Chapter 20: Short Term Financing

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Learning Objectives

• The need for short-term financing.
• The advantages and disadvantages of short-term
  financing.
• Three types of short-term financing.
• Computation of the cost of trade credit,
  commercial paper, and bank loans.
• How to use accounts receivable and inventory as
  collateral for short-term loans.

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Why Do Firms Need Short-term Financing?

• Cash flow from operations may not be sufficient
  to keep up with growth-related financing needs.
• Firms may prefer to borrow now for their
  inventory or other short term asset needs rather
  than wait until they have saved enough.
• Firms prefer short-term financing instead of
  long-term sources of financing due to
• easier availability
• usually has lower cost (remember yield curve)
• matches need for short term assets, like inventory

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Sources of Short-term Financing

• Short-term loans.
• borrowing from banks and other financial
  institutions for one year or less.
• Trade credit.
• borrowing from suppliers
• Commercial paper.
• only available to large credit- worthy businesses.

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Types of short-term loans

• Promissory note
• A legal IOU that spells out the terms of the loan
  agreement, usually the loan amount, the term of
  the loan and the interest rate.
• Often requires that loan be repaid in full with
  interest at the end of the loan period.
• Usually with a Bank or Financial Institution
  occasionally with suppliers or equipment
  manufacturers

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Types of short-term loans

• Line of Credit (Overdraft Facility)
• The borrowing limit that a bank sets for a firm
  after reviewing the cash budget.
• The firm can borrow up to that amount of money
  without asking, since it is pre-approved
• Usually informal agreement and may change over
  time
• Usually covers peak demand times, growth
  spurts, etc.

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Trade Credit

• Trade credit is the act of obtaining funds by
  delaying payment to suppliers, who typically
  grant 30 days to pay.
• 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, (furniture
  sales, Office Max), or borne by the seller as
  lower profits, or some of both.

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Estimation of Cost of Short-Term Credit

• Calculation is easiest if the loan is for a one
  year period
• Effective Interest Rate is used to determine the
  cost of the credit to be able to compare
  differing terms.

Example You borrow 10,000 from a bank, at a
stated rate of 10, and must pay 1,000 interest
at the end of the year. Your effective rate is
the same as the stated rate 1,000/10,000
.10 10
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Variations in Loan Terms

• Sometimes lenders require that a minimum amount,
  called a compensating balance be kept in your
  bank account. It is taken from the amount you
  want to borrow.
• If your compensating balance requirement is 500,
  then the amount you can use is reduced by that
  amount.
• Effective Rate (APR) for a 10,000 simple
  interest 10 loan with a 1,000 compensating
  balance 1,000/(10,000-1,000) .1111
  11.11. (1.11 more)

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Cost of Short Term Credit

• Cost of Trade Credit
• Typically receive a discount if you pay early.
• Stated as 2/10, net 60
• Purchaser receives a 2 discount if payment is
  made within 10 days of the invoice date,
  otherwise payment is due within 60 days of the
  invoice date.
• The cost is in the form of the lost discount if
  you dont take it.

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Calculating Annual Rate (APR)

• Interest Rate x Principle x Time
• i.e. Int 6 x 1,000 x 90/360 15
• APR Interest (cost) x 1
• Net Borrowed Time
• APR 15 x 1 / 90 1.5 x 4
  6.0
• 1,000 360
• Say you have a loan fee of 5.00, then
• APR 15 5 x 1/90 2.0 x 4 8.0
• 1,000 360

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Cost of Trade Credit 2/10 net 60

• Assume your purchase is 100 list price.
• If you take the discount, you pay only 98. If
  you dont take the discount, you pay 100.
• Therefore, you (buyer) are paying 2 for the
  privilege of borrowing 98 for the additional 50
  days. (Note the first 10 days are free in this
  example).
• APR 2/98 x 365/50 14.9 (If you pay in 60
  days)
• What if 2/10, net 30
• APR 2/98 x 365/20 37.25! (If you pay in
  30 days)

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Accounts Receivable as Collateral

• A pledge is a promise that the borrowing firm
  will pay the lender any payments received from
  the accounts receivable collateral in the event
  of default.
• Since accounts receivable fluctuate over time,
  the lender may require certain safeguards to
  ensure that the value of the collateral does not
  go below the balance of the loan.
• So, normally a bank will only loan you 70 -75 of
  the receivable amount
• Accounts receivable can also be sold outright.
  This is known as Factoring or Forfeiting.

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Cost of Borrowing against Receivables

• Average monthly sales 100,000
• 60 day terms, so average AR balance 200,000
• Bank loans 70 of AR 140,000
• Interest is 3 over prime (say 8) 11 x
  140,000 15,400
• 1 fee on all receivables 1 x 100,000 x 12
• 12,000
• APR 15,400 12,000 x 1/1 19.57!
• 140,000

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Inventory as Collateral

• A major problem with inventory financing is
  valuing the inventory.
• For this reason, lenders will generally make a
  loan in the amount of only a fraction of the
  value of the inventory. The fraction will differ
  depending on the type of inventory.
• If inventory is long lived, i.e. lumber, they
  (lender or a customer) may loan you up to 75 of
  the resale value.
• If inventory is perishable, i.e., lettuce, you
  wont get much ?
• Floor Plan Financing is available to High Cost
  Items such as Motor Vehicles.