Nature and sources of cash - Short-term cash sources and fac...

Learning Outcomes

After reading this article, you will be able to identify and explain common short-term sources of cash available to businesses. You will understand the features, accounting treatment, risks, and advantages of facilities such as bank overdrafts, trade credit, and factoring. You will also recognise their impact on the financial statements and control of cash flows, essential for ACCA Financial Accounting and Financial Management exams.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand the importance of cash management and the practical facilities businesses use to maintain liquidity. In particular, you should be familiar with:

• The distinction between cash and profit
• The importance of monitoring and controlling cash flows to avoid liquidity problems
• Common short-term sources of cash, including bank overdrafts, trade credit, factoring, and invoice discounting
• The accounting entries and financial statement impact of obtaining short-term finance
• The advantages and risks associated with each form of short-term finance

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 of the following is usually considered a flexible, yet potentially expensive, source of short-term finance for a business?
   1. Issuing new shares
   2. Long-term bank loan
   3. Bank overdraft
   4. Revaluation surplus
2. What is trade credit?
   1. A cash-only payment system
   2. A loan from a bank
   3. The period a supplier allows before payment is required
   4. The sale of non-current assets
3. Factoring enables a business to:
   1. Issue new bonds
   2. Sell inventory to customers
   3. Obtain cash by selling its receivables to a finance company
   4. Settle tax liabilities in installments

4. Briefly explain one risk associated with relying on a bank overdraft for day-to-day cash needs.

Introduction

Maintaining an adequate level of cash is essential for every business. While profits signal long-term health, even highly profitable firms can quickly run into trouble if they run out of cash to settle bills, pay wages, or take advantage of opportunities. Short-term cash sources and credit facilities provide the flexibility businesses need to manage seasonal fluctuations, unexpected expenses, and timing mismatches between cash inflows and outflows.

This article reviews the principal short-term sources of cash and the accounting issues associated with each. Understanding these instruments helps you analyse business liquidity and apply the correct accounting treatment in financial statements.

Key Term: liquidity
The ability of a business to meet its short-term financial obligations as they fall due.

CASH AND THE NEED FOR SHORT-TERM FINANCE

Businesses often experience periods where cash outflows temporarily exceed inflows. These situations may arise due to timing differences between payments and receipts, seasonal sales cycles, or unplanned expenditures.

Short-term finance bridges these gaps, enabling the business to continue operating smoothly without major disruption. The main types of short-term cash sources include:

• Bank overdrafts
• Trade credit from suppliers
• Factoring and invoice discounting
• Short-term bank loans

Each has distinct features, benefits, and risks.

SHORT-TERM CASH SOURCES AND FACILITIES

Bank Overdraft

A bank overdraft is an agreement with a bank that allows a business to withdraw more money than is currently available in its account, up to a specified limit. It is the most flexible short-term borrowing facility and is typically used to cover temporary cash shortfalls.

Key Term: bank overdraft
A facility that allows a business to withdraw more funds from its bank account than the available balance, up to an agreed limit, with interest charged on any overdrawn amount.

The overdraft can be repaid at any time and interest is only charged on the amount actually overdrawn.

Advantages (Bank Overdraft)

• Flexibility to draw and repay funds as needed
• Quick to arrange (for established customers)
• Only pay interest on the amount used

Risks (Bank Overdraft)

• Usually more expensive interest than term loans
• Repayable on demand; the bank can cancel the facility at any time
• May require security or regular review by the bank

Trade Credit

Trade credit refers to the arrangement where suppliers allow the business to purchase goods or services now but pay for them later, typically within 30 to 90 days.

Key Term: trade credit
The period of time that a supplier allows a buyer to pay for goods or services supplied, effectively granting credit to the buyer until payment is made.

Trade credit is the most common form of short-term finance for many businesses, especially in the retail and manufacturing sectors.

Advantages (Trade Credit)

• Interest-free finance within the allowed period
• Easier to obtain than bank facilities
• Helps match cash outflows to cash inflows

Risks (Trade Credit)

• Overreliance can harm supplier relationships
• Early payment discounts may be missed
• Late payment can damage a business’s credit rating

Factoring and Invoice Discounting

Factoring is a financing method where a business sells its trade receivables (invoices) to a finance company—called a factor—for immediate cash, minus a fee. Invoice discounting is similar but allows the business to retain responsibility for collecting payments from customers.

Key Term: factoring
The sale of trade receivables to a finance company (factor), which advances cash to the business and collects payments from customers, charging a fee for the service.

Key Term: invoice discounting
An arrangement where a finance company advances funds against unpaid trade receivables, but the business remains responsible for recovering the debts.

Factoring provides an immediate injection of cash but often at a higher cost than traditional borrowing.

Advantages (Factoring and Invoice Discounting)

• Improves cash flow quickly
• Outsources receivables collection (factoring only)
• May reduce administrative workload

Risks (Factoring and Invoice Discounting)

• Fees can be high
• Customers may view involvement of third parties negatively
• For invoice discounting, bad debt risk remains with the business

Short-Term Bank Loans

Short-term bank loans are borrowings payable usually within twelve months, granted for specific cash needs. They provide more certainty of funding than overdrafts but lack the same flexibility.

ACCOUNTING TREATMENT OF SHORT-TERM FACILITIES

Short-term finance generally creates current liabilities in the statement of financial position. Proper classification and clear disclosure are required for users to assess liquidity.

Common Accounting Entries

Bank Overdraft:

• Overdrawn balances are presented under current liabilities as “Bank overdraft.”
• Interest charged on the overdraft is recorded as a finance cost in the statement of profit or loss.

Trade Credit:

• Unpaid supplier amounts (payables) are shown as current liabilities.
• Early payment discounts received are recorded as income or reduction in purchases.

Factoring:

• If receivables are sold (non-recourse), remove receivables from the books and record cash received.
• Any retained risk requires separate disclosure and may require a provision for bad debts.

Worked Example 1.1

A retail business has a bank overdraft facility of $25,000. At year-end, its bank statement shows a balance of (15,000). The business also owes \12,000 to suppliers, paid within 60 days, and has factored $8,000 of trade receivables (with no recourse) for $7,600 cash. How would these be presented in the statement of financial position?

Answer:
The $15,000 overdrawn balance is shown under current liabilities as "Bank overdraft." Trade payables of $12,000 are listed as current liabilities. The $8,000 factored receivables are removed from assets, and $7,600 cash is added to assets. No liability remains for the factored receivables as the factor bears the collection risk.

Exam Warning

Be careful to classify bank overdrafts under current liabilities and not as negative cash balances. Remember that not all overdrafts are guaranteed; check the terms of the facility for conditions.

ADVANTAGES AND RISKS OF SHORT-TERM FACILITIES

Short-term finance provides essential flexibility but comes with risks:

• Overuse can worsen liquidity if repayments cannot be made as required
• High or variable interest charges reduce profits
• Heavy reliance on one source, such as overdraft, exposes the business to sudden facility withdrawal

Businesses should monitor and control all sources of cash carefully to maintain solvency.

Revision Tip

Review recent statements of financial position from practice questions and identify each short-term cash facility, confirming that they are correctly classified and disclosed.

Summary

Short-term cash sources and credit facilities are essential tools for managing business liquidity. The main forms—bank overdraft, trade credit, factoring, and short-term loans—vary in flexibility, cost, and risk. Proper accounting ensures that liabilities and finance costs are correctly presented, enabling users to assess cash management and short-term solvency.

Key Point Checklist

This article has covered the following key knowledge points:

• Define liquidity and explain why cash management is essential for a business
• Identify and describe key short-term cash sources: bank overdrafts, trade credit, factoring, and short-term loans
• Provide accounting entries for each type of facility and their inclusion in financial statements
• Recognise the main risks and advantages of each short-term finance method
• Understand the impact of short-term borrowing on liquidity and solvency assessments

Key Terms and Concepts

• liquidity
• bank overdraft
• trade credit
• factoring
• invoice discounting