Current Liability Components
4.5.1 SOURCE OF FINANCING
financing opportunities, though the firm has not fully exploited them so far. An analysis of these short-term financing opportunities follows in detail.
4.5.1.1 Trade credit
Trade credit is not so common in Eritrean manufacturing firms. Most of the transactions have been done on a cash basis. As can be seen from Table 3.7, the firm has a trade credit at the end of the year 2001 only. In rare instances some close suppliers, of relationships established on personal grounds, might consent to give credit. As most firms of the country Keren Metal, Wood and Cement Works purchases most of its raw materials and other merchandise needed for production on a cash basis. Trade credit accounts on average for about 11 percent of the accounts payable. In fact it was only in 2001 that an amount of 123,600 Nakfa, which is 76 percent of the accounts payable, was accounted to trade creditors. However, this did not indicate that there was no credit from suppliers during the course of the year. There could have been credit but it would be paid before the end of the year and should not have necessarily been shown on the financial statements. The financial manager noted in the questionnaire, "There are some credit purchases on occasions. But, it is paid during the year and might not be shown as a balance at the end of the period when the financial statements are closed. "
Trade credit is a two-edged sword for business enterprises. Firms usually benefit from being granted credit by their suppliers but because of the necessity of providing credit to their customers they are burdened with additional costs. It has already been noted that the firm spontaneously grants credit to some customers, for example, to government or other reputable organizations. The firm's debtors account for around 17 percent of the current assets.
Conversely, the trade creditors account only 11 percent of the accounts payable. When seen in absolute figures, 1,328,880 Nakfa had been provided as credit to its customers whereas only 123,600 Nakfa had been granted as credit from its suppliers during the five-year period. It is clear that the credit provided is far more, is about ten fold, than the credit granted. Of course, providing credit to customers involves additional costs of financing and cost of administration. In addition it involves risk such as liquidity and default of non-payment by customers. The more generous the firm is in allowing its customers with credit sales, the
greater the sales volume would be, but this is at the cost of additional expenses to finance the credit. This trade off should be assessed with caution. It is observed that the contrary was practiced in the firm. If the credit granted from suppliers is fewer than the credit provided to customers the firm certainly would loose from these transactions.
4.5.1.2 Overdraft
The most widely used short-term loan in Eritrea is the overdraft. Overdrafts are advantageous because of their flexible nature. The bank allows overdraft loans up to a certain limit as agreed to the customer. The only disadvantage is the bank has the right to discontinue this loan at short notice.
Keren Metal, Wood and Cement Works has this overdraft facility. The firm uses this loan when its bank balances are at low levels, in most cases when they are negative as it is flexible.
This is a very vital source to fulfill working capital needs. If the funds of the firm are tied up in inventory and accounts receivable, the firm needs to switch to this facility. However, so far no overdraft loan has been reported in the financial statements, the reason being that cash is always in excess in its bank current account.
Management was asked why it is hesitant to use the overdraft. The financial manager answered, "We are not unwilling to use this overdraft facility. We are already arranged the facility and have used it whenever it has been necessary. But, most of the time, our cash position is positive and we haven't suffered with cash shortages so far. "
As Arnold (2002) explains one particular problem with UK lending was said to be the excessive use of the overdraft facility compared with other countries, which used term loans more extensively. In the 1980s between one-half and two thirds of bank lending to small firms was in form of the overdrafts. In a like manner, it is evident that most of business enterprises whether they are in manufacturing business or in service business in Eritrea use this overdraft facility more than the term loan, though exact statistics were not at hand.
4.5.1.3 Term loans
In Eritrea, term loans are very common short-term loans granted by banks next to overdraft facilities. The range might be from three months up to one-two years, according to the agreement of the two contracting parties. Mostly, they are used to finance one-shot projects rather than working capital.
It was noticed that Keren workshop did not exploit these term loans either to finance the working capital or even to finance its capital expenditure. The reason is that the firm can use its internally generated funds to finance the working capital needs at any time.
As the questionnaire revealed, the firm didn't use these loans. The general manger justifies this saying, "We are not in need of these loans for the sole reason that we are not faced with cash shortages in the firm. If we feel that some urgent fund is needed, we get loans from the owners at free of interest. So why do we take loans at interest of 12 percent from banks? "
There is no stock market in Eritrea like that of most developing countries. It is very difficult to compute the cost of capital, as the exact cost of equity. (One of the components of cast of capital) cannot be ascertained, though the long-term lending rate can be taken as cost of debt.
Comparing which one is advantageous for the firm, i.e. to take a loan or not was problematic.
But as a general rule, debt financing is cheaper than equity financing, so it is beneficial for the firm to use the loan and to utilize the loan of the owners for other purposes.