Chapter 9

Short-term Debt

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Learning Objectives

 Overview of the characteristics of various forms of short-term

debt
– Main types
• Trade credit, bank overdraft, commercial and bank-accepted bills,
promissory notes, negotiable certificates of deposit, inventory
accounts receivable and factoring
 Calculations relevant to discount securities

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9.1 Short Term Debt

 Short-term debt is a financing arrangement for a period of less

than one year with various characteristics to suit borrowers’
particular needs

– Timing of repayment, risk, interest rate structures (variable or

fixed) and the source of funds

 Matching principle

– Short-term assets should be funded with short-term liabilities

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Chapter Organisation

9.1 Trade Credit

9.2 Bank Overdrafts
9.3 Commercial Bills
9.4 Calculations: Discount Securities
9.5 Promissory Notes
9.6 Negotiable Certificates of Deposit
9.7 Inventory Finance, Accounts Receivable Financing and
Factoring
9.8 Summary

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9.1 Trade Credit

 A supplier provides goods or services to a purchaser with an

arrangement for payment at a later date

 Often includes a discount for early payment (e.g. 2/10, n/30, i.e.
2% discount if paid within 10 days, otherwise the full amount is
due within 30 days)

 From provider’s perspective

– Advantages include increased sales
– Disadvantages include costs of discount and increased discount
period, increased total credit period and accounts receivable,
increased collection and bad debt costs

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9.1 Trade Credit (cont.)

 The opportunity cost of the purchaser forgoing the discount on an

invoice (1/7, n/30) is:
% discount 365
Opportunity cost  
100  % discount days difference between
early and late settlement
1.0 365 (9.1)
 
99.0 23
 0.160298 or 16.03% p.a.

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When is it beneficial to pay early?

 when the purchasing company can obtain funds at an after-tax

rate of less than the opportunity cost
 When the surplus cash that has alternative uses has less return
(after tax rate) than the opportunity cost
9.2 Bank Overdrafts

 Major source of short-term finance

 Allows a firm to place its cheque (operating) account into deficit,

to an agreed limit

 Generally operated on a fully fluctuating basis

 Lender also imposes an establishment fee, monthly account

service fee and a fee on the unused overdraft limit

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9.2 Bank Overdrafts (cont.)

 Interest rates negotiated with bank at a margin above an

indicator rate, reflecting the borrower’s credit risk
• Financial performance and future cash flows
• Length of mismatch between cash inflows and outflows
• Adequacy of collateral

 Indicator rate typically a floating rate based on a published

market rate, e.g. BBSW

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9.3 Commercial Bills

 A bill of exchange is a discount security issued with a face value

payable at a future date
 A commercial bill is a bill of exchange issued to raise funds for
general business purposes
 A bank-accepted bill is a bill that is issued by a corporation and
incorporates the name of a bank as acceptor

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9.3 Commercial Bills (cont.)

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9.3 Commercial Bills (cont.)
 Features of commercial bills—parties involved (bank-
accepted bill)

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9.3 Commercial Bills (cont.)

 Features of commercial bills—parties involved (bank-accepted

bill) (cont.)

– Drawer
• Issuer of the bill
• Secondary liability for repayment of the bill (after the acceptor)

– Acceptor
• Undertakes to repay the face value to the holder of the bill at maturity
• Acceptor is usually a bank or merchant bank

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9.3 Commercial Bills (cont.)

 Features of commercial bills—parties involved (bank-accepted bill)

(cont.)

– Payee
• The specified party to whom the bill is to be paid, i.e. the party who
receives the funds
• Usually the drawer, but the drawer can specify some other party as
payee

– Discounter
• The party that discounts the face value and purchases the bill
• The provider or lender of the funds
• May also be the acceptor of the bill

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9.3 Commercial Bills (cont.)

 Features of commercial bills—parties involved (bank-accepted

bill) (cont.)

– Endorser
• The party that was previously a holder of the bill
• Signs the reverse side of the bill when selling, or discounting, the bill
• Order of liability for payment of the bill runs from acceptor to drawer
and then to endorser

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9.3 Commercial Bills (cont.)

 The flow of funds (bank-accepted bills)

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9.3 Commercial Bills (cont.)

 The flow of funds – ALTERNATIVELY…

– A bill can be drawn by the bank and accepted by the borrower

– The bank is both drawer and discounter of the bill

• If the bank rediscounts a bill (sells to a third party), the bank becomes
the endorser, creating a bank-endorsed bill

– Funds are lent to borrower as payee

– At maturity date the borrower, as acceptor of the bill, is liable to

pay face value to the holder of the bill

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9.3 Commercial Bills (cont.)

 Establishing a bill financing facility

– Borrower approaches bank or merchant bank

– Assessment made of borrower’s credit risk

– Credit rating of borrower affects size of discount

– Maturity usually 30, 60, 90, 120 or 180 days

– Minimum face value usually $100 000

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9.3 Commercial Bills (cont.)

 Advantages of commercial bill financing

– Lower cost than other short-term borrowing forms, i.e. overdraft,

fully-drawn advances
– Borrowing cost (yield) determined at issue date (not affected by
subsequent changes in interest rates)
– A bill line
• Arrangement with a bank where it agrees to discount bills
progressively up to an agreed amount
– Term of loan may be extended by ‘rollover’ at maturity
 A bank provides both a bill acceptance facility and a bill discount
facility

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Chapter Organisation

9.1 Trade Credit

9.2 Bank Overdrafts
9.3 Commercial Bills
9.4 Calculations: Discount Securities
9.5 Promissory Notes
9.6 Negotiable Certificates of Deposit
9.7 Inventory Finance, Accounts Receivable Financing and
Factoring
9.8 Summary

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9.4 Calculations: Discount Securities

 Calculations considered

– Calculating price—yield known

– Calculating face value—issue price and yield known

– Calculating yield

– Calculating price—discount rate known

– Calculating discount rate

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Calculating price—yield known (cont.)

 An alternative formula for calculating price

(9.3)

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Calculating price—yield known (cont.)
 Example 3: A company decides to fund its short-term inventory
needs by issuing a 30-day bank-accepted bill with a face value of
$500 000. Having approached two prospective discounters, the
company has been quoted yields of 9.52% per annum and 9.48%
per annum. Which quote should the company accept, and what
amount will the company raise?

$500 000  365

 $496 118.04
365  (0.0952  30)
or
$500 000  365
 $496 134.23
365  (0.0948  30)

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Calculating face value—issue price and yield
known

yield
365  (  days to maturity)
Face value  price[ 100 ]
365

(9.4)

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Calculating face value—issue price and yield known
– Example 4: A company needs to raise additional funding of $500
000 to purchase inventory. The company has decided to raise the
funds through the issue of a 60-day bank-accepted bill rollover
facility. The bank has agreed to discount the bill at a yield of
8.75%. At what face value will the initial bill be drawn?

365  (0.0875  60)

Face value  $500 000[ ]
365
 $507 191.75

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Calculating yield

(sell price - buy price) (days in year  100)

Yield  
buy price days to maturity

(9.5)

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Calculating yield (cont.)
– Example 7: In Example 3, a company issued a 30-day bank-accepted bill with
a face value of $500 000. The bill was discounted at a yield of 9.48% per
annum, representing a price of $496 134.23. After seven days the discounter
sells the bill in the short-term money market for $497 057.36. The bill is not
traded again in the market. Calculate the yield to the original discounter and to
the holder at maturity.
Yield to original discounter:

(497 057.36  496 134.23) 36 500

  9.70%
496 134.23 7
Yield to holder at maturity:

(500 000.00  497 057.36) 36 500

  9.39%
497 057.36 23

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Question 1

 A company issues a bank-accepted bill to fund a short-term

business project. The bill is issued for ninety days, with a
face value of $100 000 and a yield of 9.50 per cent per
annum. What amount will the company raise to fund the
project?
 The company, in issuing a discount security, will raise less than
the face value of the bill. The amount raised, or the ‘price’ of the
bill is:
 
= ($100 000 × 365) / (365 + {0.095 × 90})
= $36 500 000 / 373.55
= $97 711.15
Question 2

 After twenty-seven days, the bank bill in Question 6 is sold

by the original discounter into the money market for $98
380.15. The purchaser holds the bill to maturity. What is the
return to:
(a) the original discounter?
(b) the holder at maturity?
solution

 The original discounter does not need to hold the bill to maturity.
There is an active secondary market in which the bill may be
sold. Yields in this market will change, therefore both the original
discounter, and the new purchaser of the bill, will need to
determine their respective yields for the period they each hold
the bill.
 (a) Yield to original discounter: 
yield = [($98 380.15 – $97 711.15) / $97 711.15] × [36 500 / 27]
= 9.2557%
 (b) Yield to holder at maturity:
yield = [($100 000 – $98 380.15) / $98 380.15] × [36 500 / 63]
= 9.5394%
Calculating price—discount rate known

days to maturity discount rate

Price  face value * [1  ]
days in year 100

(9.6)

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Discount rate versus Yield

 The discount rate is expressed in terms of the face value of the

security, while the yield is expressed in terms of the
purchase price, or current price.
 The securities are identical, yet the discount rate and yield differ.
 It is therefore important to be certain which calculation is being
used.
Calculating price—discount rate known (cont.)

– Example 8: The price of a 180-day bill, with a face value of $100

000, selling at a discount of 14.75%, would be:
180
Price  $100 000[1 -  0.1475]
365
 $100 000(1 - 0.0727)
 $92 726.03

– The discount in this formula is effectively the rate of return to the

buyer of the bill (or the cost of funds to the drawer of the bill),
expressed as a percentage per annum, in relation to the face
value of the bill.

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Calculating discount rate

face value - current price days in year  100

Discount rate  
face value days to maturity

(9.7)

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Calculating discount rate (cont.)
– Example 9: A 180-day bill with a face value of $100 000 and
selling currently at $92 000, with a full 180 days to run to maturity,
has a discount rate of:

(100 000 - 92 000  36 500

Discount rate  
100 000 180
 0.08  202.778
 16.22%

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Chapter Organisation

9.1 Trade Credit

9.2 Bank Overdrafts
9.3 Commercial Bills
9.4 Calculations: Discount Securities
9.5 Promissory Notes
9.6 Negotiable Certificates of Deposit
9.7 Inventory Finance, Accounts Receivable Financing and
Factoring
9.8 Summary

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9.5 Promissory Notes

 Also called P-notes or commercial paper, they are discount

securities, issued in the money market with a face value payable
at maturity but sold today by the issuer for less than face value

 Typically available to companies with an excellent credit

reputation because:

– there is no acceptor or endorser

– they are unsecured instruments

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9.5 Promissory Notes (cont.)

 Calculations—use discount securities formulae

 Issue programs
– Usually arranged by major commercial banks and money market
corporations
– Standardised documentation
– Revolving facility
– The lead manager and a dealer panel
– Most P-notes are issued for 90 days

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9.5 Promissory Notes (cont.)

 Underwritten issues
– Underwriting guarantees the full issue of notes is purchased and
typical fee is 0.1% per annum
– Underwriter is usually a commercial bank, investment bank or
merchant bank
– The underwritten issue can incorporate a rollover facility,
effectively extending the borrower’s line of credit beyond the short-
term life of the P-note issue

 Issues may also be non-underwritten

– Issuer may approach money market directly
– Commercial bank, investment bank or merchant bank may be
retained as lead manager and receive fees

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Chapter Organisation

9.1 Trade Credit

9.2 Bank Overdrafts
9.3 Commercial Bills
9.4 Calculations: Discount Securities
9.5 Promissory Notes
9.6 Negotiable Certificates of Deposit
9.7 Inventory Finance, Accounts Receivable Financing and
Factoring
9.8 Summary

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9.6 Negotiable Certificates of Deposit

 Short-term discount security issued by banks to manage their

liabilities and liquidity

 Maturities range up to 180 days

 Issued to institutional investors in the wholesale money market

 The short-term money market has an active secondary market in

CDs

 Calculations—use discount securities formulae

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Chapter Organisation

9.1 Trade Credit

9.2 Bank Overdrafts
9.3 Commercial Bills
9.4 Calculations: Discount Securities
9.5 Promissory Notes
9.6 Negotiable Certificates of Deposit
9.7 Inventory Finance, Accounts Receivable Financing and
Factoring
9.8 Summary

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9.7 Inventory Finance, Accounts Receivable Financing
and Factoring

 Inventory finance

– Most common form is ‘floor plan finance’

– Particularly designed for the needs of motor vehicle dealers to

finance their inventory of vehicles
• Bailment common—finance company holds title to dealership’s stock

– Dealer is expected to promote financier’s financial products

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9.7 Inventory Finance, Accounts Receivable Financing
and Factoring (cont.)

 Accounts receivable finance

– A loan to a business secured against its accounts receivable

(debtors)

– Mainly supplied by finance companies

– Lending company takes charge of a company’s accounts

receivable; however, the borrowing company is still responsible for
the debtor book and bad debts

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 9.7 Inventory Finance, Accounts Receivable Financing
and Factoring (cont.)

 Factoring

– Company sells its accounts receivable to a factoring company

• Converting a future cash flow (receivables) into a current cash flow

– Factoring provides immediate cash to the vendor; plus it removes

administration costs of accounts receivable

– Main providers of factor finance are the finance companies

– Factor is responsible for collection of receivables

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9.7 Inventory Finance, Accounts Receivable Financing
and Factoring (cont.)

 Factoring (cont.)

– Notification basis: vendor is required to notify its (accounts

receivables) customers that payment is to be made to the factor

– Recourse arrangement
• Factor has a claim against the vendor if a receivable is not paid

– Non-recourse arrangement
• Factor has no claim against vendor company

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9.8 Summary

 Short-term debt is appropriate for funding short-term assets

(matching principle)
 Trade credit—simple and common
 Bank overdraft—common
 Discount securities
– Bill financing—important source of funds
– Promissory notes (P-notes)—good credit rating required
– Certificates of deposit (CDs)—issued by banks to manage
liabilities and liquidity
 Inventory loans, accounts receivable finance and factoring—
alternative sources of finance for small and medium-sized
businesses (SMEs)

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