## **Learning Outcomes**

After reading this article, you will be able to identify the main methods for covering cash deficits in an organisation, explain and compare the costs associated with different short-term financing options, and select the most appropriate cash facility based on practical needs and costs. You will gain the decision-making tools needed to answer exam questions on temporary cash shortages and funding choices.

## **ACCA Foundations in Financial Management (FFM) Syllabus**

For ACCA Foundations in Financial Management (FFM), you are required to understand the techniques used to manage short-term cash shortages and select suitable sources of finance. Specifically, you should be familiar with:

- The need to manage short-term cash deficits and maintain liquidity
- The range of short-term borrowing facilities and their key features
- How to calculate and compare the cost of different short-term borrowing options
- Assessing the suitability of alternative facilities given organisational requirements, speed, flexibility, and cost

## **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 short-term funding method typically offers lowest interest cost but may, in practice, be difficult to arrange at short notice?
2. Name two non-interest costs that can apply to short-term borrowing facilities.

3. An organisation expects a cash shortfall of \$50,000 for up to 2 months. List two funding facilities it could use and state a key advantage or disadvantage of each.

4. A company can use an overdraft at 8% p.a. with a \$100 arrangement fee or a short-term loan at 7.2% p.a. for three months with a \$250 fee. Which is lower total cost for a 2-month \$40,000 borrowing if the full facility is used?

## **Introduction**

Organisations sometimes spend more cash than they receive in the short term, resulting in a cash deficit. These deficit periods may be caused by seasonal cycles, temporary drops in sales revenue, or delays in payment receipts. Failure to cover cash shortfalls can lead to inability to meet obligations, supplier issues, or even insolvency. Effective management of such situations requires both forecasting the need and selecting the most cost-effective financing method.

This article outlines the main methods of funding cash deficits, explains how to calculate the cost of finance, and compares factors in selecting the most suitable facility.

> **Key Term: cash deficit**
> A situation where outflows of cash exceed inflows within a given period, requiring external funding to avoid running out of available funds.

## **Managing Cash Deficits**

When a business expects a short-term shortfall in cash, management must choose how to raise funds to bridge the gap. There are multiple options, each with different cost structures, availability, and risks. The suitability of each depends on the length and size of the deficit, the organisation’s relationships with finance providers, and the predictability of cash flows.

### Main Short-Term Funding Facilities

The most commonly used facilities for temporary cash needs include:

- **Bank overdraft:** A pre-agreed credit limit on a current account that allows the business to withdraw more than its available balance, up to a limit.
- **Short-term bank loan:** A fixed sum borrowed from a bank, typically repayable within 12 months, sometimes even after just one or two months.
- **Invoice (receivables) finance:** Advances from a finance provider secured against amounts owed by customers.
- **Trade credit extension:** Negotiating longer payment terms from suppliers.

> **Key Term: bank overdraft**
> An agreement with a bank allowing withdrawals in excess of the current balance, up to a specified limit, usually repayable on demand and often with fluctuating interest.
>
> **Key Term: short-term bank loan**
> A fixed sum borrowed with a set repayment date, usually up to 12 months, at a specified interest rate and fee.

### Cost Considerations

When comparing borrowing facilities, both interest and non-interest costs must be taken into account.

- **Interest cost:** The rate applied to the outstanding balance or full loan, usually annualised (e.g., 8% per annum).
- **Arrangement fees:** Upfront (or sometimes ongoing) charges for setting up the facility, irrespective of use.
- **Other fees:** Penalty fees for going over limits, early repayment penalties, or ongoing commitment fees.
- **Effective period:** Many fees are charged in full even if the loan is only needed for a short time, which increases the effective annual cost.

In practice, the total cost is determined by interest charges (which may accrue daily) plus any fees spread over the borrowing period.

### Availability and Flexibility

- **Overdrafts** are most flexible—they can be used as needed and repaid at any time, but need a pre-existing agreement with the bank.
- **Loans** are less flexible—fixed amounts must be borrowed and repaid on specific dates.
- **Invoice finance** is available only up to the value of approved customer invoices and often has higher fees.
- **Trade credit** is usually interest-free but only extends payment for supplier invoices.

### **Worked Example 1.1**

A business forecasts a cash deficit of \$60,000 lasting 1.5 months. Two funding options are available:

- **Overdraft:** Approved facility, 9% per annum, \$80 fee.
- **Short-term loan:** \$60,000 for 2 months, 7% per annum flat, \$120 fee.

Which option is cheaper for the expected duration?

> **Answer:**
> Overdraft interest: \$60,000 × 9% × (1.5/12) = \$675. Plus \$80 fee = \$755 total.
> Loan interest: \$60,000 × 7% × (2/12) = \$700. Plus \$120 fee = \$820 total.
> The overdraft is cheaper by \$65 for this 1.5-month period.

### **Exam Warning**

Banks often impose minimum fees for short-term loans or overdraft arrangements, which can make short-term borrowing expensive even where the interest rate appears lower. Always calculate the total cost, including all fees, for the expected period.

### Facility Selection Criteria

When choosing a funding facility, management should consider:

- **Cost:** Total interest and fees for the borrowing period.
- **Speed:** How rapidly the facility can be arranged or accessed.
- **Flexibility:** Whether funds can be drawn and repaid as needed, or if the facility is fixed.
- **Security:** Whether collateral is required (especially for loans and invoice finance).
- **Fit to need:** For unpredictable cash flow gaps, an overdraft is better; for planned, fixed needs, a loan may be more suitable.

### **Worked Example 1.2**

Horizon Ltd needs \$25,000 for up to 1 month due to a customer payment delay. Its options:

1. Bank overdraft—already in place, charged at 10% p.a., no extra fee for use.
2. Supplier agrees to extend credit for 30 days; cost is a 2% early payment discount foregone on \$25,000.

Which is lower cost?

> **Answer:**
> Overdraft: \$25,000 × 10% × (1/12) = \$208.
> Forgone discount: \$25,000 × 2% = \$500.
> The overdraft is cheaper by \$292.

### Other Practical Factors

- If cash needs are unpredictable or amounts vary, overdrafts or invoice finance are more useful.
- If a specific, known amount is needed, a loan gives certainty of cost and repayment.
- Trade credit is cost-effective, but depends on supplier co-operation and may harm relationships if overused.

## **Summary**

Where short-term cash deficits arise, management should evaluate all available facilities, considering the total cost (interest and fees), availability, flexibility, and fit to need. Overdrafts offer flexibility, loans may offer lower headline rates but can be expensive due to fees for short periods, and trade credit/receivables finance may provide alternatives in specific circumstances.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Recognise common short-term funding facilities: overdraft, short-term loan, invoice finance, trade credit
- Calculate total cost of short-term borrowing, including both interest and fees
- Compare the features and suitability of each funding option for different cash deficit scenarios
- Apply facility selection criteria such as speed, flexibility, and cost when recommending solutions

## **Key Terms and Concepts**

- cash deficit
- bank overdraft
- short-term bank loan

Managing cash deficits - Cost considerations and facility selection