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MERITS AND DEMERITS OF SHORT-TERM FINANCE – ADVANTAGES, AND DISADVANTAGES OF SHORT TERM FINANCE
Short-term financing is an ultimate source to manage the working capital requirements of an enterprise. The need for short-term funds varies from enterprise to enterprise and depends on the nature of the business and production cycle. Short-term loans help business concerns to meet their temporary requirements of money.
They do not create a heavy burden of interest on the organization. But sometimes organizations keep away from such loans because of uncertainty and other reasons.
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Let us examine the purpose, merits, and demerits of short-term finance.
Objectives by the end of this session, you should be able to:
(a) state and explain the purpose of short-term finance
(b) discuss the merits of short-term finance
(c) examined the demerits of short-term finance
Now read on …
PURPOSE OF SHORT-TERM FINANCE
After the establishment of a business, funds are required to meet its day-to-day expenses.
For example, raw materials must be purchased at regular intervals, workers must be paid wages regularly, water and power charges have to be paid regularly. Thus, there is a continuous necessity for liquid cash to be available for meeting these expenses.
For financing such requirements short-term funds are needed. The availability of short-term funds is essential.
Inadequacy of short-term funds may even lead to the closure of business.
Short-term finance serves the following purposes:
- Smooth Running of Business – It refers to the continuity in the operations of the enterprise. The short-term fund helps in fulfilling the day-to-day financial needs of the enterprise. It facilitates the smooth running of business operations by meeting day-to-day financial requirements.
- It enables firms to hold stock of raw materials and finished products.
- With the availability of short-term finance, goods can be sold on credit. Sales are for a certain period and collection of money from debtors takes time. During this time gap, production continues and money will be needed to finance various operations of the business.
- Increase in Productivity – It refers to the use of short-term funds to enhance the production level of the enterprise. The proper utilization of funds for the procurement of labor, material, and machine can increase the productivity of the enterprise. Short-term finance becomes more essential when it is necessary to increase the volume of production at a short notice.
- Fulfillment of Emergency Needs – It implies that short-term finance is needed to meet any urgent or emergency requirement of funds. Short-term funds are also required to allow the flow of cash during the operating cycle. The operating cycle refers to the time gap between commencement of production and realization of sales.
- Business Cycle – The business cycle brings fluctuations in the demand and supply of products and services. If there is a boom in the market, the demand for the product increases. In such a situation, the enterprise needs to raise short-term funds to increase the supply of the product. Therefore, the enterprise requires short-term funds to cope up with the temporary rise in the demand for the product.
- Liquidity Position – Liquidity position refers to the capability of an enterprise to meet the immediate cash need for managing the current liabilities. Short-term financing helps in maintaining the liquidity position of an enterprise by providing excess cash to an enterprise.
- Operational Efficiency – It requires the replacement of old machines and equipment by new ones and employment of skilled labor and application of the latest technology to improve the efficiency of the enterprise. Short-term financing helps in fulfilling these requirements of an enterprise.
- Nature of Business – It refers to the different types of business operations carried out by enterprises. The requirement of short-term financing varies as per the nature of the business of the enterprise. For example, a manufacturing enterprise requires more short-term capital because it needs to procure raw material on a regular basis.
- Selling goods on Credit – Selling goods on credit reduces the cash balance of the enterprise. Therefore, if an enterprise decides to sell goods on credit, it needs to retain a sufficient amount of short-term funds to carry out its day-to-day operations smoothly.
MERITS OF SHORT-TERM FINANCE – “ADVANTAGES OF SHORT-TERM FINANCE”
(i) Economical Finance for short-term purposes can be arranged at a short notice and does not involve any cost of raising. The amount of interest payable is also affordable. It is, thus, relatively more economical to raise short-term finance.
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(ii) Flexibility Loans to meet short-term financial needs can be raised as and when required. These can be paid back if not required. This provides flexibility.
(iii) No interference in management The lenders of short-term finance cannot interfere with the management of the borrowing concern. The management retains their freedom in decision-making.
(iv) May also serve long-term purposes Generally business firms keep on renewing short-term credit, e.g., cash credit is granted for one year but it can be extended up to 3 years with annual review.
After three years it can be renewed. Thus, sources of short-term finance may sometimes provide funds for long-term purposes.
DEMERITS OF SHORT-TERM FINANCE – “DISADVANTAGES OF SHORT-TERM FINANCE”
Short-term finance suffers from a few demerits which are listed below:
(i) Fixed Burden Like all borrowings interest has to be paid on short-term loans irrespective of profit or loss earned by the organization.
That is why business firms use short-term finance only for temporary purposes. (ii) Charge on assets Generally short-term finance is raised on the basis of security of moveable assets. In such a case the borrowing concern cannot raise further loans against the security of these assets nor can these be sold until the loan is cleared (repaid).
(iii) Difficulty of raising finance When business firms suffer intermittent losses of the huge amounts of market demand are declining or industry is in recession, it loses its creditworthiness.
In such circumstances, they find it difficult to borrow from banks or other sources of short-term finance. This can be likened to a situation when the coronavirus pandemic affected Ghana in 2020. Businesses find it difficult during this period to raise short-term funds for their operations.
(iv) Uncertainty in cases of crisis, business firms always face the uncertainty of securing funds from sources of short-term finance. If the amount of finance required is large, it is also more uncertain to get the finance.
This was the case in Ghana from 2017 to 2019 when the country was hit by the banking crisis that resulted in some banks been merged into one consolidated bank, some banks been closed down, and a number of microfinance companies losing their licenses to operate in the country.
(v) Legal formalities Sometimes certain legal formalities are to be complied with for raising finance from short-term sources. If shares are to be deposited as security, then the transfer deed must be prepared. Such formalities take a lot of time and create a lot of complications.
In this guide or session, we studied the purpose of short-term finance and examined the merits and demerits of short-term finance.
These will guide us anytime we are going for short-term financing for a business.
These factors discussed must be thoroughly analyzed and tactically personalized before going for the money. What might be advantageous to one business might be disadvantageous to the other.