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risk assumed by the firm since failure to pay debt obligations results in bankruptcy or insolvency.
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liabilities. Long-term capital can be further sub-divided into internal (retained earnings and provision for depreciation) and external (bonds, equity capital and long-term loans) sources.
While practitioners know which long-term capital has been used to support current assets, analysts and researchers can only examine the extent to which these funds have been used to finance current assets.
3.8.1 Long-term internal sources
Retained earnings and depreciation are the main sources of long-term internal finance.
Retained earnings are the firm’s undistributed profits and are determined by factors such as the life of the business, the tax rate, dividend policy and method of appropriation of profits.
Depreciation provision is a non-cash expense; therefore, cash recovered as depreciation provision can be used as a source of finance for relatively long periods.
3.8.2 Long-term external sources
These sources of finance are employed by the company in accordance with its long-term capital structure policy and include equity, term loans, off-balance sheet financing and asset-based financing. Equity is capital provided by ordinary shareholders. Long term debt or term loans can be defined as medium-term debts which are extended to the firm by lenders for durations that typically range from three to five years. Repayment of the principal loan amount can take several forms; some loans have fixed principal payment during the life of the loan, while others have fixed (equal) instalments or balloon payment on maturity. Asset-based financing is a secured long-term loan that uses both current assets (short-term marketable investments, debtors, stocks) and fixed assets (machinery, land and buildings) as security for loans. Off- balance sheet financing is usually used by firms who want to maintain clean financial statements and not warp their financial ratios; these include unfunded pension liabilities, leases, and unconsolidated subsidiary debt, in-substance defeasance of debt and project financing with unconditional commitment arrangements, and factoring (Gallinger and Healey, 1987, Hill and Satoris, 1992).
68 Factoring
Factoring is the sale of the debtors’ book at a discount by a company (the vendor or borrowing firm) to a third party, called the factor. The sale of receivables can be with or without recourse depending on the type of arrangement negotiated. Factored accounts receivables become the property and responsibility of the factor which implies that factoring enables the firm to shift the collection costs and the default risk to a third party, the factor. The borrowing firm receives most3 of the proceeds of sales once the goods have been shipped to the vendee or buyers.
Factoring has several advantages over straight accounts receivable financing. Factoring accounts receivable eliminate the need for credit and collection departments, thus saving the firm the cost of setting up and managing its own collection system. Factoring makes it possible for the firm to predict its cash flows from sales. It shortens the firm’s operating cycle because it reduces its receivables period. Factoring increases financing and the borrowing capacity of the firm since it is off-balance sheet financing. Consequently, factoring may allow room for the firm to access other forms of external finance despite more indebtedness. Factoring increases the financing options of firms like small businesses that have few ways of financing receivables due to their limited capacity to raise funds through other short-term instruments like issuing commercial paper (Hill et al., 2010). Factoring addresses the liquidity challenges of most small businesses that are caused by late payment of sales invoices (Bhattacharya, 2009). The risk assessment for bank financing revolves around the firm’s (borrower’s) creditworthiness; in factoring, the factor’ risk assessment revolves around the quality of the firm’s clients (their profile, creditworthiness and the integrity of the sales invoices).
Factoring has its own disadvantages. The price the firm may pay for the immediate receipt of cash from receivables can be substantial, making factoring costs sometimes higher than a direct loan. The involvement of a third party in the buying or selling transaction and the collection/payment process may result in loss of control of the firm and customer relationship.
3The word “most” is used here because there will be a discount to the invoice value representing a charge and usually a hold-back amount until the account is actually collected.
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Customer relationships can be affected, especially when the third party’s collection practices are not the same as those of the seller. Customers who fear being dunned by a professional collector may shift their business to firms that collect their receivables themselves. Stancill (1971) contends that the argument that costs are saved by eliminating the need for a screening and collection department is “specious” as the factor charges for these services. While acknowledging that the factor’s charges for this service might be less than the firm would incur, it is not a “no-cost” proposition. While factoring receivables enable the firm to generate cash and use the proceeds to meet current obligations, caution should be exercised as this could lead to cash shortages in the long-run. According to Bhattacharya (2009), factoring may raise perceptions challenges on the part of buyer organisations. Handing over the debtors’ ledger to a factor might be perceived by buyers as an indication that the supplier is financially distressed, has low creditworthiness and therefore cannot be considered a reliable supplier. These perception challenges have been mitigated by the entry of banks and other traditional financial institutions to the factoring business.