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(^348) Financial Management
The effect of compounding is to raise the effective cost of short-term credit. Since the
differences between the two methods for periods less than one year are usually small,
the simple interest version of RATE discussed above will be used.
Sources of Short-Term Credit
Short-term credit sources can be classified into two basic groups: unsecured and secured.
Unsecured loans include all those sources that have as their security only the lenderís
faith in the ability of the borrower to repay the funds when due. There are three major
sources of unsecured short-term credit: trade credit, unsecured bank loans, and
commercial paper. Secured loans involve the pledge of specific assets as collateral in
the event the borrower defaults in payment of principal or interest. The principal suppliers
of secured credit include commercial banks, finance companies, and factors. The primary
sources of collateral include accounts receivable and inventories.
Accruals
Internal accruals is one of the major sources of funds for most companies and is derived
from the retained earnings. Profits left after paying dividends are primarily used for
working capital financing.
Trade credit
In any normal business practice, buyers are not generally required to pay cash on
delivery for the goods and services they order. Instead, the sellers ìinvoiceî, or bill the
buyers on delivery according to the terms of the particular ëtradeí or line of business.
That is, sellers extend credit to buyers, and this extension of credit provides a temporary
source of funds to the buyer in the form of accounts payable. Because suppliers are
generally more liberal in extending credit than banks are, trade credit has become the
most important source of short-term business funds in terms of total volume of credit
supplied.
Forms of Trade Credit
There are three avenues of trade credit extension: (1) the open account, which is by far
the most common; (2) the promissory note; (3) the trade acceptance.
Open-account credit is ordinarily extended only after the seller conducts a fairly
extensible investigation of the buyerís credit standing and reputation. The open account
derives its name from the fact that the buyer does not sign a formal debt instrument
evidencing the amount he owes the seller, as would be the case if he applied for and
obtained bank credit. The only evidence the seller has that credit has been extended is
the buyerís purchase order, a copy of the invoice showing that merchandise was shipped,