Introduction
Business finance is a very fast evolving world and a consistent cash flow is the only way to survive and prosper. Companies find themselves in circumstances where the goods are sold on credit, which is payment is not made immediately but the costs like wages, rent and raw materials should be paid immediately. In order to fill this gap, companies are called upon financial instruments, which are called negotiable instruments, including bills of exchange and discounting, promissory notes, and drafts. The tools do not only make transactions easy, but also enable businesses to access the short term financing by a process known as discounting.
The role that these instruments play in actual world situations can though be more fully understood by reading more about bills of exchange and discounting, how they are used in business.
This paper will fully explain these tools, modes of operation of bills of exchange and discounting, their importance in the running of short-term business financing.
Understanding Negotiable Instruments
The written financial documents that are used to secure the payment of a certain amount of money on-demand or after a certain time are called as negotiable instruments. Their peculiarity is that they can be transferred between different parties; they can be handed down and they are very helpful in business dealings.
There are three primary forms of negotiable instruments which are used in the financing of businesses; these are:
- Bills of exchange
- Promissory notes
- Drafts
All these have a specific role in enabling credit and credit security.
Bills of Exchange: Meaning and Features
A bill of exchange is a written unconditional command by the one party (the drawer) to the other party (the drawee) to deliver a particular amount of money to a third party (the payee) either upon demand or at a specific later date.
Key Parties Involved:
- Drawer: The bill owner who prepares the bill.
- Drawee: It is the individual or firm that has to pay.
- Payee: This is the recipient of the payment.
Example:
Assume that a supplier sells commodities of N500, 000 to a retailer on credit. The retailer will be asked to pay to the supplier after 60 days according to a bill of exchange issued by the supplier. The bill has to be accepted by the retailer, and it makes it a legal obligation.
Characteristics of Bills of Exchange
- Must be in writing
- An order without qualification.
- Defines a precise amount of money.
- Has a fixed date of payment or payable on demand.
- The acceptance of the drawee is required.
Bills of exchange and discounting are commonly applicable in the domestic and international trade since they give the sellers confidence that the money will be delivered.
Promissory Notes: A Simple Offer to Pay.
A promissory note is a written acknowledgment by one party (the maker) to the other party (the payee) to pay a certain amount of money either on demand or at a later date.
Key Difference from Bills of Exchange
In contrast with bills of exchange, a promissory note simply refers to two sides:
- Maker (debtor)
- Payee (creditor)
Example:
A company can write a promissory note where the company undertakes to pay a supplier N200,000 in 30 days. This note is a legal evidence of debt.
Features
- Signed and written by the producer.
- Has a promise to pay without qualification.
- Specifies a definite amount
- To be paid either on demand or on a future date.
Informal credit transactions and loan arrangements usually involve the use of promissory notes.
Drafts: Orders for Payment
A draft is like the bill of exchange but is very common in the bank system and international business. It is a written directive of one party to another to make a certain amount of payment.
Types of Drafts
- Sight Draft: Due on Presentation.
- Time Draft: To be paid in the future.
Cross-border transactions, especially involving goods exported to and goods imported by different countries, are often done using drafts so that exporters get paid and the importers get their goods.
The Role of Negotiable Instruments in Business
Negotiable instruments are important in the finance of businesses because they:
1. Empowering Trade on Credit
It allows the sale of goods without the immediate payment and enables more sales and flexibility of the customers.
2. Providing Legal Security
These instruments are enforceable in the law meaning that the creditor is entitled to receive payment in a formal way.
3. Enhancing Liquidity
They may be sold or assigned to other parties giving businesses the opportunity to convert receivables into cash.
4. Supporting Financial Planning
Businesses are able to plan their cash flows better with set payment dates.
What is Discounting of Bills?
Discounting is a monetary activity in which a company will sell its bill of exchange or promissory note to a bank or other financial institution prior to its due date in order to obtain instant cash.
The bank gives the business the worth of the bill less a discount fee which is the interest in the remaining time before the maturity date.
Why Discount Bills?
Businesses are likely to require cash prior to the due date of the bill to:
- Pay suppliers
- Meet operational expenses
- Invest in new opportunities
They can receive the money immediately by way of discounting instead of waiting until the debtor has made the payment.
How Discounting Works
We can split it into several steps:
- One of the businesses has a bill of exchange of N100, 000 that is payable within 90 days.
- The company goes to a bank to provide a discount on the bill.
- The bank works out a discount depending on the time and interest rate.
- The bank remits the business a less sum (e.g., N95, 000).
- Upon maturity, the bank is entitled to collect back the entire N100, 000 with the drawee.
Discount Computation of Financial Institutions.
The formula used to calculate the discount is:
Discount = Face Value x Discount rate x Time.
Example Calculation:
- Face Value = N100, 000
- Discount Rate = 10% per annum
- Time = 90 days (or 90/365 years)
Discount = 100,000 x 10% x (90/365)
Discount= N2, 466
Amount received by business:
N100, 000 – N2, 466 = N97, 534
This margin indicates the profits of the bank to avail early cash.
Advantages of Discounting Bills
- Immediate Access to Cash: Firms are able to turn the credit sales into cash.
- Improved Cash Flow: Helps keep the liquidity and cover the short-term liabilities.
- Reduced Credit Risk: The responsibility of payment is transferred to the bank.
- Flexibility: Depending on the needs, businesses can select the bills they can discount.
Disadvantages of Discounting
- Cost of Discount: The business gets less than the value of the bill.
- Reliability on creditworthiness: Banks are not likely to discount bills of parties that are not reliable.
- Potential Liability: There are instances whereby the defaulting drawee can still make the business liable.
Why Businesses utilize these Instruments
1. To Manage Working Capital
Companies require having a continuing stream of funds to run smoothly. The negotiable instruments enable them to deal with timing variations between revenue and expenditures.
2. To minimize Risk in Transactions
These instruments minimize the uncertainty and conflicts by documenting credit agreements.
3. To Enhance Trust in Trade
The suppliers will be in a better position to provide goods on credit with support of legally binding documents.
4. To Enable Financing Options
Discounting is an option of loans that are usually less complex to do.
Real-life Implementation in Business
Consider a manufacturing firm which sells his goods to retailers in Nigeria. The company does not insist on immediate payment instead of providing the bills of exchange on 60-day terms.
But the company is still required to pay the workers and suppliers within 30 days. To overcome this, it sells the bills at a discount to a bank and gets the cash instantly and so it can go on with its operations without hitches.
Through this cycle, the business is able to:
- Continue production
- Supplier relationship maintenance.
- Avoid cash shortages
Bills of Exchange International Trade
Bills of exchange and drafts play a vital part in international trade.
Example:
An exporter sells the products to an importer and attracts a bill of exchange that will be paid after 90 days. The bill is received by the importer and the exporter can discount the bill with a bank and get instant payment.
This system:
- Guarantees exporters against non-payment.
- Gives the importers time to sell goods without paying.
Legal Aspects of Negotiable Instruments
Negotiable instruments have some laws governing their use, transfer and enforcement.
Most important legal principles are:
- Holder in Due Course: One who gets possession of the instrument legally and is entitled to payment.
- Endorsement: Signing on to make the conveyance of ownership.
- Maturity Date: The date the payment is to be made.
Such legal safeguards cannot be considered risky because the negotiable instruments are trusted and spread all over.
Risks Management and Risk Control
Although these instruments are handy, there are certain things that a business should consider:
- Re-check the credit worthiness of the drawee.
- Make sure that everything is properly written.
- Keep proper records
- Cooperate with the well-known financial institutions.
Otherwise, it may cause financial losses or conflicts.
The Future of Negotiable Instruments
The instruments, which are paper-based, are changing with the introduction of digital banking and electronic payments. Electronic bills and digital signatures are now supported by many countries.
But all the main principles are the same:
- Written commitment
- Legal enforceability
- Transferability
These characteristics will make sure that negotiable instruments will remain critical in business financing.
Conclusion
Financial instruments such as bills of exchange and discounting, promissory notes and drafts play a very crucial role in helping businesses to control credit, secure payment and stabilize cash flow. The discounting process allows companies to obtain the funds they might need within a short period of time without having to wait until payment dates, which is why these tools are a convenient option to use in the short-term funding.
The knowledge of their operation and the way in which financial institutions determine the discounts helps businesses to make wise decisions that can enhance liquidity and minimize financial stress. In the local trade or in international trade, negotiable instruments are in any case a pillar of sound financial management.
In the end, learning how to use them will enable businesses to work efficiently, capture an opportunity to grow, and navigate the obstacles of contemporary business with ease.
Get more well researched information about Bills of Exchange and Discounting here.