Financial Management and Strategic Management · Types of Financing

Short-term Finance: Trade Credit, Bank Finance and Commercial Paper

Updated 4 October 2026 · Fact-checked

Short-term finance funds working capital for up to about one year. Main sources are trade credit, bank finance (cash credit, overdraft, bill discounting), commercial paper, certificates of deposit and factoring. To solve questions, identify the source, apply its features, and compute the effective annual cost where numbers are given.

Understand Short-term Finance: Trade Credit, Bank Finance and Commercial Paper

Short-term finance pays for day-to-day needs: buying raw material, paying wages, carrying stock and waiting for customers to pay. It is usually repaid within a year, so it should match current assets. Using it for long-term assets is risky because you must keep refinancing.

Trade credit is credit your supplier gives you by letting you pay later. It is spontaneous and has no formal documents. It looks free, but if the supplier offers a cash discount and you skip it, the credit has a real cost.

Bank finance comes in several forms. In cash credit, the bank sanctions a limit against stock and receivables. You draw and repay as needed, and interest is charged only on the amount used. In an overdraft, you draw more than your balance in a current account up to a sanctioned limit. Interest is charged on the daily overdrawn amount. Overdraft is usually for short, temporary needs and may be allowed against security. In bill discounting, the bank buys your bill of exchange before maturity at a discount and pays you the amount less the discount.

Commercial paper (CP) is an unsecured, short-term promissory note issued at a discount by strong, creditworthy companies. It is sold to investors and is redeemed at face value. Certificates of deposit (CDs) are negotiable deposit instruments issued by banks and eligible financial institutions. Both are money market instruments. Eligibility, minimum credit rating, tenure limits and denominations are set by RBI, so learn them as given in your study material.

Factoring is the sale or assignment of receivables to a factor, who collects them, may advance cash, and may bear the risk of non-payment. In recourse factoring the seller bears bad debts. In non-recourse factoring the factor bears them and charges more. Factoring is for domestic receivables. Forfaiting is for export receivables, is medium-term, and is usually without recourse to the exporter.

Key rules to remember

Effective annual cost of forgoing cash discount: Cost = [Discount % ÷ (100 − Discount %)] × [365 ÷ (Credit period − Discount period)]; Use days. This is the simple annualised form. Compounded form is (1 + d ÷ (100 − d))^(365 ÷ days) − 1. Use the form the question asks for.
Discount on bill or commercial paper: Discount = Face value × Discount rate × Days ÷ 365; Net proceeds = Face value − Discount. Check whether the question says 360 or 365 days.
Effective cost of discounting: Effective rate = (Discount ÷ Net proceeds) × (365 ÷ Days); Divide by net amount received, not face value. Add any fees to the discount before dividing.
Cost of factoring: Cost = (Factoring commission + Interest on advance) ÷ Advance received, annualised; Deduct savings such as saved credit-administration cost and bad debts (non-recourse) before finding net cost.
Factor advance: Advance = (Receivables × Advance %) − Commission − Interest; Interest is on the advance for the collection period. Reserve is the balance held back.

How to solve Short-term Finance: Trade Credit, Bank Finance and Commercial Paper questions

Use this order for any numerical or theory question on short-term sources.

1Identify the instrument: trade credit, cash credit, overdraft, bill discounting, CP, CD or factoring.
2Note the data: amount, rate, period, fees, days basis (360 or 365).
3For theory, write definition, features, advantages, limitations, in that order.
4For cost questions, find the amount actually received (net proceeds), not the headline amount.
5Add all charges (commission, fees, interest) to the cost; subtract genuine savings if given.
6Annualise the cost using days in a year as stated.
7Compare the cost with the alternative (for example, discount foregone vs bank loan rate) and state the decision.
8 Write a one-line conclusion with the figure.

Quickest way: Cost-then-compare under time pressure

When to use it: Use it for MCQs and for 5-8 mark cost comparison questions.

MCQs: eliminate options that confuse factoring (domestic, short-term) with forfaiting (export, medium-term, without recourse).
Cash credit means interest on amount used; overdraft means interest on daily overdrawn balance. Eliminate options mixing these up.
For discount cost, write 'd ÷ (100 − d) × 365 ÷ days' straight away and substitute.
For written answers, use headings: Working, Cost, Decision. Each earns step marks.
Always state the days basis and the decision in the last line.

Common mistakes in Short-term Finance: Trade Credit, Bank Finance and Commercial Paper

Dividing the discount by face value instead of net proceeds when finding effective cost.
The face value is the number printed in the question.
Fix: The company only receives the net amount, so divide by net proceeds.
Treating trade credit as free.
No interest is shown on the invoice.
Fix: If a cash discount is offered, skipping it has a cost. Compute it before deciding.
Using the full credit period instead of (credit period − discount period) when annualising.
Students read 'credit period' as the time for which money is borrowed.
Fix: The extra borrowing time is only the days after the discount period ends.
Mixing up factoring and forfaiting.
Both deal with receivables.
Fix: Factoring: domestic, short-term, may be with or without recourse. Forfaiting: export, medium-term, without recourse to the exporter.
Confusing cash credit with overdraft.
Both let you draw up to a limit.
Fix: Cash credit is a running limit against stock and receivables for regular working capital. Overdraft is drawn on a current account, usually for temporary needs.
Ignoring commission or fees when computing cost of factoring or CP.
Only the interest rate is highlighted.
Fix: List every charge in the numerator before annualising.

Worked examples

Example 1

A supplier offers terms 2/10 net 30. Compute the annualised cost (simple, 365 days) of not taking the discount. Should the firm take the discount if it can borrow from a bank at 18% p.a.?

Show the solution

Discount % = 2; credit period = 30 days; discount period = 10 days.
Extra credit days = 30 − 10 = 20.
Cost = [2 ÷ (100 − 2)] × [365 ÷ 20].
2 ÷ 98 = 0.020408.
365 ÷ 20 = 18.25.
0.020408 × 18.25 = 0.37245, which is 37.24%.
Compare: 37.24% is more than the bank rate of 18%.

Answer: Cost of forgoing the discount is about 37.24% p.a. The firm should take the discount and borrow from the bank at 18% to pay on day 10.

Example 2

A company discounts a bill of ₹5,00,000 with its bank for 90 days at a discount rate of 12% p.a. (365-day year). Find the discount, the net proceeds and the effective annual cost (simple).

Show the solution

Discount = 5,00,000 × 12% × 90 ÷ 365.
5,00,000 × 0.12 = 60,000.
60,000 × 90 = 54,00,000; ÷ 365 = ₹14,794 (approx.).
Net proceeds = 5,00,000 − 14,794 = ₹4,85,206.
Effective cost = (14,794 ÷ 4,85,206) × (365 ÷ 90).
14,794 ÷ 4,85,206 = 0.030491.
365 ÷ 90 = 4.0556.
0.030491 × 4.0556 = 0.12366, which is 12.37%.

Answer: Discount ≈ ₹14,794; net proceeds ≈ ₹4,85,206; effective annual cost ≈ 12.37%, higher than the 12% quoted rate because the discount is deducted upfront.

Exam tips

Practise the discount-forgone formula until it takes under a minute; it is a frequent numerical.
Learn a two-column comparison of factoring vs forfaiting and cash credit vs overdraft for short theory answers and MCQs.
Learn CP and CD conditions (issuers, rating, tenure, denomination) exactly as in your latest study material, since RBI rules change.
In cost questions, state 360 or 365 days and stick to it; show each working line for step marks.
MCQs carry no negative marking, so attempt every one after eliminating wrong options.

Practice questions from Types of Financing

Short-term Finance: Trade Credit, Bank Finance and Commercial Paper in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Short-term Finance: Trade Credit, Bank Finance and Commercial Paper: frequently asked questions

What is the difference between cash credit and overdraft?

Cash credit is a sanctioned running limit against stock and receivables for regular working capital. Overdraft is drawing beyond the balance in a current account up to a limit, usually for temporary needs. In both, interest is charged on the amount used.

What is the difference between factoring and forfaiting?

Factoring deals with domestic trade receivables, is short-term, and can be with or without recourse. Forfaiting deals with export receivables, is medium-term, and is generally without recourse to the exporter.

Is trade credit really free?

Only if no cash discount is offered, or you take the discount. If you skip a discount, the implied annual cost can be very high, often above bank rates.

What is commercial paper?

It is an unsecured short-term promissory note issued at a discount by creditworthy companies and redeemed at face value. It is a money market instrument regulated by RBI, so check the latest conditions in your study material.