Short-term funding sources - Overdrafts, revolving credit, a...

Learning Outcomes

After reading this article, you will be able to compare and contrast the main short-term funding sources available to companies: overdrafts, revolving credit facilities, and commercial paper. You will be able to identify the key features, advantages and disadvantages, costs, and risks associated with each source. By the end, you should be able to evaluate which instruments are most appropriate for different business needs and understand potential exam pitfalls.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand the characteristics, use, and risks of major short-term funding sources. In particular, revision should cover:

• The key features, advantages, and disadvantages of overdrafts, revolving credit facilities, and commercial paper
• Assessment of suitability in different business contexts and for working capital management
• The financial and risk implications (including cost, security, liquidity, and refinancing risks)
• Methods of comparing short-term funding options and their impact on liquidity and financial statements
• The role of short-term funding within overall treasury management

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. Which characteristic best distinguishes commercial paper from an overdraft?
   1. It is secured on inventory
   2. It bears a floating interest rate
   3. It is issued to institutional investors in the capital market
   4. It is available only to SMEs

2. True or false? A revolving credit facility is always automatically renewed without new credit checks.

3. List two major risks to a company associated with reliance on short-term borrowing for funding long-term assets.

4. Company X has a seasonal cash flow cycle and uncertain sales. Which short-term funding source provides the greatest repayment flexibility?

Introduction

Efficient management of short-term funding is critical in financial management, supporting day-to-day operations and liquidity. Financial managers routinely choose between various instruments to meet working capital requirements, bridge timing gaps, and manage unexpected cash flow pressures. The three most common sources are overdrafts, revolving credit facilities, and commercial paper. Each offers different features, costs, and risks.

Selecting the right source of short-term finance has implications for a company’s cash management, gearing, risk exposure, and access to further capital. This section examines the nature of each funding method, their main advantages and disadvantages, and practical considerations that feature regularly in the ACCA AFM exam.

MAIN SHORT-TERM FUNDING SOURCES

Overdrafts

A bank overdraft is a flexible short-term borrowing facility allowing a business to withdraw more than its current bank balance up to an authorised limit. Overdrafts are usually repayable on demand, with interest charged on the overdrawn balance. Businesses often use overdrafts for working capital, covering temporary cash shortages or unexpected payments.

Key Term: overdraft
A short-term borrowing facility from a bank allowing withdrawals in excess of credit balance up to a set limit, usually repayable on demand.

Advantages

• Fast access; minimal formalities once in place
• Only pay interest on the amount used
• Flexibility—can reduce or clear at any time without penalties

Disadvantages

• Repayable on demand—withdrawal risk if bank changes terms
• Often carries a higher interest rate than longer-term loans
• Facility fees and possible requirement for security (e.g., floating charge on assets)
• Potential for informal/unauthorised overdrafts, subject to much higher fees

Revolving Credit Facilities

A revolving credit facility (RCF) is a committed line of credit provided by a bank or syndicate of banks allowing the borrower to draw, repay, and re-draw funds up to a set limit during an agreed period (often 1–5 years). The facility is contractually committed and cannot be withdrawn by the bank (unless terms are breached), making it more reliable than a standard overdraft. Interest accrues on the drawn balance; an additional commitment fee is usually charged on undrawn amounts.

Key Term: revolving credit facility
A contractually committed, renewable line of credit up to a specified limit, permitting repeated drawing and repayment during the agreed availability period.

Advantages of Revolving Credit Facilities

• Certainty of funding compared to overdraft
• Allows flexible drawdown to match variable working capital needs
• Large facilities can be syndicated, increasing access to funds

Disadvantages of Revolving Credit Facilities

• Arrangement and commitment fees (even on undrawn balances)
• Financial covenants and conditions may apply (e.g., maintaining certain ratios)
• Less flexible than overdraft for short, small, or irregular cash deficits
• Typically reserved for larger or creditworthy borrowers

Commercial Paper

Commercial paper (CP) is a short-term unsecured debt instrument issued by large, creditworthy companies to institutional investors (banks, pension funds, money market funds), with typical maturities ranging from a few days to one year. CP is issued at a discount and redeemed at face value, and is generally used to finance short-term liabilities such as payroll or inventories.

Key Term: commercial paper
An unsecured, short-term promissory note issued by corporations to institutional investors, typically with maturities from 1 to 364 days.

Advantages of Commercial Paper

• Generally lower interest rates than overdrafts or RCFs for creditworthy issuers
• Increases funding diversification beyond the banking sector
• Does not require collateral

Disadvantages of Commercial Paper

• Available only to strong, credit-rated companies with high standing
• Access to the market can be volatile; refinancing risk in periods of market stress
• Issuer must maintain a continuous issuing programme—set-up can be expensive

RISKS AND PRACTICAL CONSIDERATIONS

Short-term funding can expose a business to risks if not managed properly.

• Liquidity Risk: Over-reliance on repayable-on-demand funding (overdrafts) exposes the business to possible withdrawal at short notice.
• Refinancing Risk: For commercial paper, if market sentiment declines or the company’s rating drops, refinancing maturing paper may be impossible or costly.
• Matching Principle: Funding long-term assets with short-term borrowing increases the risk of cash flow shortfalls if facilities are not renewed.

Worked Example 1.1

A manufacturer uses an overdraft to purchase extra inventory in anticipation of a seasonal sales spike. The sales do not materialise as projected, and the overdraft remains overdrawn for several months. The company's bank notifies it that the overdraft will be reviewed and may be reduced.

Answer:
The business is exposed to withdrawal risk as the overdraft is repayable on demand. If the bank reduces or withdraws the facility, the company may face liquidity problems and could be forced to dispose of inventory or seek alternative urgent finance at higher cost.

Worked Example 1.2

Company Y issues a 6-month commercial paper at a discount to fund short-term payables. During the period, market confidence weakens and it becomes more expensive, or even impossible, to issue new CP at maturity. What is the risk?

Answer:
This scenario demonstrates refinancing risk: the company may be unable to roll over its maturing commercial paper due to market conditions, forcing it to find more expensive or less suitable alternative finance, or even default.

Revision Tip

When choosing a funding method, always check the maturity profile of assets being financed and avoid funding long-term assets with sources payable on demand or within very short periods.

Summary

Overdrafts, revolving credit, and commercial paper are key short-term finance tools, each suited to different circumstances. Overdrafts are most flexible but less secure; revolving credit combines reliability with some flexibility; commercial paper offers low rates for strong companies but requires constant market access. Selection depends on the business’s liquidity needs, financial strength, and appetite for risk.

Key Point Checklist

This article has covered the following key knowledge points:

• Define overdrafts, revolving credit facilities, and commercial paper
• Compare their structure, main features, and typical uses
• Identify the main advantages and disadvantages of each method
• Explain the principal risks (liquidity, withdrawal, refinancing)
• Apply the matching concept to funding choices
• Evaluate the suitability of each source for different business needs

Key Terms and Concepts

• overdraft
• revolving credit facility
• commercial paper