Terry Fegarty Seneca College: Slides Developed by

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Sources of Short-Term
Financing
Slides Developed by:

Terry Fegarty
Seneca College

2006 by Nelson, a division of Thomson Canada Limited

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Chapter 5 Outline (1)
Sources of Short-term Financing
Spontaneous Financing
Trade Credit
The Prompt Payment Discount
Abuses of Trade Credit
Bank Operating Loans
Short Term Bank Credit
Line of Credit or Revolving Credit Agreement
Interest Rates on Loans
Annual Interest Rate
Cleanup Requirements


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Chapter 5 Outline (2)
Short-Term Credit Secured by Current Assets
Receivables Financing
Pledging Accounts Receivable
Factoring Accounts Receivable
Inventory Financing
Types of Inventory Financing
Money Market Instruments
Commercial Paper
Bankers Acceptances
Securitization of Receivables


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Sources of Short-term Financing
Spontaneous financing
Accounts payable and accruals
Bank operating loans
Revolving credit agreement, line of credit
Secured loans for accounts receivable and
inventory
Money market instruments
Commercial paper
Bankers acceptances
Securitization of receivables


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Spontaneous Financing
Accruals
For example, money you owe employees for work
they have performed but not yet been paid
Tend to be very short-term
Accounts payable (AKA: trade credit)
Money you owe suppliers for goods you bought on
credit
Attractive source of financing
No security required
Interest-free
Credit Terms: Terms of trade specify when you are
to repay the debt


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Trade Credit
Seller lends buyer purchase price from
time of shipment to time of payment
No security and no interest
Seller may offer cash discount for early
payment
Cost of forgoing a cash discount:

% discount 365
APR =
100% - % discount Final payment date - Last discount date


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The Prompt Payment Discount
Q: Vendor offers a discount of 2% if payment is made within ten
days. If the discount is not taken, full payment is due in 30 days.
What is the annual cost of not accepting the 2% discount?

A:

= 37.24%

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% discount 365
=
100% - % discount Final payment date - Last discount date
2 365
=
100 - 2 30 - 10


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Abuses of Trade Credit
Abuses of Trade Credit Terms
Trade credit is now expected in many
businesses
Companies offer it because they have to

Stretching payablesa common abuse of
trade credit
Paying payables beyond the due date (AKA:
leaning on the trade)
Slow paying companies receive poor credit ratings
in credit reports issued by credit agencies


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Bank Operating Loans
Represent primary source of short-term loans
for most companies
Provide financing for working capital and
expenses
Advanced against value of receivables and
inventory
Repaid from collections on receivables
May be arranged for specific transactions or as
revolving credit agreement or line of credit


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Line of Credit or Revolving Credit
Agreement

Line of credit
Non-binding agreement to borrow up to
predetermined limit at any time
Revolving credit
Legally commits the bank
Usually secured
Requires commitment fee on unborrowed
funds


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Prime rate is rate that bank charges its largest and
most creditworthy corporate customers.
Interest rates on operating loans are usually based
on banks prime rate plus a risk premium


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Loan rates will depend upon such factors as:
How intense is competition among lenders for loan
business?
How large is the loan?
Does borrower have good credit history?
Does borrower have adequate and reliable cash
flow?
Does borrower have adequate security?
Is loan guaranteed under a government program?
What is term of the loan?
What is debt-to-equity ratio?


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Annual Interest Rate
where: r = Annual rate
I = Interest paid (dollars)
P = Principal
d = Number of days loan is outstanding
I 365
r =
P d


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Example 5.1: Revolving Credit
Agreement

Q: The Arcturus Company has a $10 million revolving credit agreement
with its bank at prime plus 2.5%. Prior to June, the company had
borrowed $4 million that was outstanding for the entire month. On
June 15, it took borrowed $2 million. Prime is 9.5% and the banks
commitment fee is 0.25% annually.
What bank charges will Arcturus incur for the month of June?

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A: Arcturus will have to pay both interest on the money borrowed
and a commitment fee on the unused balance of the revolving
agreement.
Monthly interest rate: (Prime + 2.5%) 12 = 1%
Monthly commitment fee: 0.25% 12 = 0.0208%
$4 million was outstanding for the entire month of June
and $2 million was outstanding for 15 days of June, so the
total dollar interest charges are:

( )
| |
=
|
\ .
15
$4,000,000 0.01 + $2,000,000 $50,000
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The commitment fee must be paid on an average of
$5,000,000 that was unused during June, or:
$5,000,000 .000208 = $1,040
Total bank charges = $51,040
Example 5.1: Revolving Credit
Agreement
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Clean Up Requirements
Theoretically a firm can constantly roll-
over its short-term debt
Borrow on a new note to pay off an old note
Risky for both firm and bank

Banks require that borrowers clean up
short-term loans once a year
Remain out of short-term debt for certain
time period


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Short-Term Credit Secured by
Current Assets

Debt is secured by the current assets
being financed ( accounts receivable and
inventory)

Common in seasonal businesses such as
retail


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Receivables Financing
Receivables Financing:
Lenders may extend credit backed by the
value of accounts receivable
Receivables may make excellent collateral:
Fairly liquid
Easy to recover in event of default
Collectibility of accounts is key issue
Common arrangements
PledgingFirm retains title
FactoringFirm sells A/R


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Pledging Accounts Receivable
Borrower uses A/R as collateral for a loan
Accounts Receivable still belong to borrower,
which still collects the accounts
Borrower promises to use collected accounts
to pay off loan
Lender can provide
General line of credit tied to all receivables
Specific line of credit tied to individual accounts
receivable
Lender generally charges interest at rates
over prime, plus an administrative fee.


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Example 5.2: Pledging Accounts
Receivable
Q: The Kilraine Quilt Company has an average receivables balance
of $100,000 which turns over once every 43 days. It generally
pledges all of its receivables to the Cooperative Finance
Company, which advances 75% of the total at 4% over prime
plus a 1.5% administrative fee.
If prime is 5%, what total financing rate is Kilraine effectively
paying for its receivables financing?

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Example 5.2: Pledging Accounts
Receivable

A: Average Receivables balance: $100,000
Average loan outstanding: 75% x $100,000 = $75,000
Interest rate: 5% + 4% = 9%
Receivables pledged in year: $100,000 x 365 / 50 = $730,000
Administrative fee: 1.5% x $730,000 = $10,950
% of the average loan balance:$10,950 / $75,000 = 14.6%
Annual financing cost: 9% + 14.6% = 23.6%
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Firm sells Accounts Receivable to lender
(at a severe discount) and lending firm
(factor) takes control of the accounts
Accounts receivable are now paid directly to
factor
Factor usually reviews accounts and only
accepts accounts it deems creditworthy


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Factors offer wide range of services
Perform credit checks on potential customers
Advance cash on accounts it accepts or remit
cash after collection
Collect cash from customers
Assume bad-debt risk when customers dont
pay


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Inventory Financing
Use firms inventory as collateral for a
short-term loan

Popular but subject to number of
problems
Lenders arent usually equipped to sell
inventory
Specialized inventories and perishable goods
are difficult to market


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Types of Inventory Financing
Blanket lienslender has a lien (claim) against all
inventories of borrower
Borrower remains in physical control of inventory

Trust receipt (chattel mortgage agreement)
collateralized inventory is identified by serial number
and cant be sold without lenders permission
Borrower remains in physical control of inventory

Warehousingcollateralized inventory is removed
from borrowers premises and placed in a warehouse
(borrowers access controlled by third party)
When inventory is sold, lender is informed to expect money
from borrower soon


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Money Market Instruments

Larger corporations may sell short-term
debt instruments in the money market
Another method to borrow to meet
temporary cash needs
Instruments include commercial paper,
bankers acceptances and
securitization of receivables


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Commercial Paper
Notes issued by large, financially-strong
firms and sold to investors
Unsecured (usually)
Buyers are usually other corporations and
financial institutions
Maturity is less than 270 days
Considered very safe investment, therefore
pays a relatively low interest rate (sold at a
discount)
No flexibility in repayment terms


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Commercial Paper
Annual Interest Rate on Discounted
Money Market Security

where M = Maturity (face) value of the security
P = Discounted price (net proceeds on issue)
d = Number of days to maturity
r = Annual interest rate
d
(M-P)
P

365
r =


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Bankers Acceptances
bankers acceptancecreated when a bank adds
guarantee of payment to the promissory note or
draft of the issuer (corporate borrower)
Issuer receives money from bank. Bank then sells
the bankers acceptance in the money market to an
investor.
At maturity, bank repays face value to the investor
and the issuer repays bank
Traded on a discount basis to yield interest rate
slightly lower than that of commercial paper
Usual terms are 30, 60, and 90 days.


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Securitization of Receivables
Sale of receivables by large firms in
public offerings arranged by securities
dealers
The issuing firm thus receives immediate
cash for future cash flows
Financing is raised at a relatively low
cost, often lower than prime or
commercial paper rate, because the issue
is asset-backed.

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