Sources of Business Finance

Retained Earning, Trade Credit and Factoring

You have heard about credit card and debit card. But what is Trade Credit? What is Retained Earning? What is Factoring? Let’s find out more about Retained Earning, Trade Credit and Factoring.

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Retained Earning

Earning

The portion of profits of a business that are not distributed as dividends to shareholders but are reserved for reinvestment back into business is called Retained Earnings. Generally, these funds are for working Capital and fixed asset purchases or allotted for debt obligations.

These Earnings are reported on the Balance Sheet under the shareholder’s equity at the end of each and every accounting period. To calculate Retained Earnings, the beginning Retained Earning balance is added to the net income or loss and dividend payouts are subtracted. A report called a statement of retained earnings is also maintained, outlining the changes in Retained earning for a specific period

The Formula for Retained Earnings is

Retained Earnings (RE) = Beginning RE + Net Income – Dividends.

Beginning Of Period Retained Earnings

Retained earnings are shown on the balance sheet as accumulated income from the prior year (including the current year’s income) subtracts dividends paid to shareholders. Also in the next accounting cycle, the Retained earnings ending balance from the previous accounting period will now become the retained earnings beginning balance.

Net Income Impacts on Retained Earnings

Any changes or movement with net income will directly impact the Retained Earning balance. Factors, such as increase or decrease in net income and incurrence of Net loss, will pave the way to either business profitability or deficit.

How Dividends Impact Retained Earnings

Distribution of dividend to shareholders can be in the form of cash or stock. Both forms can reduce the value of Retained earnings of the business. Cash dividends represent cash outflow and are recorded as reductions in the cash account. owns. Stock dividends, however, do not require cash outflow. Instead, they reallocate a portion of the RE to common stock and additional paid-in capital accounts

End of period Retained Earnings

In the end, we can calculate final retained earnings balance for the balance sheet by showing the beginning period, adding one of the  Net income or net loss, and subtracting any dividends.

Trade Credit

It is an agreement or understanding between agents engaged in business with each other that allows an exchange of goods or services of goods and services without any immediate exchange of money. When the seller of goods or service allows the buyer to pay for the goods or service at a later date, the seller is said to extend credit to the buyer.

Trade credit is usually offered 7, 30, 60, 90 or 120 days but an exception to some businesses such as goldsmiths and jewellers may extend credit. For example, the customer is granted credit with terms of 4/10, net 30. This means that the customer has 30 days from the invoice date within which to pay the seller. In addition, a cash discount of 4% from the s sales price is to be given to the customer if payment is made within 10 days of invoicing.

Credit Period

 Credit periods differ from industries to industries. A food wholesaler, selling fresh fruit and produce, may use net 7. Generally, a firm must consider three factors in setting credit period:

  • The probability that customer will not pay – A firm whose customers are in high-risk businesses may find itself offering restrictive credit terms.
  • The size of the account – If the account is small, the credit period will be shorter. Small accounts are more costly to manage.
  • The extent to which goods are perishable – If the values of the goods are low and cannot be sustained for longer periods, less credit will be granted.

Credit Analysis

While providing Credit, a firm tries to find the difference between customers who will pay and customers who will not. There are many sources of to determine creditworthiness.

  • Financial Statements– A firm can ask a customer to give financial statements. Rule of thumb financial ratios can be used.
  • Credit Reports on customer’s payment history with other firms – Many organizations sell information showing credit strength of firms.
  • Banks – Banks will generally provide help to their customers in gathering information on the creditworthiness of many other firms.
  • The customer’s payment history with the firm – It is the way to obtain an estimate of a customer’s probability of non-payment is whether he or she has paid previous bills with the company granting credit.
  • The 5 C’s of credit:
    1. Character
    2. Capacity
    3. Capital
    4. Collateral
    5. Conditions 

Factoring

Factoring means a financial arrangement between the factor and client, in which the firm (client) gets advances in return for receivables, from a financial institution (factor). It is a technique, in which there is an outright selling of trade debts by a firm to a third party, i.e. factor at discounted prices.

Types of Factoring

  • Recourse and Non-recourse Factoring: It is a type of arrangement, the financial institution, can resort to the firm when the debts are not recoverable. In non-recourse factoring, the factor cannot recourse to the firm, in case the debt turn out to be irrecoverable.
  • Disclosed and undisclosed Factoring: This factoring is in which the factor’s name is shown on the invoice of the goods or services asking the purchaser to pay the factor, is called disclosed factoring.
  • Domestic and Export Factoring: When three parties to factoring, i.e customer, client, and factor, live in the same country, it is called as domestic factoring.

Export factoring, also known as cross-border factoring.It is one where there are four parties involved, i.e. exporter (client), the importer (customer), export factor and import factor.

Advance and Maturity Factoring

In advance factoring, the factor gives an advance to the client, against uncollected receivables. In maturity factoring, the factoring agency not provide any advance to the firm. Whereas, the bank collects the amount from the customer and gives to the firm.

 Solved Example

Q1: In 1996, SLR on total NDTL has been brought down to ________.

  1. 25%
  2. 30%
  3. 35%
  4. 40%

Sol. The correct answer is the option ”a”.