## **Learning Outcomes**

After reviewing this article, you will be able to identify and evaluate core short-term funding sources for businesses. You will be able to assess the costs and main risks associated with each option, distinguish between key financing instruments, and explain the significance of covenants imposed by lenders. You should be able to recommend suitable short-term funding solutions in different business situations, recognising both financial and operational impacts.

## **ACCA Advanced Financial Management (AFM) Syllabus**

For ACCA Advanced Financial Management (AFM), you are required to understand how businesses fund short-term cash requirements. In particular, you should focus your revision on:

- The identification and evaluation of short-term funding sources for organisations
- Analysis of the direct and indirect costs of short-term borrowing
- Assessment of the financial risks associated with different instruments (e.g., interest rate, liquidity, refinancing, and default risks)
- The function and impact of lender covenants on corporate funding strategies
- Comparison of secured versus unsecured funding
- Practical considerations in negotiating and managing short-term finance arrangements

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. Identify three commonly used short-term funding sources for a medium-sized trading business.
2. What is the difference between an explicit cost and an implicit cost in the context of short-term borrowing?
3. Explain the main risk faced by a company relying exclusively on bank overdraft finance for working capital.
4. What purpose do covenants in loan agreements serve, and how could they affect a borrower’s financial flexibility?

## **Introduction**

Businesses often require short-term funding to cover working capital needs, address seasonal fluctuations, or manage timing differences between cash inflows and outflows. Choosing the correct short-term financing source is essential, as it directly affects liquidity, costs, and operational flexibility. This article examines the main types of short-term finance available, the associated explicit and implicit costs, the principal risks each method carries, and the practical implications of lender-imposed covenants.

> **Key Term: Short-term funding**
> Any financial arrangement providing cash to a business for less than one year, primarily to meet temporary operating requirements.

## MAIN SOURCES OF SHORT-TERM FUNDING

Short-term funding is usually employed to finance inventory, receivables, or immediate cash shortfalls. The core sources include:

### Bank Overdrafts

A bank overdraft allows businesses to withdraw more money from a current account than they have deposited, up to an authorised limit. This facility is typically repayable on demand.

> **Key Term: Bank overdraft**
> An agreement with a bank permitting a business to withdraw more than its account balance, creating a negative balance up to a set limit.

### Short-term Bank Loans

These loans have a fixed term (often less than one year), negotiated at a specified interest rate, with repayments scheduled over the agreed term.

> **Key Term: Short-term bank loan**
> A formal borrowing arrangement from a bank with a set amount, fixed interest rate, and fixed repayment date, typically not exceeding twelve months.

### Trade Credit

This is credit extended by suppliers, allowing the business to delay payment for goods and services. It is usually interest free for a basic period, then penalty interest may accrue on overdue accounts.

> **Key Term: Trade credit**
> The practice of purchasing goods or services and deferring payment until an agreed future date, extended by suppliers as part of normal trading terms.

### Other Common Sources

- Commercial paper (for large, creditworthy corporates)
- Invoice discounting and factoring
- Short-term finance from group companies (in a group context)

## COST CONSIDERATIONS

Each source of short-term finance carries distinct costs, both visible and hidden.

### Explicit Costs

The explicit or direct costs include:

- Interest charges (fixed or variable)
- Arrangement or facility fees
- Penalty charges for unauthorised borrowing or late payments

### Implicit Costs

There are also indirect costs to consider:

- Loss of early payment discounts when extending trade credit
- Higher prices from suppliers if credit taken is regularly overdue
- Opportunity costs, such as the loss of supplier goodwill or increased risk of supply chain disruption

### Comparative Cost Analysis

The real cost of finance should always include both explicit and implicit costs. For instance, a supplier may offer a 2% discount for payment within 10 days, with a standard term of 30 days. By foregoing this, the business is incurring an implicit cost much higher than typical bank loan rates.

### **Worked Example 1.1**

**A company has obtained a \$100,000 overdraft at an interest rate of 8% p.a., and also has trade creditors offering a 2% discount for payment within 10 days, or payment in 30 days with no discount. What is the effective annual cost of not taking the trade discount?**

> **Answer:**
> The cost of not taking the discount:
>
> - Discount lost: 2% of \$100,000 = \$2,000 for 20 days’ finance.
> - Annualised effective cost:
>   $$
>   \text{Cost per period} = \$2,000 / \$98,000 = 2.04\% \text{ for 20 days}
>   $$  
>   Number of periods per year = 360 / 20 = 18
>
>   Effective annual rate = $ (1 + 0.0204)^{18} - 1 \approx 43.6\% $
>
> This is significantly higher than the bank overdraft rate, demonstrating trade credit can be very expensive if discounts are ignored.

## RISK CONSIDERATIONS IN SHORT-TERM FINANCE

Short-term funding offers flexibility but comes with pronounced risks.

### Liquidity Risk

Over-reliance on short-term sources can lead to liquidity problems, especially if lenders refuse to renew facilities or withdraw them unexpectedly.

> **Key Term: Liquidity risk**
> The danger that an entity cannot meet its short-term obligations as they fall due.

### Refinancing and Roll-over Risk

For arrangements such as short-term loans or commercial paper, the ability to refinance at maturity is not guaranteed, especially in periods of credit market turbulence.

### Interest Rate Risk

Variable-rate products like overdrafts expose businesses to fluctuations in market rates, which can increase borrowing costs suddenly.

### Default and Credit Risk

Failing to meet repayment terms, especially on trade credit, may damage credit ratings and disrupt essential supplier relationships.

### Security and Collateral Risk

Some facilities require asset pledges (such as inventories or receivables), which can restrict further borrowing or put key assets at risk if covenants are breached.

### **Worked Example 1.2**

**A wholesaler uses invoice discounting as its principal short-term funding source. The receivables facility is secured against sales invoices and is subject to monthly re-approval by the funder. What risk does the company face if a significant customer defaults?**

> **Answer:**
> If a major customer fails to pay, the lender may reduce the funding available or demand immediate repayment. The business could face a sudden withdrawal of cash, disrupting operations and possibly forcing it to seek more expensive or restrictive funding.

## COVENANT CONSIDERATIONS

Most formal short-term funding, particularly bank products, involves covenants—contractual restrictions designed to protect the lender.

> **Key Term: Covenant**
> A clause in a finance agreement requiring the borrower to comply with specific financial or operational conditions during the life of the facility.

### Types of Covenants

- **Financial**: Minimum current ratio, maximum gearing, or minimum net worth requirements.
- **Non-financial**: Restrictions on asset disposals, dividend payments, or changes in business activity.

Breach of a covenant may result in the withdrawal of funding, immediate repayment, or increased interest rates. Some covenants may limit the borrower's operational flexibility or ability to take on additional finance from other lenders.

### **Worked Example 1.3**

**A manufacturing company’s overdraft facility stipulates a minimum current ratio of 1.2. If the ratio falls due to an inventory write-down, what are the potential consequences?**

> **Answer:**
> Breaching the current ratio covenant gives the bank the right to call in the overdraft or renegotiate terms at higher cost. The company may face urgent liquidity issues or be forced to find alternative finance on less favourable terms.

### **Exam Warning**

> Be prepared in the exam to analyse scenarios where a company’s operations cause it to breach a covenant. Consider the potential consequences: funding withdrawal, renegotiation at higher cost, or cross-defaults with other agreements. Show your understanding of both financial and practical effects.

### **Revision Tip**

> Always highlight both the explicit and implicit costs when recommending a short-term funding source in exam answers. Examiners want to see recognition of less obvious costs and risks.

## **Summary**

Short-term funding provides essential liquidity but exposes organisations to significant costs, refinancing and covenant risks. Every funding solution must be evaluated in terms of interest costs, lost discounts, cash flow reliability, and operational constraints imposed by lender covenants.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Identify common short-term funding sources: overdrafts, loans, trade credit, invoice finance
- Calculate and compare explicit versus implicit costs of short-term borrowing
- Assess main risks: liquidity, refinancing, and interest rate exposure
- Explain the purpose and impact of covenants in short-term funding contracts
- Differentiate between secured and unsecured borrowing in terms of cost and risk
- Appraise funding choices in context, recognising operational trade-offs

## **Key Terms and Concepts**

- Short-term funding
- Bank overdraft
- Short-term bank loan
- Trade credit
- Liquidity risk
- Covenant

Short-term funding sources - Cost, risk, and covenant considerations