## Learning Outcomes

After reading this article, you will be able to explain the primary types of short-term and alternative finance available to businesses, specifically overdrafts, trade credit, and commercial paper. You will understand their features, practical uses, advantages and drawbacks, and be able to apply this knowledge in ACCA Financial Management (FM) exam scenarios.

## ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand short-term and alternative finance, especially how businesses manage cash flow needs and select between sources. This article focuses on:

- The features, benefits, and risks of short-term finance instruments: overdrafts, trade credit, and commercial paper
- The practical considerations for choosing between these alternatives
- Impacts on liquidity, funding risk, and working capital management
- The role of short-term finance in overall capital structure and business operations

## Test Your Knowledge

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

1. Which statement best describes a bank overdraft as a source of finance?
   a) It provides long-term fixed finance to businesses.
   b) It allows businesses to borrow up to a set limit and is repayable on demand.
   c) It is only available to large, listed companies.
   d) It must be repaid in fixed monthly instalments.

2. What is the main risk to a supplier providing trade credit to a customer?
   a) Loss of ownership of goods.
   b) Customer delay or failure to pay.
   c) Being subject to market interest rate changes.
   d) Exposure to currency risk.

3. True or false? Commercial paper is typically used by small businesses to obtain cash from suppliers.

4. Briefly explain one advantage and one disadvantage of using commercial paper compared to bank overdrafts.

## Introduction

Efficient working capital management often requires businesses to cover short-term funding gaps. Temporary needs can arise due to seasonal fluctuations, unexpected bills, or delays in customer payments. The main sources of short-term finance—overdrafts, trade credit, and commercial paper—support a company's day-to-day liquidity and provide flexibility. Choosing the right instrument affects both costs and risks.

> **Key Term: short-term finance**
> Finance that is expected to be repaid within one year, typically used to meet immediate working capital needs.

### OVERDRAFTS

A bank overdraft is a flexible short-term borrowing facility in which a business may withdraw funds up to an agreed limit even when the account balance is zero. Interest is paid only on the overdrawn amount, and the amount outstanding can vary as required.

### Main Features

- Flexible: Borrow only what is needed up to the limit.
- Interest: Charged only on the amount used, typically above the base rate.
- Repayable on demand: Banks can request repayment at any time.
- Security: May require collateral or personal guarantees.

> **Key Term: bank overdraft**
> A facility allowing a business to withdraw more money than is in its bank account up to a set limit, with interest charged on overdrawn amounts.

### Advantages

- Provides immediate access to cash for short-term needs.
- Easy to arrange for established businesses.
- Can help manage timing differences in receipts and payments.

### Disadvantages

- Repayable on demand—lack of certainty.
- Interest rates are often variable and may increase with risk.
- May incur arrangement fees and require security over assets.

### Worked Example 1.1

A company has an agreed overdraft limit of \$200,000 but only uses \$120,000 during the month, paying 8% annual interest on the balance.

Question:
How much interest will the company pay for the month, and what risk should be considered for relying on overdrafts?

> **Answer:**
> Monthly interest = (\$120,000 × 8% × 1/12) = \$800.
> The company pays for what it uses, but risks having the facility withdrawn or the limit reduced without notice.
>
> **Exam Warning:**
> Be careful not to assume that an overdraft provides permanent finance. In exam scenarios, overdraft funding may be withdrawn at any time unless specifically stated otherwise.

### TRADE CREDIT

Trade credit arises when suppliers allow a business to purchase goods or services and pay at a later date. This is a widely used source of informal short-term funding and is critical for smoothing cash flows.

### Main Features (Trade Credit)

- Typical credit terms: e.g., "30 days net"—payment is due 30 days after invoice.
- Cost: Often interest-free if paid within agreed period, but late payment may incur penalties or loss of discounts.
- No specific legal documentation—usually just a statement of terms.

> **Key Term: trade credit**
> Payment terms given by a supplier to a customer, allowing goods or services to be paid for after delivery, often in 30 or 60 days.

### Advantages (Trade Credit)

- Frees up cash for other uses until payment is due.
- Easy to arrange as part of normal business with suppliers.
- No direct interest charge if paid promptly.

### Disadvantages (Trade Credit)

- Late payment can damage supplier relationships and risk loss of discounts.
- Suppliers may refuse further supply or demand cash on delivery if payment problems arise.
- Over-reliance may signal financial weakness.

### Worked Example 1.2

A retailer purchases goods worth \$15,000 from a supplier with 30 days credit. The supplier offers a 2% discount for payment within 10 days.

Question:
If the retailer takes the discount and pays early, what is the equivalent annual interest rate being "earned" by doing so?

> **Answer:**
> Discount taken = \$15,000 × 2% = \$300.
> Early payment period = 20 days early (30 – 10).
> Annualised return: (2% / 98%) × (365/20) ≈ 37% effective annual rate.
> This shows trade credit discounts can be costly if not used.

### COMMERCIAL PAPER

Commercial paper (CP) is an unsecured, short-term debt instrument issued by large companies to meet urgent cash flow requirements. It is sold to investors at a discount, usually for periods from a few days up to one year.

> **Key Term: commercial paper**
> An unsecured, short-term promissory note issued by corporations to raise funds directly from investors, typically with maturities up to 12 months.

### Main Features (Commercial Paper)

- Issued by financially strong, usually large companies with high credit ratings.
- Sold at a discount, redeemed at face value.
- Flexible: Issues can be tailored to funding needs.
- No collateral required.

### Advantages (Commercial Paper)

- May be cheaper than bank borrowing—especially for companies with a strong credit rating.
- Can raise large sums rapidly without bank intermediation.
- Improves funding diversification.

### Disadvantages (Commercial Paper)

- Not accessible to smaller companies or those without a high credit rating.
- Unsecured and market-dependent—may be unavailable during credit crunches.
- Defaulting on commercial paper can damage reputation.

### Worked Example 1.3

TechCo issues \$5 million of 3-month commercial paper at a discount rate of 6% per annum.

Question:
What are the net proceeds TechCo receives, and what is the effective cost of this finance?

> **Answer:**
> Discount = \$5m × 6% × 3/12 = \$75,000.
> Proceeds received = \$5m – \$75,000 = \$4,925,000.
> At maturity, TechCo repays the full \$5m; the effective borrowing rate is 6% p.a.

### Alternative and Hybrid Short-term Finance

Other short-term sources such as bank loans, invoice discounting, factoring, and supply chain finance may be used when traditional routes are unavailable or less suitable. Evaluate the company's needs, creditworthiness, and the comparative costs and risks.

### Comparing Short-term Finance Sources

![Trade credit discount decision process comparing the effective annual rate of forgone discount with short-term borrowing cost.](https://static.pastpaperhero.com/images/acca-fm-short-term-and-alternative-finance-overdrafts-trade-credit-and-commercial-paper_00.png)

_Supplier credit terms are evaluated by annualising the cost of not taking a discount and comparing it with current funding rates._

| Source           | Typical User     | Key Features                        | Main Risk                |
| ---------------- | ---------------- | ----------------------------------- | ------------------------ |
| Overdraft        | All businesses   | Flexible, repayable on demand       | Sudden withdrawal        |
| Trade credit     | All businesses   | Linked to trade volumes             | Loss of supply/discounts |
| Commercial paper | Large corporates | Direct market borrowing, short-term | Market/demand collapse   |

> **Revision Tip:**
> When answering exam questions, clearly identify the source, advantages, and risks. Use examples to show understanding.

## Summary

Short-term and alternative finance options—overdrafts, trade credit, and commercial paper—are essential tools for funding day-to-day operations and managing liquidity risk. Understanding the characteristics, advantages, and drawbacks of each allows financial managers to select the most appropriate method for different scenarios, balancing flexibility, cost, and security.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Define and explain short-term finance, including overdrafts, trade credit, and commercial paper
- Compare key features, benefits, and risks of each instrument
- Apply these sources in practical scenarios to manage working capital requirements
- Recognise the advantages and disadvantages relevant to ACCA exam questions

## Key Terms and Concepts

- short-term finance
- bank overdraft
- trade credit
- commercial paper


Short-term and alternative finance - Overdrafts, trade credit, and commercial paper