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LENDING FOR NORMAL TRADE FINANCE AND OVERTRADING

In addition to requiring funds for capital investment, businesses would also


require funds to finance day to day operations. In other words they have to
finance their current assets. Providers of finance for current assets are normally
the proprietors themselves, trade creditors and other lenders.

Borrowing by a business will normally result in two main things:

Increase the assets of the business


Cash inventory
Decrease in other liabilities.

Where the borrowing is to increase the assets , the bank must ascertain whether
the purpose is to finance fixed assets or non-current assets. Where a customer
requests an overdraft to finance day to day trading, the Bank must ensure that
that is really the case because a customer may request for day to day trading
advance while the cause of the need would have been the purchase of a fixed
asset.

For example, A Enterprise Balance sheet at 31 Dec 2006 as follows:


Balance Sheet

100. 120.
Fixed Assets 00 Capital 00

30.0 Current 10
Current Assets 0 Liabilities .00

130. 130.
00 00

On 1 January 2007, A purchases a fixed asset for GHC 50, utilizing proceeds from
debtors and short term loans. The position would be as follows:

Balance Sheet

150.0 120.
Fixed Assets 0 Capital 00
Current Current 60
Assets 30.00 Liabilities .00

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180.0 180.
0 00

As a result of this decision, current liabilities now exceed current assets, giving a
current ratio of less than one. Had the facility been used to finance current
assets e.g. stocks or debtors, the current ratio may have remained unchanged.

An overdraft for day to day trading should in effect either:


Increase a current asset; or
Decrease a current liability.

Increasing Total Current Assets

Three main current assets that may be funded by borrowing are:

Stocks
Overall debtors
Overall increase in business volume through increasing inventories and
stocks.

Increasing Stocks Without Increasing Sales

A business may seek finance for stocks when it has received a firm order from
clients and the client will only pay after the order has been delivered. A bank
overdraft would be suitable in this instance since the client will pay our
customer as soon as the order is delivered, bringing the account into a credit
position.
Businesses may also decide to build up stocks in anticipation of seasonal
sales e.g. building up stocks for Christmas sales.
Purchasing of stock may also be speculative, either taking advantage of a
good bargain or speculating that there would be a surge in demand in the
near future. This tends to be a very risky affair and should be examined
critically before any commitment is made.

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Where the business wishes to build up stock levels permanently without any
of the above reasons, but merely to maintain a higher level of stocks, the
overdraft would not be suitable.

Financing Debtors No increase in Sales

When a business wishes to increase its total debtors without necessarily


increasing sales for the purpose of having funds to finance day to day trading it
may be due to the following reasons:

There has been a decline in the efficiency of credit collection.


Inability of existing debtors to pay without allowing some credit.

The bank must exercise caution in these circumstances and must only grant the
request if it is to maintain sales e.g. by providing the funds lost to finance normal
inventory purchases.

Example: Sales Level at 100,000

Balance Sheet Extracts

Inventory - 2 % of Overdraf 22,000.0


sales 2,000.00 t 0

Debtors - 20 % of 20,000.0
sales 0 -

22,000.0 22,000.0
0 0

If debtors were to be increases to 25 % of sales this would trigger off an increase


in overdraft or the business may delay paying creditors which may not be
acceptable to some creditors.

Balance Sheet

Inventory - 2 % of Overdraf 27,000.0


sales 2,000.00 t 0
Debtors - 25 % of

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25,000.0
sales 0 -

27,000.0 27,000.0
0 0

Increasing Sales Turnover

When a business increases its sales turnover, it will definitely require increased
investment in inventory and debtors to maintain the increased turnover. Trade
creditors may also increase as a proportion of sales.

Sales

100,000.
2006 00

2007 120,000.
(projected) 00

Balance Sheet

Fixed 30,000.0 38,000.


Assets 0 Capital 00

Current Current
Assets Liabilities

15,000.
stocks 5,000.00 Overdraft 00

15,000.0
Debtors 0

Cash 3,000.00

23,000.0
0

53,000.0 53,000.
Total Assets 0 00

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If sales increases by 20 %, if the percentage to sales ratio for stocks and debtors
is maintained at the same ratio as at the end of 2006, the projected balance
sheet would be as follows:

Balance Sheet

Fixed 30,000.0 38,000.


Assets 0 Capital 00

Current Current
Assets Liabilities

15,000.
stocks 6,000.00 Overdraft 00

18,000.0
Debtors 0

Cash 3,000.00

27,000.0
0

Total 57,000.0 53,000.


Assets 0 00

Financing 4,000.0
Need 0

Using Overdraft to reduce other current liabilities

Usually, the current liabilities that require financing are:

Tax liabilities
Reduction in the volume of trade creditors

Tax Liabilities

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It is normal for a business to seek funding for the payment of income tax of
employees, VAT or end of year corporation tax. Source of payment should be
proceeds from day to day trading. However, the bank should find out why the
business did not set aside funds to pay the tax.

Where the tax is overdue however, the bank should exercise caution because it
is obvious the business will not be able to generate the required funds from
operations to pay the tax.

Creditors

A reduction in trade creditors may be required when a business wishes to take


advantage of settlement discounts offered by suppliers. The net effect of taking
a discount would be taken into consideration. While the discount will increase
profits, interest paid on the increased overdraft would reduce it.

Where the facility is required to pay a supplier who is pressing for early payment
it may be because the business is falling behind on payments or that the
company itself is desperate for money. In these situations, the bank should
decline the request because obviously cash generated from trading will not be
sufficient to pay off the facility.