Sources of Finance (medium-term & short-term)

Medium-term Sources of Finance

Medium-term sources of finance are the sources which usually provide finance for one to five
years. Such Finance are raised mainly from:
(1) Public Deposits, and
(2) Medium-term loan from Commercial Banks.

1. PUBLIC DEPOSITS
In India, accepting deposits from public is a traditional source of medium as well as short-term
finance of the company. Many companies accept deposits from their members, directors &
general public. This mode of raising finance has become quite popular & widespread because of
squeeze of bank credit & also the bank credit becoming quite costlier. Rates of interest offered
on public deposits are usually higher than those allowed by commercial banks. Companies
generally invite public deposits for a period up to three years. This is regulated by the R.B.I. and
cannot exceed 25% of its paid up share capital and reserves.

Merits of Public Deposits:

i. The procedure for obtaining public deposits is simpler than share and Debenture.
ii. Cost of public deposits is generally lower than the cost of borrowings from banks.
iii. Public deposits do not usually create any charge on the assets of the company.
iv. They do not have voting right therefore the control of the company is not diluted.
v. Interest paid on public deposits is tax deductible.

Demerits of Public Deposits:

i. New companies generally find it difficult to raise funds through public deposits.
ii. They are not secured.
iii. They are costly as most of the companies have to offer high interest.
iv. It is an unreliable source of finance as the public may not respond when the company needs
money.

2. MEDIUM-TERM LOAN FROM COMMERCIAL BANKS

Medium-term lending by commercial banks is a recent phenomenon. Initially it was felt that
commercial banks couldn’t lock up their funds in term loan because it would adversely affect
their liquidity. Their funds are mainly the deposits the public & are withdrawable at short notice,
and hence the funds cannot be for lending for a specific period of one year or more. As such, the
bank hesitate in extending such loans. But with the extension of re-financing facility by
Industrial Development Bank of India (IDBI), bank found it possible to provide medium-term
loans to industrial enterprises. Under the refinancing scheme, the bank can provide loans for
periods ranging between 3 to 7 years & get them re-financed at comparatively lower interest
rates. This reduces the pressure on the short-term deposits of the bank & also increases the profit
of the lending bank. Hence, the medium-term loans by commercial banks on the full backing of
tangible & readily marketable securities.

Merits of Medium-term Loans from Commercial Banks:

i. Commercial Bank provide timely financial assistance to business.

ii. Secrecy is maintained about loan taken from a Commercial Banks.
iii. This is the easier source of finance as there is no need to issue prospectus and underwriting
for raising funds.
iv. Loan from a bank is a flexible source of finance.

Demerits of Medium-term Loans from Commercial Banks:

i. Funds are generally available for short periods.

ii. Banks may ask for security of assets and personal sureties for sanctioning loan.
iii. In some cases, difficult terms and conditions are imposed by banks for the grant of loan.

Short-term Sources of Finance

Working Capital requirements of a firm are met from short-term funds. These funds are required
by a firm for a period of one year. Short-term sources of finance may be divided into two parts:

(1) Bank Sources

(2) Non-Bank Sources

(1) BANK SOURCES

Commercial banks are the most important source of providing short-term finance. They provide
such finance in various forms according to the specific requirement of the concern. The different
forms in which the banks normally provide short-term finance are as follows:

a. Cash Credit: A cash credit is an arrangement under which you are allowed to withdraw
money from the bank upto a certain limit, on hypothecation or pledge of certain security such
as stock. Minimum amount of credit limit is determined on the basis of financial position &
credit worthiness of the borrower. In case of hypothecation, the possession is not given to the
bank & the goods remain at the disposal & in the godown of the borrower whereas in case of
pledge, the goods are placed in custody of the Bank.

Interest on the Cash credit account is charged only on the amount actually withdrawn & not
on the full limit of cash credit allowed. The rate of interest charged by the bank on cash
credit is a little bit higher than the interest charged on term loan. This is because the bank has
 to keep the entire amount always ready as the money may be demanded by the customer at
any time.

b. Overdrafts: It is a temporary arrangement by which a customer operating current account

with the bank is allowed by the bank to overdraw money upto a certain limit. Like cash
credit, in case of overdrafts also, interest is charged on actual amount withdrawn by the
customer & the rate of interest is a little higher as compared to term loans.
c. Term Loans: It is an advance of a fixed amount withdrawn in lump sum is sanctioned for a
fixed term. Interest is charged on the total amount but the rate of interest is usually lower as
compared to cash credit & overdraft because the bank needs not to keep the money idle.
d. Discounting of Bills: It is a form of advance by which the bank advances money to the
holder of the bill before its maturity date after deducting the discount. The bank holds the bill
till its maturity date & gets its payment from the drawee on the due date.

(2) NON-BANK SOURCES:

These sources include the following:

a. Trade Credit

Trade credit represents the credit automatically allowed by the suppliers to their customers
according to custom of trade. In simple words, when the goods are purchased from the
supplier & the payment is not made immediately, it becomes a short-term source of finance.
Securing of trade credit depends upon the credit-worthiness of a firm & the confidence of its
suppliers.

Merits of Trade Credit:

i. Trade credit is a convenient and continuous source of funds.

ii. It does not create any charge on the assets of the firm.
iii. Trade credit may be readily available in case the credit worthiness of the customers is
known to the seller.
iv. Trade credit needs to promote the sales of an organization.

Demerits of Trade Credit:

i. It may induce a firm to indulge in overtrading.

ii.Only limited amount of funds can be generated through trade credit.
iii.
It is generally a costly source of funds as compared to other sources of fund.
iv.The biggest disadvantage of trade credit is that the price charged by the supplier of goods
is higher than the cash price.
v. Buyers has to bear the loss of cash discount which he could have availed on cash
purchases.
b. Commercial Papers:

These are short-term unsecured securities issued by highly creditworthy large companies.
Commercial Papers are regulated by the RBI & the main features of this are:

i. Only those companies are allowed to issue commercial papers who have a net worth of
₹ 10 crore or more.
ii. The minimum size of an issue is ₹25 lakh & the size of each commercial paper should
not be less than ₹5 lakh.
iii. They can be issued for periods ranging between 15 days & one year.

Merits of Commercial Papers:

i. A commercial paper does not contain any restrictive conditions.

ii. As it is a freely transferable instrument, it has high liquidity.
iii. A commercial paper provides a continuous source of funds.
iv. They are cheaper than a bank loan.
v. It is a useful source of finance during periods of tight bank credit.

Demerits of Commercial Papers:

i. Only financially sound and highly rated firms can raise money through commercial
papers
ii. The size of money that can be raised through commercial paper is limited
iii. Commercial paper is an impersonal method of financing. Extending the maturity of a CP
is not possible.
iv. Issue of commercial paper is very closely regulated by the RBI guidelines.
v. It cannot be redeemed before maturity date even if the issuing firm has surplus funds.

c. Advance from Customers

Manufacturers whose products are in great demand, usually demand advance money from
the customers & agents at the time of accepting orders. Such an advance is a fixed
percentage of the value of the orders. Such advances are a part of the prices of the goods &
no interest is paid on them.

d. Accrued Expenses

These are the expense which have been incurred but haven’t become due for payment. The
most common item of accruals are wages, salaries, interest & taxes. Wages & salaries are
usually pain in the next month to the month in which the services were rendered. Similarly
the interest is paid periodically whereas the principle amount is used continuously.
 Likewise, the tax is also paid periodically much after the earning of profits. Thus, the time-
lag in payment of accrued expenses becomes a short-term source of finance.

e. Miscellaneous Sources:

Some concerns resort to miscellaneous sources of finance in times of pressing needs. Such
sources may include loan from directors, indigenous bankers, inter-corporate deposits, etc.