chance to dispose of obsolete assets.
Other internal sources of finance include debt collection, sale of stock, personal savings from business owners, contributions from employees etc
External Sources of Finance
Refers to sourcing finances from lending institutions, other than from the business. Some of the external sources of finance include:
Invoice discounting: This is a form of short-term financing, where the banks or financial institutions pays the bill at the discounting time and recovers the money from the customer when it falls due.
Trade Credit: Business line of credit is a short time financing most suitable for temporary working capital needs. A financial institution or bank issues a certain amount of money to a business and is repayable as soon as customers make payments. This financing option is very effective since interest is charged only on the utilized amount and not on the credit issued.
Factoring: This is a short term financing issue by either banks or financial institutions. It is an arrangement where accounts receivables are traded to a third party at a slightly lower amount than the attainable value.
Working capital loans: A working capital loan is also referred to as short-term loans. These are loans granted by banks and other financial lending institutions upon thorough scrutiny of the business working capital cycle and creditworthiness. The loans are either repaid in full at the end of the loan period or in partial instalments.
Other sources of external finances include commercial paper, lease financing, etc