question_answer

Explain trade credit and bank credit as sources of short term finance for business enterprises.

Answer:

Ans.     Trade Credit: Trade credit is the credit extended by the trader to another to purchase goods and services. It facilitates the purchase of supplies without immediate payment. In books of accounts they are shown as "creditors' or 'ills payable'.

Merits of Trade Credit

1. It is a convenient and continuous source of finance.

2. It is readily available.

3. It helps in promoting sales of an organization.

4. If an organization wants to expand its inventory level so as to meet expected rise in demand, it may use trade credit.

5. It does not demand any security.

Demerits of Trade Credit

1. When easy and flexible trade credit is available, it may induce the firm to indulge in overtrading.

2. Trade credit can meet only limited financial needs. Funds required for inventory can be met through it but not others like plant and machinery, land and building or salaries of employees etc.

Bank Credit: Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days.

Short term lending may be in the form of:

(a) An overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day.

(b) A short-term loan, for up to three years.

(c) Medium-term loans are loans for a period of three to ten years.

The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and risk of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted after the end of every three, six, nine or twelve months in line with recent movements in the Base Lending Rate.

Merits of Bank Credit

1. Economical: Rate of interest charged by banks is quite nominal and is therefore economical.

2. Maintains business secrecy: Banks maintain secrecy of the business. They do not disclose the information shared to any third party.

3. Less formalities: As compared to issue of shares, debentures or accepting public deposits, it has less legal formalities.

4. Flexible source: It can be increased or decreased as per the requirements of the business. It is not so that once a loan is taken it can't be reduced.

Limitations of Bank Credit

1. Short - term financing: It does not provide loans for long term as shares and debentures do.

2. Difficult procedure: As compared to commercial papers and trade credit, it involves many legal and paper formalities. It makes its procedure difficult.

3. Restrictive clauses: Bank credit has many restrictive clauses which includes mortgage on company's assets or ineligibility to raise funds from specific sources.