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Short Term Debt Explained

Short-term debt is available from a range of institutions including banks, merchant banks, investment banks and finance companies. The debt may take a variety of forms, ranging from a loan to a situation in which the borrower sells a financial instrument directly into the market and promises to pay the holder of the instrument its face value on the maturity date. The form that the debt will take is normally determined by the credit rating of the issuer, the size of the funding requirement, and the preferences of the investors.

In of the simplest and most common forms of debt finance is trade credit, where the seller of goods and services provides businesses with a period of free credit, which may also include a discount for prompt payment. Of the sources of debt available through the more traditional avenues of the financial markets, very short-term loans are available through the Intercompany market in the form of 11am and 24-hour call loans. Since these are usually made on an unsecured basis, only the best credit-rated borrowers have access to the market.

Bank overdrafts have historically played a major role in providing short-term business finance. Over more recent years, however, the banks have priced overdrafts such that their popularity has declined. From the point of view of the banks, overdrafts are expensive, since, whether or not the borrower draws funds up to the approved limit, the bank has to make provisions to cover the full limit. To avoid the liquidity management problems posed by overdrafts, the banks have moved to a greater reliance on full drawn advances (FDAs) as the preferred arrangement for short-term loans. Merchant banks may also provide short-term loans.

Bill financing is another important source of business finance. The banks encouraged the development of the market since it allowed them to meet their clients’ requirements for finance without having to fund the loan through their deposit base. Though there are numerous arrangements available of the drawing and discounting of bills, a common approach is for the borrower to draw the bill and for a bank to accept the bill. Funds are paid to the payee when the bill is discounted by the borrower. The bank’s acceptance of the responsibility for the redemption of the bill on maturity improves the credit rating of the instrument and allows it to be discounted on better terms that would have prevailed without the bank’s acceptance.

Borrowers with a good credit rating and high profile in the markets may elect to draw promissory notes (P-notes). P-notes are generally referred to in the money markets as ‘commercial paper’. P-notes are similar to bills in that they are discount securities; however, they do not involve an acceptor, nor is endorsement required when the instruments are traded in the secondary market. In marketing P-notes, the issuer may choose to have the issue underwritten. Certificates of Deposit are also a discount security issued by banks as part of their short-term liability management and liquidity management.

Where the issue of P-notes as a debt facility is available only to larger and better credit-rated borrowers, inventory loans and accounts receivable finance, and factoring, are available to smaller and medium-sized businesses as well. Inventory financing is common in the motor vehicle retail industry. The usual arrangement is that the financier secures the financing facility through ownership of the vehicles that are being financed. Factoring and accounts receivable finance are similar in that the business obtains finance against its accounts receivable. With accounts receivable finance, select accounts receivable are used as security for the loan. In the case of factoring, the accounts receivable are sold to the financier who then takes responsibility for the collects of the amount due. These forms of finance are predominantly provided by finance companies.