Chapter 5.

Short Term Financing

1. 1. Short-Term Financing
2. 2. Financial Decisions Revisited 2
3. 3. Section 1 Spontaneous Financing 3
4. 4.  The two sources are; a)trade credits; b)accruals; 4 There are two
common characteristics; a)there is no need for any additional attempts or
negotiations; b)it arises as a result of company’s normal routine
operations; What is Spontaneous Financing?
5. 5.  The three types are; a) open-account arrangements; b)notes payables;
c)trade acceptances; 5 Credit allowed by one business to another;
Trade Credits from Suppliers
6. 6.  Seller extends credit based on the records of creditworthiness; 6
Typically take place between longstanding partners;  Arrangement
whereby sales are made with no formal debt contract;  Terms of trade
usually involving invoicing but no additional security for payment; Open
Account Arrangements
7. 7.  “Net 30” implies full payment in 30 days from the invoice date; 7 Net
Period(no cash discount)Net Period(no cash discount) -when credit is
extended, the seller specifies the period of time allowed for payment; 
CBD reduces the seller’s risk because problems such as refusal of
shipment by customer are avoided completely;  COD and CBD(COD and
CBD(no trade credit): the buyer pays cash on deliverycash on delivery or
cashcash before deliverybefore delivery; Terms of the Sale
8. 8.  Seasonal DatingSeasonal Dating - credit terms that encourage the
buyer of seasonal products to take delivery before the peak sales period
and to defer payment until after the peak sales period; 8 “2/10, net 30”
implies full payment within 30 days from the invoice date less a 2%
discount if paid within 10 days;  Net Period(cash discount)Net
Period(cash discount) -when credit is extended, the seller specifies the
period of time allowed for payment and offers a cash discount if paid in the
early part of the period; Terms of the Sale
9. 9. Cost to Forgo a Discount Approximate annual interest cost = %
discount 365 days (100% - % discount) (payment date - discount period)
What is the approximate annual cost toWhat is the approximate annual
cost to forgo the cash discount offorgo the cash discount of “2/10, net
30”“2/10, net 30” after the first ten days?after the first ten days? X 9
10. 10. Cost to Forgo a Discount Approximate annual interest cost = 2% 365
days (100% - 2%) (30 days - 10 days) = (2/98) x (365/20) = 37.2% What is
the approximate annual cost to forgoWhat is the approximate annual cost
to forgo the cash discount ofthe cash discount of “2/10, net 30,” and
pay“2/10, net 30,” and pay at the end of the credit period?at the end of the
credit period? X 10
11. 11.  It’s not too bad if the stretching is due to seasonal or cyclical factors;
11 The possible disadvantages are; a)cost of the cash discount (if any)
forgone; b)late payment penalties or interest; c)deterioration in credit
 rating;  Postponing payment beyond the end of the net (credit)Postponing
payment beyond the end of the net (credit) period is known asperiod is
known as “stretching accounts payable”“stretching accounts payable”
oror “leaning on the trade”“leaning on the trade”;; S-t-r-e-t-c-h-i-n-g
Account Payables
12. 12.  Legally it stands in somewhere between IOU and bank loans; 12
Seller may require this formal procedure when he feels insecure as a
result of former past due or default;  The buyer signs a note that
evidences a debt to the seller;  Sometimes referred as promissory notes;
Notes Payables
13. 13.  Trade Acceptances-the seller draws a draftdraft on the buyer that
orders the buyer to pay the draft at some future time period. 13Trade
Acceptances DraftDraft -A signed, written order by which the first party
(drawer) instructs a second party (drawee) to pay a specified amount of
money to a third party (payee).The drawer and payee are often one and the
same.
14. 14.  TaxesTaxes - Benefits accrue until the due date, but costs of
penalties and interest beyond the due date reduce the benefits; 14
WagesWages - Benefits accrue via no direct cash costs, but costs can
develop by reduced employee morale and efficiency;  The accrued
expenses account is a short-term liability;  Accrued ExpensesAccrued
Expenses -amounts owed but not yet paid for wages, taxes, interest, and
dividends; Accrued Expenses
15. 15.  Greater flexibility as a means of financing; Compare costs of forgoing
a possibleCompare costs of forgoing a possible cash discount against the
advantages ofcash discount against the advantages of trade credit.trade
credit. 15 No need for legal arrangements;  Convenience and availability
of trade credit; Advantages of Trade Credit
16. 16. BothBoth -when costs can partially be passed on to buyers by sellers;
16BuyerBuyer - when costs can be fully passed on through higher prices
to the buyer by the seller; SuppliersSuppliers - when trade costs cannot
be passed on to buyers because of price competition and demand; Who
Bears the Cost of Funds for Trade Credit?
17. 17. Section 2 Negotiated Financing 17
18. 18.  It’s an unsecured,negotiable, short-term loan( Short-term financing
instrument for corporations who want to avoid bank procedures;
Commercial Paper < Commercial paper market is composed of two parts;
a)the dealer market-medium-sized companies and industrial firms;
b)direct-placement markets-big corporations; 18 As no collateral is
intended only big and creditworthy corporations may issue the instrument;
270 days) issued by a corporation;
19. 19.  In fact some commercial paper dealers may require borrowers to
keep lines of credit at bank as an assurance of future payments; 19 The
main advantage is the lower interest rate in compared to bank loans; 
The instrument should be rated by independent rating agencies;
Commercial Paper(cont.)
20. 20.  Best for lesser-known firms to access lower cost funds; 20 It is
frequently used to guarantee payment of an obligation;  Letter of credit
(L/C)Letter of credit (L/C) - a promise from a third party (usually a bank) for
payment in the event that certain conditions are met;  A bank provides a
letter of creditletter of credit, for a fee, guaranteeingguaranteeing the
investor that the company’s obligation will be paid; “Bank-Supported”
Commercial Paper
21. 21.  Secured LoansSecured Loans –a form of debt for money borrowed in
which specific assets have been pledged to guarantee payment; 21
Unsecured LoansUnsecured Loans –a form of debt for money borrowed
that is not backed by the pledge of specific assets; Short-Term Business
Loans
22. 22.  “Cleanup” provision requires the firm to owe the bank nothing for a
period of time; 22 Credit line is based on the bank’s assessment of the
creditworthiness and credit needs of the firm;  One-year limit that is
reviewed prior to renewal to determine if conditions necessitate a change;
 Line of Credit (with a bankLine of Credit (with a bank)) -an informal
arrangement between a bank and its customer specifying the maximum
amount of credit the bank will permit the firm to owe at any one time;
Unsecured Loans
23. 23.  Agreements frequently extend beyond 1 year; Revolving Credit
AgreementRevolving Credit Agreement - a formal, legal commitment to
extend credit up to some maximum amount over a stated period of time.
23 Firm receives revolving credit by paying a commitment
feecommitment fee on any unused portion of the maximum amount of
credit; o Commitment feeCommitment fee -- A fee charged by the lender
for agreeing to hold credit available; Unsecured Loans
24. 24.  The loan is paid off at the completion of the project by the firm from
resulting cash flows; 24 Each request is handled as a separate
transaction by the bank, and project loan determination is based on the
cash-flow ability of the borrower;  Transaction LoanTransaction Loan - a
loan agreement that meets the short-term funds needs of the firm for a
single, specific purpose; Unsecured Loans
25. 25. Differential from prime depends on: o Cash balances; o Other business
with the bank; o Cost of servicing the loan; 25Prime Rate -short-term
interest rate charged by banks to large, creditworthy customers; Detour:
Cost of Borrowing
26. 26.  Collect BasisCollect Basis - interest is paid at maturity of the note;
Example: $100,000 loan at 10% stated interest rate for 1 year. = 10.00%
26$10,000 in interest $100,000 in usable funds Detour: Cost of Borrowing
Computing Interest RatesComputing Interest Rates
27. 27. $10,000 in interest $90,000 in usable funds Detour: Cost of Borrowing
Discount BasisDiscount Basis -interest is deducted from the initial loan.
Example: $100,000 loan at 10% stated interest rate for 1 year. = 11.11% 27
28. 28.  Demand deposits maintained by a firm to compensate a bank for
services provided, credit lines, or loans. Example: $1,000,000 loan at 10%
 stated interest rate for 1 year with a required $150,000 compensating
balance. = 11.76% 28$100,000 in interest $850,000 in usable funds
Detour: Cost of Borrowing Compensating BalancesCompensating Balances
29. 29.  The fee charged by the lender for agreeing to hold credit available is
on the unused portions of credit. Example: $1 million revolving credit at
10% stated interest rate for 1 year; borrowing for the year was $600,000; a
required 5% compensating balance on borrowed funds; and a .5%
commitment fee on $400,000 of unused credit. What is the cost of
borrowing?What is the cost of borrowing? 29Detour: Cost of Borrowing
Commitment FeesCommitment Fees
30. 30. $60,000 in interest + $2,000 in commitment fees $570,000 in usable
funds Detour: Cost of Borrowing Interest: ($600,000) x (10%) = $ 60,000
Commitment Fee: ($400,000) x (0.5%) = $ 2,000 Compensating Balance:
($600,000) x (5%) = $ 30,000 Usable Funds: $600,000 - $30,000 = $570,000
= 10.88% 30
31. 31. Secured (or Asset-Based) Loans • Marketability • Life • Riskiness
Security (collateral)Security (collateral) -asset (s) pledged by a borrower
to ensure repayment of a loan. If the borrower defaults, the lender may sell
the security to pay off the loan. 31
32. 32. Accounts-Receivable- Backed Loans • Quality: not all individual
accounts have to be accepted (may reject on agingaging); • Size: small
accounts may be rejected as being too costly (per dollar of loa Loans by
commercial banks or finance companies (banks offer lower interest rates).
Loan evaluations are made onLoan evaluations are made on: 32 One of
the most liquid asset accounts. n) to handle by the institution;
33. 33.  Non notificationNon notification -- firm customers are not notified that
their accounts have been pledged to the lender. The firm forwards all
payments from pledged accounts to the lender; 33
NotificationNotification -firm customers are notified that their accounts
have been pledged to the lender and remittances are made directly to the
lending institution. Types of receivable loan arrangementsTypes of
receivable loan arrangements: Accounts-Receivable- Backed Loans
34. 34. Inventory-Backed Loans • Marketability • Perishability • Price stability
• Difficulty and expense of selling for loan satisfaction • Cash-flow ability
Relatively liquid asset accounts Loan evaluations are made onLoan
evaluations are made on: 34
35. 35. Chattel MortgageChattel Mortgage -a lien on specifically identified
personal property (assets other than real estate) backing a loan.
35Floating LienFloating Lien - a general, or blanket, lien against a group
of assets, such as inventory or receivables, without the assets being
specifically identified; Types of Inventory-Backed Loans
36. 36.  Terminal Warehouse ReceiptTerminal Warehouse Receipt - a receipt
for the deposit of goods in a public warehouse that a lender holds as
collateral for a loan; 36 Trust ReceiptTrust Receipt -a security device
acknowledging that the borrower holds specifically identified inventory
 and proceeds from its sale in trust for the lender; Types of Inventory-
Backed Loans
37. 37. Factoring Accounts Receivable FactoringFactoring -the selling of
receivables to a financial institution, the factorfactor, usually “without
recourse.”; FactorFactor is often a subsidiary of a bank holding company;
FactorFactor maintains a credit department and performs credit checks on
accounts; Allows firm to eliminate their credit department and the
associated costs; Contracts are usually for 1 year, but are renewable; 37
38. 38. Factor receives a commission on the face value of the receivables
(typicallyFactoring Accounts Receivable Factoring CostsFactoring Costs
<Although expensive, it provides the firm with substantial flexibility;
38Total cost of factoring is composed of a factoring fee plus an interest
charge on any cash advance; If the factor advances money to the firm,
then the firm must pay interest on the advance; Cash payment is usually
made on the actual or average due date of the receivables; 1% but as
much as 3%);
39. 39.  Degree to which the assets are encumbered; The best mix of short-
term financingThe best mix of short-term financing depends on:depends
on: 39 Flexibility;  Timing;  Availability of funds;  Cost of the financing
method; Composition of Short-Term Financing
40. 40. Thank You 40