Short Term Financing

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Short Term Financing

• Instructor
• Lin Wen
• 2006

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Outline

• Short Term v. Long Term Financing
• Need For Short Term (S-T) Financing
• Types of S-T Financing
• Business Loans
• Trade Credit
• Commercial Paper
• Factoring
• Calculation Methods for S-T Financing
• Collateral Analysis
• Debt Service Analysis in S-T Financing

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Short Term v. Long Term Financing

• Short Term Financing
• Less than one (1) year period
• Long Term Financing
• More than one (1) year period

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Short Term v. Long Term Financing (Example)
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Why Short Term (S-T) Financing?

• Profits may not be sufficient to keep up with
  growth-related financing needs.
• Firms may prefer to borrow now for their needs
  rather than wait until they have saved enough.
• Short-term financing instead of long-term sources
  of financing due to
• easier availability
• usually lower cost

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Types of S-T Financing

• Business Loans
• Trade Credit
• Commercial Paper
• Factoring

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Business Loans
Concept Borrowing from banks or other financial
institutions for short and long term financing.
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Trade Credit
Concept Borrowing from suppliers

• Trade credit is the act of obtaining funds by
  delaying payment to suppliers.
• Even though it is obtained by simply delaying
  payment, it is not always free.
• The cost of trade credit may be some interest
  charge that the supplier charges on the unpaid
  balance. More often, it is in the form of a lost
  discount that would be given to firms who pay
  earlier.
• Credit has a cost. That cost may be passed along
  to the customer as higher prices, absorbed by the
  seller as lower profits, or some of both.

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Commercial Paper

• Concept Available to large credit- worthy
  businesses.
• Business issues notes to the public and finances
  its short term needs
• Notes can be issued between 30 days and 360 days
• Principal and interest is due by the end of
  maturity

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Factoring
Concept Borrowing from factoring companies by
selling Accounts Receivables arising from sales

• Factoring companies collect the interest in
  advance
• Flat fee is paid in advance
• Flat fee covers administrative expenses for A/Rs
• Factoring agreements can be With-Recourse or
  Without-Recourse
• Without-Recourse agreements are costly than
  With-Recourse ones (High risk, High premium)

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Factoring

• With Recourse
• Factoring company is not responsible to collect
• delinquent receivables
• Without Recourse
• Factoring company has to collect delinquent
• accounts

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Interest Rate Calculations
I---------------------t days----------------------
-------------------?
Net Amount
Final Payment of Financing
Interest for t days Final Payment Net
Amount of Financing Final Payment- Net
Amount of Financing Interest for t days
--------------------------------------------------
- Net Amount of Financing
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Interest Rate Calculations (Example)
I---------------------30 days---------------------
------------------?
1,000
1,010
Interest for 30 days 1,010 1,000
10 1,010 1,000
Interest for 30 days ---------------------
1,000
1 (for 30 days only!!!)
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Simple Interest v. Compound Interest

• Simple Annual Interest
• (Final Payment- Net Amount of Financing) 360
• -------------------------------------------------
  -- X --------
• (Net Amount of Financing)
  t
• (1,010 1,000) 360
• Example ------------------- X ---------
  12
• 1,000
  30

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Simple Interest v. Compound Interest
Concept Effective Interest Rate is used to
determine the cost of the credit to be able to
compare differing terms.

• Effective (Compound) Annual Interest
• Final Payment
• ----------------------------------
  - 1
• Net Amount of Financing
• 1,010
• Example ------------------- - 1
  1.1268 - 1
• 1,000
• 0.1268 or 12.68

360 t
360 30
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Coffee Time
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Interest Calculation Methods S-T
FinancingBusiness Loans

• In terms of payment method, business loans are
• classified as
• Term Loans Principal and Interest monthly
• (Usually for long term financing, however,
  in some cases, it can be used for short term
  financing)
• Line of Credits Interest monthly
• (Common use is for short term financing and
  sometimes lenders require that a minimum amount,
  called a compensating balance be kept in the bank
  account.)

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Interest Calculation Methods S-T
FinancingBusiness Loans

• Term Loan Interest Calculation
• First Step Monthly Payment Calculation
• Loan Amount
• Monthly Pmt ________________________
• 1
• 1- ________________
• Interest Rate n OR
  EXCEL FUNCTION
• 1 ____________
• 12
• ___________________
• Interest Rate
• _____________ n Number of months
• 12
•  
•  

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Term Loan Monthly Payment Calculation
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Interest Calculation Methods S-T
FinancingBusiness Loans

• Second Step Interest paid
• Interest Paid
• (Monthly Pmt X Number of Months) (Loan Amount)
• Third Step Interest Paid (Annual)
• (Monthly Pmt X Number of Months) (Loan Amount)
• Loan Amount_______________
• Number of Years

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Interest Calculation Methods S-T
FinancingIllustration

• Purchasing CNC Equipment of 10,000 with business
  term loan.
• 5-interest 5-year term (60 months)
• First Monthly Payment Calculation
• By using the formula, monthly payment is
  calculated at 188.71
• Second Interest calculation
• Interest Paid
• (188.71 X 60 months) (10,000)
  1,322.60
• Interest Paid (Annual)
• (188.71 X 60 months) (10,000)
  2.64
• 10,000 ____________
  
• 5 years

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Interest Calculation Methods S-T
FinancingBusiness Loans

• Line of Credit Interest Calculation
• Since some lenders require borrowers to keep a
• minimum amount in the bank account, called
• compensating balance, interest rate calculation
  should
• take into consideration this balance. Formula for
  the
• effective cost is shown as follows
• Interest Paid / (Loan Amount Comp. Balance)

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Interest Calculation Methods S-T
FinancingBusiness Loans

• Example
• Annual simple real cost for a line of credit of
  30,000
• with simple interest of 5 and a 5,000
  compensating
• balance is
• 1,500 /(30,000-5,000) 6 (real cost)
• Assumed the line is fully utilized.

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Mechanism of Trade Credit

• Typically receive a discount accounts payable
  early.
• Stated as 2/10, net 60 Purchaser receives a 2
  discount if pay within 10 days of receiving
  invoice, otherwise due within 60 days.
• The cost is in the form of the lost discount.

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Mechanism of Trade Credit

• Assume your purchase is 100 list.
• If you take the discount, you pay 98.
• If you dont take the discount, you pay 100.
• Therefore, you are paying 2 for the privilege of
  
• borrowing 98 for the additional 50 days.
• (Note the first 10 days are free in this
  example).

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Interest Calculation Methods S-T FinancingTrade
Credit
Day 0 Day 10
Day 60
98
98 2

• The exponent is the number of times per year the
  firm can take 50 days of credit.
• The cost of trade credit for 2/10 net 60 1
  (2/98))7.2 -1 15.66.

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Interest Calculation Methods S-T
FinancingFactoring (Discount Loan)

• Must pay the interest up front so that reduces
  the
• dollars available to use.
• Illustration
• 9 Discount
• 20 Flat Fee
• 10,000 x 9 x 90days 20
• 360 days
• 225 20 245
• 245/(10,000-245)4
• 10.04 ( Real Cost)

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Case Analysis
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Debt Service Coverage Analysis in S-T
Financing(Eligibility Criteria for business
loans)

• Lenders also calculates debt service coverage
  ratio before they give loan to businesses. Since
  each lender has different minimum requirements
  for this ratio, the calculation methods are
  identical.
• If the business cash flow is eligible under
  lenders debt service coverage criteria, the
  lender usually grants the loan.

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Debt Service Coverage Analysis in S-T Financing
(Example)
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Debt Service Coverage Analysis in S-T Financing
(Example)

• If the lender requires minimum debt
• service coverage ratio of 1.2x from the
• borrower, Neptune Inc. is eligible to get
• the loan with a higher debt service
• coverage ratio, 2.58x.

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Mini Case
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