Spontaneous Financing

Spontaneous Financing is divided into two main parts:

I. Accounts Payable II. Accrued Expenses

I. Accounts Payable (Trade credit from suppliers)

Trade liabilities are a form of short-term financing common to almost all businesses. It is money owed to the suppliers. Trade liabilities are collectively the largest source of short term funds for business. In most markets, buyers are not required to pay for goods on delivery but are allowed short deferment before payment is due. During this period the seller of the good extends credit to the buyer. Companies specially the small ones rely heavily on this trade credit (credit granted from one business to another).

There are three most popular method of trade credit are:

1. Open Accounts: the seller ships goods to the buyer with an invoice specifying goods shipped, total amount due, and terms of the sale. In open account system the buyer does not sign a formal debt instrument indicating the amount owed to the supplier. Open accounts appear on buyer’s balance sheet as ‘account payable’.

2. Notes Payable: the buyer signs a note that evidences a debt to the seller. The note indicates the payment of the obligation at some future specified date. Generally this method is used when the supplier wants the buyer to acknowledge the debt formally.

3. Trade Acceptances: the seller draws a draft on the buyer that orders the buyer to pay the draft at some future time period. A draft is a signed, written order by which the first party (drawer) instructs a second party (drawee) to pay a specified amount of money to a third party (payee). The drawer and payee are often one and the same. The seller does not release the goods until buyer signs the time draft. Accepting the draft, the buyer designates a bank at which the draft will be paid when it matures.

Out of these the Open-account arrangement is the most common. Open account are heavily affected by the ‘terms of sale’ mentioned in the invoice. These terms can be placed in many broad categories based on ‘net period’ mentioned on the invoice:

1. COD and CBD – No trade credit: COD means cash-on-delivery of goods. The only risk taken by the supplier is that buyer may refuse the shipment. Sometimes the seller can ask for cash-before-delivery to avoid all risk. Under this category, the seller doesn’t extend credit.

2. Net Period – No cash Discount: when credit is extended, the seller specifies the period of time allowed for payment. For example, ‘Net 30’ implies full payment in 30 days from the invoice date.

3. Net Period - Cash Discount: When credit is extended, the seller specifies the period of time allowed for payment and offers a cash discount if paid in the early part of the period. For example, ‘2/10, net 30’ implies full payment within 30 days from the invoice date less a 2% discount if paid within 10 days.

4. Seasonal Dating: Credit terms that encourage the buyer of seasonal products to take delivery before the peak sales period and to defer payment until after the peak sales period.Under this arrangement, credit is extended for a longer period of time than usual.

Thus, trade credit serves as a source of fund to the buyer. If the firm automatically pays its bills after a certain no. of days from the issuance of invoice then trade credit becomes spontaneous which varies with the production. There can be two special situations which can occur in spontaneous financing:

1. A firm does not take a cash discount but pays on the last day of the period ( Cost to forgo a discount):In this situation, the firm forgoes a cash discount but pays its bill on the final due date of the period. Since, the firm does not use the cash the cash discount there is a definite opportunity cost which it incurs. For example, if the terms of sale are ‘2/10, net 30’ for a Rs. 100 invoice. Then if the firm is not taking the cash discount then it uses Rs. 98 for 20 days and pays Rs. 2 for this privilege (equivalent to taking a loan of Rs. 98 for 20 days and paying Rs. 2 as interest). Converting this into approximate annual interest rate using formula:

Putting the values:

The approximate annual rate comes out to be = 37.2%.

Thus, trade credit can be very expensive form of short term finance when a cash discount is offered but not accepted.

2. A firm pays its bills beyond the net period:Postponing payment beyond the end of the net (credit) period is known as stretching accounts payable or leaning on the trade. It builds up additional short term financing for the firm by the way of the additional build up in a liability account.Possible costs of stretching accounts payable are:

Cost of the cash discount (if any) forgone Late payment penalties or interest Deterioration in credit rating

Advantages of Trade Credit A firm must balance the advantages of trade credit against the cost of forgoing a cash discount, any possible late payments penalties etc. The major advantages of trade credit are:

1. Convenience and availability of trade creditThere is no need for the firms to formally arrange for a financing in this case, as it is already in place. Account payable of most firms represents a ‘continuous form of credit’.

2. Greater flexibility as a means of financingIn other form of credit, there is lead time when the need for fund is recognized and the time firm is able to borrow, which is not the case here. Also, in trade credit generally firm does not have to sign any collateral to borrow.

Cost bearing in trade credit Suppliers: when trade costs cannot be passed on to buyers because of price

competition and demand. Buyers: when costs can be fully passed on through higher prices to the buyer by the

seller. Both: when costs can partially be passed on to buyers by sellers.

II. Accrued Expenses

Amounts owed but not yet paid for wages, taxes, interest, and dividends. The accrued expenses account is a short-term liability. In sense, accrued expenses represent costless financing. It is a measure to be undertaken as a last resort, but many companies on the brink of cash flow disaster find itself having to postpone wages as well as other payments.