Financial Management and Business Data Analytics · Sources of Finance

Short-Term and Working Capital Sources of Finance

Updated 10 October 2026 · Fact-checked

Short-term sources of finance are funds repaid within about one year, used mainly to fund working capital. They include trade credit, bank overdraft, cash credit, commercial paper, factoring and bill discounting. To answer a question, identify the source, compute its effective cost, then compare cost, risk and flexibility.

Understand Short-Term and Working Capital Sources

Working capital is the money a business needs to run day to day: to buy raw material, pay wages and carry stock and receivables until customers pay. Short-term finance is raised to cover this need. It is usually repaid within a year, so it is cheaper and more flexible than long-term finance, but it must be renewed often.

Trade credit is the credit your suppliers give you when you buy goods and pay later, for example on 30 days' terms. It is spontaneous and has no explicit interest. But if the supplier offers a cash discount and you skip it, the credit has a real cost.

Bank finance comes in two common forms. A bank overdraft lets a current account holder draw more than the balance up to a sanctioned limit; interest is charged on the amount actually used. Cash credit is a sanctioned limit against the security of stock and receivables (hypothecation or pledge); the borrower draws and repays as needed, and interest is charged on the daily amount used. Many banks also charge a commitment fee on the unused limit. In practice, overdraft is often for temporary needs, usually against collateral, while cash credit is a regular working-capital facility against current assets. Check the wording of the question.

Commercial paper (CP) is an unsecured, short-term promissory note issued at a discount by strong, creditworthy companies. It is repaid at face value on maturity. Its cost is the discount, plus issue expenses such as rating, issuing and paying agent fees. Do not confuse it with a certificate of deposit (CD), which is issued by banks and financial institutions against deposits, not by ordinary companies.

Factoring is the sale or assignment of receivables to a factor, who collects them and usually advances part of the amount at once. It can be with recourse (the seller bears bad-debt risk) or without recourse (the factor bears it). Bill discounting means the bank buys a bill of exchange before its due date at a discount. Forfaiting is different: it is without-recourse finance for export receivables, usually medium-term, whereas factoring is mostly for short-term domestic or export trade debts.

Key rules to remember

Cost of foregoing cash discount (simple): [Discount % ÷ (100 − Discount %)] × [365 ÷ (Credit period − Discount period)] × 100; Use credit period and discount period in days. Example: 2/10 net 30. Use 360 days if the question says so.
Effective cost of foregoing discount (compound): [1 + Discount % ÷ (100 − Discount %)]^(365 ÷ (Credit period − Discount period)) − 1; Use only when the question asks for the effective or compounded rate.
Cost of discounted instrument (CP, bill): [Discount ÷ Net amount received] × [365 ÷ Days to maturity] × 100; Add issue costs and fees to the discount. Net amount = face value − discount − fees.
Discount on a bill or CP: Discount = Face value × Rate % × Days ÷ 365; Follow the day-count given in the question.
Factoring advance: Advance = (Receivables − Factor reserve) − Factoring commission − Interest on advance; Reserve is a retained percentage. Interest is charged on the advance, often for the credit period.
Net benefit of factoring: Savings (collection cost, bad debts, interest on lower receivables) − Factoring commission − Extra interest; Accept factoring when net benefit is positive, or compare the effective cost with the bank rate.

How to solve Short-Term and Working Capital Sources questions

Use this method for any numerical or descriptive question on short-term sources.

1Identify the source asked: trade credit, overdraft, cash credit, CP, factoring or bill discounting.
2List the facts: amount, period in days, rate, discount, commission, reserve, fees and day-count (360 or 365).
3Find the cash actually received by the business, after deducting discount, commission, reserve and fees.
4Find the total cost: interest plus fees plus any foregone discount.
5Convert the cost to an annual percentage on the amount actually received (or usable), not on the face value.
6Add or subtract side effects: saved collection cost, bad-debt protection, lower receivables, or commitment fee.
7Compare the cost with the alternative source and also consider risk, flexibility and security.
8State a clear conclusion in one line with the figure.

Quickest way: Cost per rupee received, then annualise

When to use it: Use it for CP, bill discounting, factoring and cash discount questions where the options differ in cost.

Cost for the period = amount paid in total minus amount received.
Divide by the amount received (not the face value).
Multiply by 365 ÷ days (or 360 if given).
For cash discount, use the formula directly with the credit period minus the discount period.
Rank the options by annual cost and choose the lowest, unless the question adds non-cost factors.

Common mistakes in Short-Term and Working Capital Sources

Dividing the discount by the face value instead of the net amount received.
Students treat the discount like simple interest on the maturity value.
Fix: Divide by the amount actually received after discount and fees, since that is the money you can use.
Using the full credit period instead of credit period minus discount period in the foregone-discount formula.
The word 'credit period' is read on its own.
Fix: The extra days you gain by not paying early are credit period − discount period. Use that gap.
Treating overdraft and cash credit as the same with no difference.
Both charge interest only on the amount used.
Fix: Note the difference: overdraft is generally a temporary facility on a current account; cash credit is a regular limit against stock and receivables.
Confusing commercial paper with a certificate of deposit.
Both are discounted money-market instruments.
Fix: CP is issued by companies; CD is issued by banks and financial institutions against deposits.
Confusing factoring with forfaiting.
Both involve selling receivables.
Fix: Factoring: short-term trade receivables, may be with or without recourse, and includes services like collection. Forfaiting: without recourse, export receivables, usually medium-term, and usually backed by a bank guarantee or similar.
Ignoring the reserve and fees when finding the advance under factoring.
Students apply the advance percentage to the full invoice and stop.
Fix: Deduct reserve, commission and interest in that order, and compute interest on the advance only.

Worked examples

Example 1

A supplier offers terms of 2/10 net 45 to Mehta Traders. Calculate the approximate annual cost of foregoing the discount (365 days). Should Mehta pay on day 10 if it can borrow from a bank at 14% per annum?

Show the solution

Discount % = 2; discount period = 10 days; credit period = 45 days.
Extra days of credit = 45 − 10 = 35 days.
Discount ÷ (100 − Discount) = 2 ÷ 98 = 0.020408.
Annualising factor = 365 ÷ 35 = 10.4286.
Cost = 0.020408 × 10.4286 × 100 = 21.28% (approx.).
Compare: 21.28% > 14% bank rate.

Answer: The cost of foregoing the discount is about 21.28% a year. Since the bank rate is only 14%, Mehta should borrow and pay on day 10 to take the discount.

Example 2

Sundaram Ltd issues commercial paper of face value ₹1,00,00,000 for 90 days at a discount rate of 8% per annum (365-day year). Issue expenses (rating, agents and stamp duty) are ₹50,000. Find the net proceeds and the effective annual cost (simple).

Show the solution

Discount = 1,00,00,000 × 8% × 90 ÷ 365 = ₹1,97,260 (rounded).
Net proceeds = 1,00,00,000 − 1,97,260 − 50,000 = ₹97,52,740.
Total cost for 90 days = 1,97,260 + 50,000 = ₹2,47,260.
Cost on money received = 2,47,260 ÷ 97,52,740 = 2.5352%.
Annualised = 2.5352% × 365 ÷ 90 = 10.28% (approx.).

Answer: Net proceeds are about ₹97,52,740 and the annual cost is about 10.28%, higher than the 8% quoted rate because of issue expenses and because the discount is on the face value.

Exam tips

In the 2-mark MCQ, look for the key phrase: 'unsecured promissory note' means CP; 'issued by banks' means CD; 'without recourse, export' means forfaiting.
For numericals, always show the cost formula, the net amount received and the annualisation step; each earns marks even if the final figure is slightly off.
Use the day-count (360 or 365) the question states, and say so in your answer.
In descriptive answers, write advantages and limitations for each source in short points, and end with a comparison on cost and flexibility.
If a question asks which source to choose, give the cost comparison first and then one line on non-cost factors such as security and renewal risk.

Practice questions from Sources of Finance

Short-Term and Working Capital Sources 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 and Working Capital Sources: frequently asked questions

What is the difference between cash credit and overdraft?

Both let you borrow up to a sanctioned limit and pay interest on the amount used. Overdraft is generally a temporary facility on a current account, often against collateral. Cash credit is a regular working-capital limit against hypothecation or pledge of stock and receivables.

What is the difference between commercial paper and a certificate of deposit?

Commercial paper is an unsecured short-term note issued by creditworthy companies to raise working capital. A certificate of deposit is issued by banks and financial institutions against funds deposited with them. Both are sold at a discount and repaid at face value.

What is the difference between factoring and forfaiting?

Factoring covers mainly short-term trade receivables, may be with or without recourse, and often includes collection and credit services. Forfaiting is without-recourse finance for export receivables, usually of medium term, where the forfaiter buys them at a discount.

Is trade credit really free?

It carries no explicit interest, but it is not free if the supplier offers a cash discount that you skip. In that case the foregone discount is the cost, and it can be much higher than the bank rate.