CHAPTER 14

MANAGING
SHORT-TERM
FINANCING
(LIABILITIES)

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 Learning Outcomes
LO.1 Describe working capital management.
LO.2 Describe the cash conversion cycle and
how it can be used to better manage
working capital activities.
LO.3 Describe the policies that a firm might
follow when financing current assets.

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 Learning Outcomes (cont.)
LO.4 Describe the characteristics of different
sources of short-term credit, including (a)
accruals, (b) trade credit, (c) bank loans, (d)
commercial paper, and (e) secured loans.
LO.5 Discuss and compute the cost (both APR
and EAR) of short-term credit.
LO.6 Describe how working capital management
differs in multinational firms compared to
purely domestic firms.
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 Working Capital Management
○ The management of short-term (ST) assets
(ST investments) and short-term (ST)
liabilities (ST financing sources).
○ Net Working Capital =
 Current assets - current liabilities
 Amount of current assets financed by long-
term liabilities

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 Working Capital Management
○ Working Capital Policy
 Target levels for each current asset account
 How current assets will be financed
○ Working capital only includes current
liabilities that are specifically used to finance
current assets.

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 The Cash Conversion Cycle

○ The length of time from the payment for

purchases of raw materials used to
manufacture a product until the collection
of accounts receivable associated with the
sale of the product.
 Inventory conversion period (ICP)

 Receivables collection period (DSO)

 Payables deferral period (DPO)

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 The Inventory Conversion Period
(ICP)
○ Length of time required to convert materials into
finished goods and then to sell those goods.
○ The amount of time the product remains in
inventory in various stages of completion.
Inventory Inventory
ICP  
Cost of goods sold per day Cost of goods sold
 360 days 
360 days 360 days
 
 Cost of goods sold
Inventory  Inventory turnover

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 The Receivables Collection
Period (DSO)
○ Average length of time required to convert the
firm’s receivables into cash; also called days sales
outstanding (DSO)

Receivables Receivables
DSO  
Daily credit sales Annual credit sales
360 days  
360 days 360 days
 
 Annual credit sales
Receivables
Receivables turnover 

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 The Payables Deferral Period
(DPO)
○ Average length of time between the purchase of
raw materials and labor and the payment of cash
for them.
Accounts payable Payables
DPO  
Daily credit purchases Cost of goods sold
 360 days 
360 days 360 days
 
 Cost of goods sold
Payables  Payables turnover

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 The Cash Conversion Cycle
○ Average length of time a dollar is tied up in
current assets.

Cash
conversion  ICP + DSO – DPO
cycle

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 The Cash Conversion Cycle for Unilate
Textiles

Inventory Conversion Receivables Collection

Period (79.0 days) Period (43.2 days)

Payables
Deferral Cash Conversion Cycle
Period (79.0 days + 43.2 days – 8.8 days = 113.4 days)
(8.8 days)

Purchase Raw Pay for Raw Sell Finished Goods Collect Accounts
Materials—Increase Materials —Increase Accounts Receivable
Accounts Payable Receivable

(CASH OUT) (CASH IN)

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 Current Asset Financing Policies
○ Basic question: How should current assets
be financed?
○ Permanent current assets versus temporary
current assets:
 Permanent CA—level that remains stable no
matter seasonal or economic conditions (some
minimum level of CA).
 Temporary CA—level that fluctuates according
to seasonal or economic conditions.

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 Alternative Current Asset Financing
Policies
○ Maturity Matching Approach
○ Conservative Approach
○ Aggressive Approach

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 Alternative Current Asset Financing
Policies—Maturity Matching Approach
○ “Self-liquidating”, because the idea is to
match liabilities’ maturities with assets’
maturities.
○ If maturities can be matched, the firms that
use this approach should not have difficulty
paying maturing obligations.
○ Some assets’ lives are uncertain.
○ Moderate approach.
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 Alternative Current Asset Financing
Policies—Maturity Matching Approach
Dollars

Short-Term
Nonspontaneous Debt
Financing

Temporary Permanent Level Long-Term Debt and

Current Assets of Current Assets Equity plus Spontaneous
Current Liabilities
Total
Permanent
Assets Fixed Assets

1 2 3 4 Time
5 6 7 8

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 Alternative Current Asset Financing
Policies—Conservative Approach
○ Use permanent (long-term) capital to finance
all permanent assets and some seasonal,
temporary needs.
○ Use spontaneous, short-term debt to finance
the rest of the temporary assets (seasonal
needs).
○ Store liquidity during the off season.
○ Least profitable, but also least risky approach
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 Alternative Current Asset Financing
Policies—Conservative Approach
Dollars Short-Term
Marketable Nonspontaneous Debt
Securities Financing

Temporary Permanent Level Long-Term Debt and

Current Assets of Current Assets Equity plus Spontaneous
Current Liabilities
Total
Permanent
Assets Fixed Assets

1 2 3 4 Time
5 6 7 8

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 Alternative Current Asset Financing
Policies—Aggressive Approach
○ Finance all temporary assets with short-
term, spontaneous debt, and finance all
fixed assets and some permanent assets
with long-term, non-spontaneous funds.
○ Riskiest approach.
○ Most profitable approach.

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 Alternative Current Asset Financing
Policies—Aggressive (Somewhat)
Approach
Dollars
Temporary
Current Assets Short-Term
Nonspontaneous Debt
Financing

Temporary Permanent Level

Current Assets of Current Assets Long-Term Debt and
Equity plus Spontaneous
Total Current Liabilities
Permanent
Assets Fixed Assets

1 2 3 4 Time
5 6 7 8

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 Using Short-Term Financing
○ Maturity—short-term debt generally is
defined as a liability originally scheduled for
repayment within one year.
○ Speed—a short-term loan can be obtained much
faster than long-term credit.
○ Cost—short-term debt generally is less expensive
(interest rate is lower) than long-term debt.
○ Risk—short-term debt is considered riskier than
long-term debt.

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 Sources of Short-Term Financing
○ Accruals
 Continually recurring short-term liabilities.
 Liabilities, such as wages and taxes, that
increase spontaneously with operations.
○ Accounts Payable (Trade Credit)
 Credit created when one firm buys on credit
from another firm.

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 Sources of Short-Term Financing
(cont.)
○ Short-Term Bank Loans
 Maturity typically 90 days or less
 Promissory notes specify terms and conditions,
including amount, interest rate, repayment
schedule, collateral, and any other
agreements.

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 Sources of Short-Term Financing
(cont.)
○ Short-Term Bank Loans
 Compensating Balance (CB) of 10 to 20 percent
might be required to be maintained in a
checking account.
 Line of credit (LOC) can be arranged—specified
maximum amount of funds available
• Revolving line of credit—line of credit where
funds are committed
 Commitment fee—fee charged on the unused
balance of a revolving credit agreement

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 Sources of Short-Term Financing
(cont.)
○ Commercial Paper
 Unsecured short-term promissory notes (IOUs)
issued by large, financially sound firms to raise
funds.
 Discounted financial instrument—investors
purchase for less than face value.
 Maturity is 270 days or less.

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 Sources of Short-Term Financing
(cont.)
○ Secured Loans (collateralized)
 Generally secured by short-term assets,
especially accounts receivable and inventory.
 Loan will not be for 100 percent of asset’s
value.
 Accounts receivable financing:
• Pledging receivables—receivables are used as
collateral for loans.
• Factoring receivables—receivables are sold to
a factor.
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 Sources of Short-Term Financing
(cont.)
○ Secured Loans (collateralized)
 Inventory financing:
• Blanket lien—lien against all inventory;
generally used when inventory is low-priced,
fast moving.
• Trust receipt—inventory held in trust for
lender; items can be identified by serial
numbers or some other unique feature.
• Warehouse receipt—inventory used as
collateral is physically separated from
borrower’s other inventory.
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 Computing the Cost of Short-term
Credit
○ First, compute the cost of using the funds
for a given period, rPER

 $ cost of 
 
Percentage cost borrowing
 rPER   
per period  $ amount of 
 
 usable funds 

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 Computing the Cost of Short-term
Credit (cont.)
○ Using rPER, compute the EAR and APR:

EAR  rEAR  1  rPER   1.0

m

APR = rPER × m = rSIMPLE

○ m = the number of borrowing periods in

one year
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 Computing the Cost of Short-term
Credit—Example: Trade Credit
○ Suppose a firm buys on credit from its supplier
with terms of 2.5/10 net 40.
○ If the firm purchases products with an invoice
price of $100, its effective price is $97.50 because
it receives a $2.50 discount for paying on Day 10
of the billing cycle.
○ If the firm pays on Day 40, effectively, it would pay
$2.50 interest on a 30-day loan in the amount of
$97.50.

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 Computing the Cost of Short-term
Credit—Example: Trade Credit
○ Suppose a firm buys on credit from its supplier
with terms of 2.5/10 net 40.
0.025 0.025
rPER    0.025641  2.56% per 30-day period
1  0.025 0.975

 360 
APR  2.56%     2.56%  12  30.72%
 30 
 360 
 30 
EAR  rEAR  (1  0.0256)   1  0.3544  35.44%

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 Computing the Cost of Short-term
Credit—Example: Bank Loan
○ Suppose a firm borrows $50,000 at 9 percent for
three (3) months (90 days).
○ Simple interest loan—both the principal and
interest are paid at maturity

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 Computing the Cost of Short-term
Credit—Example: Bank Loan
○ Suppose a firm borrows $50,000 at 9 percent for
three (3) months (90 days).
○ Simple interest loan
  3 
$50,000  0.09    
  12   $1,125
rPER    0.0225  2.25%  3  month
$50,000 $50,000 int erest rate

 12 
APR  2.25%     9.00%
 3 
 12 
 3 
EAR  rEAR  (1  0.0225)   1  0.931  9.31%
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 Computing the Cost of Short-term
Credit—Example: Bank Loan
○ Suppose a firm borrows $50,000 at 9 percent for
three (3) months (90 days).
○ Discount interest loan—interest is paid “up front”
  3 
$50,000  0.09    
  12   $1,125
rPER    0.0230  2.30%  3  month
 int erest rate
  3    $48,875
$50,000  $50,000  0.09     
   12   

APR  2.30%  4  9.20%

EAR  rEAR  (1  0.0230)4  1  0.0952  9.52%

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 Computing the Cost of Short-term
Credit—Example: Bank Loan
○ Suppose a firm borrows $50,000 at 9 percent for
three (3) months (90 days).
○ Installment loan—interest is “added on,” and both
the interest and the principal are paid back in
equal installments.
○ Repayment period = 3 months

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 Computing the Cost of Short-term
Credit—Example: Bank Loan
○ Suppose a firm borrows $50,000 at 9 percent for
three (3) months (90 days).
○ Installment loan
$1,125  12 
APR      18.00%
 $50,000
2   3 

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 Computing the Cost of Short-term
Credit—Example: Bank Loan
○ Suppose a firm borrows $50,000 at 9 percent for
three (3) months (90 days).
○ Installment loan
Monthly $50,000  $1,125
  $17,041.67
payment 3

Using a financial calculator, compute the monthly rate:

N = 3; PV = 50,000; PMT = -17,041.67; FV = 0; I/Y = ? = 1.12%

EAR  rEAR  (1  0.0112)12  1  0.1430  14.30%

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 Computing the Cost of Short-term
Credit—Example: Commercial Paper
○ Suppose a firm issues 3-month commercial paper
with a $50,000 face value and a 9 percent
interest. Transactions fees are 0.5 percent of the
issue amount.
○ Discount instrument
 12 
Discount  $50,000(0.09)     $1,125
 3 
Transaction
 $50,000(0.005)  $250
fees

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 Computing the Cost of Short-term
Credit—Example: Commercial Paper
○ Suppose a firm issues 3-month commercial paper
with a $50,000 face value and a 9 percent
interest. Transactions fees are 0.5 percent of the
issue amount.
$1,125  $250 $1,375
rPER    0.0283  2.83%  3  month
$50,000  ($1,125  $250) $48,625 int erest rate

 12 
APR  2.83%     11.32%
 3 
 12 
 3 
EAR  rEAR  (1  0.0283)   1  0.1181  11.81%
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 Principal Amount versus
Required Amount
○ Suppose a firm needs $50,000 to support
operations. The firm plans to raise the funds by
borrowing from the bank. The loan would be for
three months, its interest rate would be 9
percent, and a 20 percent compensating balance
would be required. The firm has no money in the
bank.
○ To use $50,000, the firm must borrow more than
$50,000, because some of the loan must be put in
the compensating balance.
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 Principal Amount versus
Required Amount
○ Firm needs $50,000; interest is 9 percent;
compensating balance requirement is 20 percent
of the amount borrowed.
Pr incipal Usable funds $50,000
   $62,500
amount  % reductions from  1-0.20
1-  
 principal amount 

○ If the firm borrows $62,500, it will be able to use

$50,000 = $62,500( 1 – 0.2) after satisfying the
compensating balance requirement
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 Principal Amount versus
Required Amount
○ Firm needs $50,000; interest is 9 percent;
compensating balance requirement is 20 percent
of the amount borrowed.
  3 
$62,500  0.09    
  12   $1,406.25
rPER    0.0281  2.81%
$62,500  $62,500(0.20) $50,000

 12 
APR  2.81%     11.24%
 3 
 12 
 3 
EAR  rEAR  (1  0.0281)   1  0.1172  11.72%
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 Multinational Working Capital
Management
○ How Working Capital Policies of U.S. Firms
Differ from European Firms:
 Average cash conversion cycle of European
firms more than twice that of U.S. firms.
 U.S. firms follow more conservative working
capital policies than European firms do.

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