Short-Term Sources of Finance

Every business has gaps between paying its bills and being paid by its customers. The gaps are closed with short-term finance: money that is expected to be repaid within a year, or that can be called back at any time.

Used well, it is cheap and flexible; used badly, for instance to pay for a new factory, it exposes the company to a lender who can demand repayment just when cash is short. This topic opens the study of business finance.

It explains why a company needs a balance between short-term and long-term finance, and then the main short-term sources: the bank overdraft, short-term bank loans, trade credit, factoring and invoice discounting, commercial paper, and operating leases as an alternative to buying. It shows how to calculate the true annual cost of each, which is usually higher than the quoted rate, and how to choose between them. The next topic covers long-term sources of finance.

The use of an overdraft to fund long-term assets was the subject of part (b) of May Diet, 2026, Question 1 (15 marks). Read capital rationing first, which closes the study of investment appraisal.

Why a balance is needed

A company needs a suitable balance between short-term and long-term funding, adequate working capital, and a suitable balance between debt and equity in its long-term capital. Short-term finance is used to fund part of the current assets (some companies operate with current liabilities above current assets, but this is unusual).

It is normally cheaper and more flexible than long-term finance. But riskier: it must be repaid or renewed soon, and if lenders will not renew it the company may not be able to pay its debts. The funding policies in the working capital topics set out how much of the current assets should be financed short-term.

Bank overdraft and short-term loans

A bank overdraft is a facility agreed with a bank up to a limit, drawn and repaid as needed. From the bank’s point of view the company should use it as follows:

• For short-term operating deficits. The balance should move regularly between overdraft and credit; there should not be a permanent overdraft, and it should not be a long-term source of funds.
• For running costs, not for non-current assets. Buying a machine or building with an overdraft mismatches a long-lived asset with finance that can be withdrawn at any time.
• Repayable on demand. The bank can usually withdraw the facility, and may do so if it thinks the company’s cash is poorly managed.

Interest is charged on the daily balance used, which makes the overdraft cheap when the need is temporary. But there may also be an arrangement fee on the limit and security may be required. A short-term bank loan is for a specified amount and a specified period, often for a specific purpose, with a repayment schedule.

It gives certainty (the bank cannot call it in early unless there is a default) but the company pays interest on the whole amount whether or not it is needed.

Trade credit

Credit from suppliers is a source of finance with no explicit interest, and so is attractive. The company should negotiate favourable terms and pay at the end of the agreed period, not later. Stretching payables beyond the agreed terms damages supplier relations and credit standing. If the supplier offers an early settlement discount, the credit is no longer free: giving up the discount is a cost.

With terms of 2% discount for payment within 10 days, or the full amount in 40 days, paying late means borrowing the 98% for 30 days at a cost of 2 ÷ 98 = 2.04% for the 30 days. As an effective annual rate this is (1 + 0.0204)^{365 ÷ 30} − 1 = 27.9%. If the company can borrow from the bank at less than 27.9%, it should take the discount.

Factoring and invoice discounting

A debt factor that collects a company’s receivables can advance up to 70% or 80% of their value straight away, turning invoices into cash. The cost is the interest on the advance plus a service fee, offset by the administration and bad debts saved.

Example: invoices of ₦40m; advance 80% = ₦32m for 45 days at 24% a year, interest 32 × 24% × 45 ÷ 365 = ₦0.95m; service fee 1.5% of the invoices = ₦0.60m; saved administration ₦0.20m. The net cost is 0.95 + 0.60 − 0.20 = ₦1.35m on ₦32m for 45 days, 4.21%, or about 39.7% a year as an effective rate. Factoring is expensive as a source of money; its value is in the services and the speed.

Commercial paper

Commercial paper (CP) is an unsecured promissory note, issued at a discount to face value, by which a company borrows directly from investors, usually banks, pension funds and other institutions, for a short period (the rules of the Securities and Exchange Commission describe it as an unsecured note maturing in 30 to 364 days, while the FMDQ market convention caps the tenor at 270 days).

It is cheaper and quicker than a loan for companies that can use it. But it is open only to creditworthy corporates: the issuer and the issue normally need an investment-grade rating (market practice and the exchange rules require it), the paper is registered and quoted on the FMDQ Securities Exchange, and the Central Bank of Nigeria’s guidelines govern the dealing of banks and discount houses in it.

As reported, six companies registered ₦191.42bn of paper in the first half of 2026, showing how heavily larger companies now use it for working capital.

Example: a company issues ₦500m of 180-day paper at a discount rate of 18%. The price is 500 × (1 − 0.18 × 180 ÷ 365) = ₦455.62m, so it receives ₦455.62m now and repays ₦500m. The true yield is (500 − 455.62) ÷ 455.62 × 365 ÷ 180 = 19.75% a year, above the quoted discount rate because the interest is paid at the start. Add the costs of the rating, the issuing house and the paying agent.

A new issue to refinance maturing paper is a sign of weakness if it replaces cash that should have been generated.

Operating leases

Operating leases give the use of an asset for a rental without buying it, similar to a rental agreement though sometimes longer. They avoid the need to raise capital to buy the asset and are used by small and medium-sized businesses that find it hard to obtain finance for assets. The lease versus buy decision was covered in the previous topics.

Choosing between sources

Compare the sources on cost (effective annual rate, including fees), flexibility, the speed of access, security demanded, the covenants imposed and whether the lender can withdraw the money.

For a three-month need of ₦20m: an overdraft at 26% a year on the amount used, with an arrangement fee of ₦0.25m (1% of a ₦25m limit), costs 20 × 26% × 3 ÷ 12 = ₦1.30m plus ₦0.25m = ₦1.55m, or 7.75% for the quarter, an effective 34.8% a year; a three-month loan at 27% with a ₦0.1m fee costs ₦1.35m + ₦0.10m = ₦1.45m, 7.25% for the quarter, an effective 32.3%.

Although the loan has the higher quoted rate, it is the cheaper once fees are counted. The overdraft would be preferable if the need were uncertain, because interest is paid only on the amount drawn.

The ideas in more depth

Why quoted rates understate the cost

Fees raise the cost, interest paid at the start (as with a discount) raises the cost of the money actually received, and compounding turns a periodic rate into a higher annual one. A fair comparison converts every source to an effective annual rate on the cash actually available to the company.

Why matching matters

If long-term assets are financed by short-term money, the company must keep finding new short-term money, each time at the rate and on the terms of the day. A rise in interest rates or a withdrawal of the facility can force the sale of assets or a rescue.

The reverse, funding short-term needs with long-term money, is safer but more expensive, because long-term finance is paid for when it is not needed. This is the trade-off between the conservative, matching and aggressive funding policies.

Sources and references

• The Securities and Exchange Commission rules (the New Rules and Sundry Amendments, 2024) and the Investments and Securities Act 2025 for commercial paper; the Central Bank of Nigeria Guidelines on the Issuance and Treatment of Bankers Acceptances and Commercial Papers (2019); the FMDQ Commercial Paper Registration and Quotation Rules (November 2024).

These points are stated as at 5 November 2026.

Worked examples

1. Cost for 30 days.
   2 ÷ 98 = 2.04%.
2. Annual.
   1.0204^{365 ÷ 30} − 1 = 27.9%.

1. Proceeds.
   500 × (1 − 0.18 × 180 ÷ 365) = ₦455.62m.
2. Yield.
   44.38 ÷ 455.62 × 365 ÷ 180 = 19.75%.

1. Cost.
   1.35 + 0.10 = ₦1.45m, 7.25% for the quarter.
2. Annual.
   1.0725⁴ − 1 = 32.3%.

How to answer in the exam

• Identify the need: temporary or permanent, size, and how certain.
• Name the suitable sources and give the effective cost of each, not the quoted rate.
• Match the finance to the asset: short-term for working capital, long-term for non-current assets.
• Recommend and justify, noting the risk of the source being withdrawn.

Common mistakes in the exam

• Quoting the nominal rate without fees or compounding.
• Treating trade credit as free when a discount is offered.
• Using an overdraft to finance non-current assets without comment on the mismatch.
• Comparing a 45-day rate with an annual rate.
• Ignoring the administration saved when costing a factor.
• Forgetting that an overdraft is repayable on demand.

Quick revision

• Overdraft: flexible, on demand, not for non-current assets. Loan: fixed term and schedule.
• Trade credit: free unless a discount is given up.
• Factoring: 70% to 80% advance; commercial paper: discounted, rated, 30 to 364 days.
• Compare effective annual costs; match finance to the asset.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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