The most common type of credit that most business firms use is short-term credit. It is generally cheaper than long-term capitals, and is easier to obtain. But this type of credit it riskier and less dependable source of financing. Interest rates can increase dramatically and the financial position of the company can greatly affect the cost and availability of short-term credit. The more stable the company is, the greater the chance of getting the credit and the greater the amount of credit that can be obtained. But this type of credit is much faster than long-term credit.
Therefore, if funds are needed in a hurry, the firm should look in short-term markets. This type of credits has many forms. Included are bank loans, trade credit, commercial paper, and accruals. Trade credit is an interfirm debt that arises “from credit sales and recorded as an account receivable by the seller and as account payable by the buyer”. In trade credit, the debt is recorded as the amount payable. It is the largest single category of short-term debt. It is a spontaneous source of financing in the sense that it arises from ordinary business transaction (Brigham ?
Gapenski, 1997). Firms that sell on credit have certain terms of credit that are included in their credit policy. An example of this is 2/10, net 20. This term of credit means that 2% of discount shall be given if payment is made within 10 days of invoice date, with the total amount is due and payable within 30 days if the discount is not taken. The discount received during the discount period is the free trade credit while the credit taken in excess of free trade credit, whose cost is equal to the discount loss, is the costly trade credit.
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Aside from the terms of credit, there is also what is called line of credit. It is an agreement in which the bank agrees to lend a maximum amount of money that must be paid in a specified length of time. The formal, committed line of credit that the bank or other lending institutions extends is the revolving credit agreement (Brigham, 1991). Aside from trade credit, there is also commercial paper. It is consist of negotiable promissory note that matures in less than a year, usually four to six months.
In this type of credit, the credit applicant does not give a security to ensure that the credit will be paid. This security is called collateral. Because of this, commercial paper is only open to the most credit-worthy companies. The only assurance that the lender can get is the ability of the barrower to pay the credit. There is no substantial assurance that the credit will be paid fully or on time. It is not appropriate to borrow under a line of credit or revolving credit agreement when there is only a single purpose. Let as look at this situation.
Suppose that the borrower will use the amount borrowed for completing a project. After the project, the contractor can collect the money that will be used to pay the creditor. If this will be the situation, each request shall be considered by the bank or creditor as a separate transaction. The cash-flow ability of the barrower will be of great importance. If the borrower is to borrow for another purpose, the previous transaction will not be included. But if the borrower will borrow for the purpose of completing two projects, then the lender shall consider it as a single transaction (Van Horne, 1977).
Commercial paper is sold by the borrower to a lender, which is generally a bank, pension fund, insurance company, or other firms. There are instances where the commercial paper is sold directly; meaning the borrower directly borrows from a lender. In some other instance, the sale is handled through a broker. This type of credit does not include interest in payment. It is rather sold at a discount and paid at the face amount. The difference between the amount received and the amount paid is the interest (Pritchard, 1977).