FACTORS AFFECTING SHORT-TERM FINANCING

Whether the firm uses an aggressive approach, a conservative approach, or maturity matching depends
on an evaluation of many factors affecting the business. The company's operating characteristics will
affect a firm’s financing strategy. Other factors having an impact include tug, the cost, flexibility, the
case of future financing, and other qualitative influences.

OPERATING CHARACTERISTICS

The nature of the demand for funds depends in part on the industry in which a business operates and
on the characteristics of the business itself. It is influenced by such factors as seasonal variations in soles
and on the growth of the company. The need for funds also depends on fluctuations of the business
cycle.

INDUSTRY AND COMPANY FACTORS

Some industries, such as utilities and oil refineries, have larger proportions of fixed assets to current
assets. Others, such as service industries, have larger proportions of current assets to fixed assets.
Within each industry, some firms will choose different operating structures with different levels of
operating leverage.

The composition of the asset structure, or current assets versus fixed assets, of an industry and of a firm
within that industry is a significant factor in determining the relative proportions of their long-term and
short-term financing. An industry that needs large amounts of fixed capital can do more long-term
financing than one that has a relatively small investment in fixed assets.

While manufacturing companies often require substantial investments in fixed assets for manufacturing
purposes, they also have significant investments in inventories and receivables. Manufacturers generally
have a more equal balance between current and fired assets than electric utility and telephone
companies and so will use relatively more short-term financing than utilities.

The same is true for large retail stores. They often lease their quarters and hold substantial assets in the
form of inventories and receivables. They are characterized by relatively high current assets to fixed
assets ratios and so will have a greater tendency than utilities to use short-term debt. The size and age
of a company and stage in its financial life cycle may also influence management's short-term/long-term
financing mix decisions.

SEASONAL VARIATION

Our earlier discussion of Figure 16.3 pointed out that seasonal variations in sales affect the demand for
current assets. Inventories are built up to meet seasonal needs, and receivables rise as sales increase.
The peak of receivables will come after the peak in sales, the intervening time depending on the credit
terms and payment practices of customers. Accounts payable will also increase as inventories arc
purchased. The difference between the increase in current assets and accounts payable should be
financed by short-term borrowing because the need for hinds will disappear as inventories are sold and
accounts receivable are col-elected. When a need for additional funds is financed by a short-term loan,
such a loan is said to be self-liquidating since funds arc made avail-able to repay it as inventories and
receivables arc reduced.

Sales Trend

A firm's sales trend affects the financing mix. As sales grow, fixed assets and current assets also must
grow to support the sales growth, as depicted in Figure 16.3. This need for funds is ongoing unless the
upward trend of sales is reversed.

If asset growth is initially financed by short-term borrowing, the outstanding borrowings will continue to
rise as sales rise. The amount of debt may rise year by year as the growth trend continues upward. After
a while the current ratio will drop to such a level that no financing institution will provide additional
funds. The only alternative then is long-term financing. Since the cycle is not regular in timing or degree,
it is hard to predict exactly how much, or for how long, added funds will be needed. The need should be
estimated for a year ahead in the budget and checked quarterly. When the sales volume of business
decreases, the need for funds to finance accounts receivable and inventory will decrease as well. It is
possible, however, that locution during the downturn the need for financing will increase temporarily.
This will occur if the cash conversion cycle lengthens as receivables are collected more slowly and
inventories move more slowly and drop in value.

Cyclical Variations

The need for current funds increases when there is an upswing in the business cycle or the sales cycle of
an industry.

OTHER INFLUENCES IN SHORT-TERM FINANCING

There are other advantages to using short-term borrowing rather than other forms of financing. Short-
term borrowing offers more flexibility than long-term financing, since a business can borrow only those
sums needed currently and pay them off if the need for financing diminishes. Long-term financing
cannot be retired so easily and it may include a prepayment penalty, as is the case with the call premium
for callable bonds. If an enterprise finances its growing current asset requirements entirely through
long-term financing during a period of general business expansion, it may be burdened with excess
funds and financing costs during a subsequent period of general business contraction. Using short-term
financing along with long-term financing creates a financial flexibility that is not possible with long-term
financing alone. Short-term financing has advantages that result from continuing relationships with a
bank or other financial institution.

PERSONAL FINANCIAL PLANNING

The Role of Money Market Mutual Funds

Money market mutual funds IMMMF) are a link between an individual, savings and investment needs
and alien's need for short-term financing. MMMF invest in money market securities-securities that
mature, or come due, in less than one year. In reality, the typical MMMF invests in securities that
mature much sooner than that. The average maturity of the securities held by some MMMF is one week
or less. Money market securities exist because of the short-term financing needs of governments, banks,
and business. The MMMFs pool the savings of many investors. The funds use the savings to invest in T-
bills, short-term state and local govern. meet debt, negotiable certificates of deposit (CDs), and
commercial paper. The typical denominations (125,000 or higher) of these shoe-teen financing sources
are usually beyond the reach of the small investor. The advent of MMMF in the early 1970s allows the
small investor to tap into this market and ram returns higher than those paid on short-term bank CDs or
checking accounts. In turn, the MMMF provide another source of liquidity to the short-term financing
markets. By pooling the savings of small investors, borrowers of short-term funds have another outlet
for obtaining short-term financing. This extra supply of loanable funds pro-vided by the MMMF helps to
keep short-term financing rates a bit lower than would be the ease without MMMFs.

COMMERCIAL BANK LENDING OPERATIONS

Although many banks require a pledge of specific assets, the unsecured loan still remains the primary
type of loan arrangement. The stated rate on such loans is based on the bank's prime rate, or the
interest rate a bank charge its most creditworthy customers. Interest rates on loans typically are stated
in terms of the prime rate plus a risk differential, such as prime + 2 percent. Loan papers will call this
prime plus 2 or simply P + 2. Higher-risk borrowers will have higher differentials to compensate the bank
for lending to riskier customers.

BANK LINKS OF CREDIT

A business and a bank often have an agreement regarding the amount of credit that the business will
have at its disposal. The loan limit that the bank establishes for each of its business customers is called a
line of credit. Lines of credit cost the business only the normal interest for the period during which
money is actually borrowed. Under this arrangement, the business does not wait until money is needed
to negotiate the loan. Rather, it files the necessary financial statements and other evidences of financial
condition with the bank prior to the need for credit. The banker is interested in how well the business
has fared in the past and in its probable future because the line of credit generally is extended for a year
at a time. The banker may require that other debts of the business be subordinated to, or come after,
the claim of the bank. Banks also usually require their business customers to "clean up" their lines of
credit for a specified period of time each year—that is, to have no out-standing borrowing against the
credit line, usually for a minimum of two weeks. This ensures that the credit line is being used for short-
term financing purposes rather than for long-term needs. Continued access to a line of credit may be
subject to the approval of the bank, if there are major changes in the operation of a business. A major
shift or change in management personnel or in the manufacture or sale of particular products can
influence greatly the future success of a company. Hence, the bank, having contributed substantially to
the financial resources of the business, is necessarily interested in these activities. The bank may also
seek information on the business through organized credit bureaus, through contact with other
businesses having dealings with the firm, and through other banks.

COMPUTING INTEREST RATES

Chapter 9, The Time Value of Money, illustrated how to use time value of money concepts to calculate
interest rates. The same concepts can be used to calculate the true cost of borrowing funds from a bank.
If, for example, Global Manufacturing can borrow $10,000 for 6 months at 8 percent APR, the six-month
interest cost will be 8%/2 x $10,000, or $400. Global will repay the $10,000 principal and $400 in interest
after six months. As we learned in Chapter 9, the true or effective interest rate on this loan is
 EAR = (1 + APR/m) — 1 or {1 + 0.08/2}² — 1 0.0816, or 8.16 percent.

At times banks will discount a loan. A discounted loan is one in which the borrower receives the
principal less the interest at the time the loan is made. At maturity, the principal is repaid. Discounting
has the effect of reducing the available funds received by the borrower while raising the effective
interest rate. If Global's loan is discounted, Global will receive $9,600 ($10,000 less $400) and will repay
$10,000, in essence. paying $400 interest on the $9,600 funds received. This is a periodic rate of
S400/$9,600, or 4.17 percent. The effective annual rate is (I + 0.0417)2 — 1, or 8.51 percent, an increase
of 0.35 percentage points over the undiscounted loan. When a loan is discounted, a firm has to borrow
more money than the amount it really needs. To counteract the effect of discounting, to acquire
$10,000 in usable funds they will have to borrow $10,000/(1—0.04) or $10,416.67. When a loan of
$10,416.67 is discounted at a six-month rate of 4 percent, the net proceeds to Global will be $10,000
(that $10,416.67 — (0.04)110,416.67) $10,000). In general, to receive the desired usable funds, the loan
request must equal:

Loan request = Desired usable funds/(1 — discount).

A loan with a compensating balance is similar to a discounted loan as for as its effect on the effective
interest rate and usable funds is concerned. Compensating balances are equivalent to discounting when
the firm currently has no money on deposit at the bank. The firm's loan request should be large enough
so that after funds arc placed in the compensating balance it will have the usable funds it desires.

REVOLVING CREDIT AGREEMENTS

The officers of a business may feel rather certain that an agreed-upon line of credit will provide the
necessary capital requirements for the coming year. But the bank is not obligated to continue to offer
the credit line if the firm's financial condition worsens. Line of credit agreements usually allow she bank
to reduce or withdraw its extension of credit to the firm.

The well-established business with an excellent credit rating may be able to obtain a revolving credit
agreement. A revolving credit agreement is a commitment in the form of a standby agreement for a
guaranteed line of credit. Unlike a line of credit, a revolving credit agreement is a legal obligation of the
bank to provide funds up to the agreed-upon borrowing limit during the time the agreement is in effect.
In addition to paying interest on borrowed funds for the period of the loan, the business most pays a
commission or fee to the bank based on the unused portion of the credit line, or the money it has "on
call" during the agreement period.

ACCOUNTS RECIEVABLE FINANCING

The business that does not qualify for an unsecured bank loan or that has emergency needs for funds in
excess of its line of credit may offer a pledge of accounts receivable as security. When banks use.
accounts receivable as security, they make the same sort of credit investigation as they do for unsecured
loans. Particular attention is given to the col-lection experience of the business on its receivables and to
certain characteristics of its accounts receivable.