This finance is obtained by companies by which purchase goods on credit and pay for such goods later. This “kind” and is available to companies which can pay bills on time as and when they fall due. It the largest source of finance to sole traders and wholesalers in Kenya. This is cheap source of finance and it does not entail any explicit cost except discounts foregone. This finance may be long-term in particular if the company meets its bills regularly such that after settling a given bill the same company obtains further credit immediately, thus may become a continuous source of finance. In order to be a source of finance, credit received must exceed credit given.
Advantages of using trade credit in Kenya a source of finance (reasons why trade credit is popular in Kenya)
1. Most businesses in Kenya lack collateral securities which are necessary to raise other forms of debt finance thus resort to trade credit.
2. it is cheap source of finance because the only cost involved is discounts lost I,e no implicit or explicit costs.
3. most other finances need the borrower to maintain healthy accounts which small businesses in Kenya may not have thus resort to trade credit.
4. The fact that small businesses in Kenya are not known to lenders makes trade credit the best source of finance as they may not qualify for other finances which require that the borrower be known to the lender.
Disadvantages (limitations) of using Trade Credit.
1. The debtor company will undergo the opportunity cost of the discount foregone by the very buying company.
2. This finance is not reliable because in the event of default on the buyer’s side the seller cannot give it and this way cut the buyer’s credit line which may lead a lot of inconveniences and in some cases stoppages in production or sales of the debtor.
3. It is usually restricted to working capital items and as such may not be available for fixed assets which are important for profitability reasons.
Promissory Note
A promissory note is a bill wherein one party promises to pay another party on a specific date and conditions, a specific sum of money. It is a short term source of finance to the company, usually up to 3 months. This type of finance is used when the two parties know each other well. It acts as a source of finance in as much as it can be discounted or endorsed. It can also used as security for loans.
Advantages and disadvantages promissory note
Advantages of promissory note
1. It does not involve a lot of formalities and as such will allow the drawer to obtain finance faster.
2. It is highly negotiable making it a liquid investment which the company can liquidate fast ( if the drawee is of high credit rating)
3. Since it is unconditional the drawer will use the same finance obtained on the strength of the bill without preconditions and restrictions.
4. It does not affect the company’s gearing level.
Disadvantages of promissory note
1. It is a very short-term source of finance and as such it may not be profitable as its duration cannot warrant any profitable ventures i.e finance from the bill cannot be invested in profit table ventures.
2. There are possibilities that the bills may be dishonored by the drawee and drawer may have to settle any liabilities incurred thereon.
3. It is a foreign bill of exchange this may delay the finance in that it may require the approval of the central bank before discounting it.
Invoice Discounting (confidential factoring)\
This is an arrangement where the selling company discounts its invoices usually with a bank or financial institution and will receive a large percentage of its invoices in cash in advance. Usually it is expensive source of finance and should only be used if the company cannot obtain overdraft finance from commercial banks. The invoice discounter analyse which invoices to discount and in this case he will request the selling company to send original invoices to the customer and a copy to the discounter. The invoice discounter has not only lien on the debts but also recourse to the borrower in which case the seller or borrower will have to pay the discounter should any debtor default to pay his bills on the due date.
Advantages of using invoice discounting as a source of finance
1. it is useful as a solution to short term liquidity problems
2. it does not call for a collateral security and as such it is a flexible of finance to raise.
3. it is easy to raise as it does not entail a lot of formalities
4. Normal credit will be extended to customers as the discounting of invoices does not affect the relationship between the selling company and its customers.
Disadvantages of using Invoice discounting as a source of finance.
1. The discounter has resource to the borrower and in case may debtor fails to honour his obligation then the discounter can turn to the seller to pay such debt and interest on finance advanced to him.
2. It may be an expensive source of finance in particular if the invoices are small and numerous in which case the costs of collecting these may be too high.
3. This type of finance is usually available to those companies whose debtors are highly rated in credit payment point of view thus may be discriminative if a given company has unknown debtors in which case they cannot be discounted.
Similarities between invoice discounting and factoring
1. Both are raised on the account of the company’s debtors or invoices.
2. both are expensive sources of finance to the company because discount rates in both case will be higher than the bank rate on borrowed funds
3. both fall in the family ( group) of short term sources of finance to the company, thus are aimed at solving the company’s liquidity problems
Differences between invoice discounting and factoring
Invoice discounting
1. the bank has recourse to the borrower
2. the borrower keeps the debtor’s ledger
3. Chances of bad debts are high and this may increase the cost of the company of using such finance.
4. invoices act more or less as securities for a short term loan
5. the discount rate is usually low
Factoring
1. the factor has no recourse to the borrower
2. The factor takes over the debtor’s ledger.
3. The chances of bad debts are minimal and even then these are borne by the factor.
4. The invoices are sold outright to the factors and cannot act as securities for loans.
5. The discount rate is relatively high.
Advantages of leasing as a source of finance
1. It may be a long –term source of finance e.g for land leased for a period of 99 years
2. In case the lease agreement gives the option to purchase the asset after the expiry of the lease term then
Such a company will have known which asset it is taking over, and thus make a good investment decision based on experience.
3. Lease charges are tax-allowable expenses thus will reduce the company’s tax liability.
4. The lessee enjoys the benefits of wear and tear which reduce his tax liability.
5. The company does not risk holding assets which may turn to be technologically obsolete.
Disadvantages of leasing as a source of finance.
1. This type of finance is available for fixed assets and as such does not have provision for working capital which is important in generating sales.
2. the periodic rental charges may outweigh the cost of the same asset in the long-term i.e in the long run the leasee may pay more in rental charges that the cost of this asset.
3. The lessor may not renew the lease agreement and this may put the lessee out of business.
4. It is limited only to those assets which are available from the lessor’s business thus is not useful in all financial requirements of the company.
5. Lease finance entails implicit costs e.g maintenance and insurance of the same asset leased which may compound the cost of this finance.
