Business Environment and Concepts

FINANCING CURRENT ASSETS -

A. Many firms have seasonal fluctuations in demand for their products.
Accordingly, current assets tend to vary in amount from month to month.
\ 1. Permanent current assets are those that are required to operate the business
in even the slowest times of the year.
2. Temporary current assets are the additional amounts of current assets that
are accumulated during periods of higher production and sales. • :, -
3. A conservative approach is to finance permanent current assets with long-term
financing sources and finance temporary current assets with short-term financing
sources. However, long-term financing sources generally are more expensive,
have more covenants that restrict management actions, and often have prepayment
penalties.
There are a number of short-term sources of funds, including:
B.
1.
Accounts payable (trade credit) is a source of funds when a firm purchases
goods on credit. However, it can be expensive if the firm does not take advantage
of the cash discounts available for early payment of invoices. The following
formula is used to calculate the interest rate cost of not taking the discount:
Discount percent___ _________365 days_________
Rate =
100% - Discount percent
Total pay period - Discount period
2.
3.
4.
5.
6.
Short-term bank loans are loans from financial institutions that typically mature
in about 90 days and involve an interest rate tied to the prime rate or the London
Interbank Offered Rate (LIBOR). These rates are referred to as nominal rates; the
actual rate that a borrower receives is adjusted for the borrower's credit risk.
a. To calculate the interest cost when the loan is made on a discounted basis or
involves a compensating balance, the interest amount should be divided by the
cash available (e.g., the principal minus the discount or compensating balance).
b. A line of credit is an informal specification of the maximum amount that the
bank will lend the borrower.
c. A letter of credit is an instrument that facilitates international trade. It is a
promise by an importer's bank that the bank will pay for imported merchandise.
Large creditworthy borrowers can issue commercial paper to obtain short-term
funds. Accounts receivable can be used as collateral for short-term loans. These
loans typically involve pledging of receivables, factoring of receivables, or asset-
backed public offerings.
Inventory is also used as collateral for short-term debt, in the form of blanket
inventory liens, trust receipts, or warehousing arrangements.
If a firm has a large amount of variable rate debt, management may decide to
hedge the interest rate risk by selling derivatives in the financial futures market.
PROBLEMS AND SOLUTIONS FINANCING CURRENT ASSETS
1. If a firm goes to a reputable financial institution, the firm will pay a nominal
rate of interest. (True or False?)
28 - Financing Current Assets