FINANCIAL MANAGEMENT
SOURCES OF SHORT-TERM FUNDS / CURRENT LIABILITIES MANAGEMENT
Spontaneous Liabilities
spontaneous liabilities
• Financing that arises from the normal course of business; the. two major short-term sources of such liabilities
are accounts payable and accruals.
• There is normally no explicit cost attached to either of these current liabilities, although they do have certain
implicit costs.
• both are forms of unsecured short-term financing whose characteristics are:
o short-term financing
o obtained without pledging specific assets as collateral
o “interest-free” sources of unsecured short-term financing
Accounts Payable Management
• Management by the firm of the time that elapses between its purchase of raw materials and its mailing payment
to the supplier.
• They result from transactions in which merchandise is purchased but no formal note is signed to show the
purchaser’s liability to the seller.
Analyzing Credit Terms
• The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchases
• the purchaser should carefully analyze credit terms to determine the best time to repay the supplier.
• The purchaser must weigh the benefits of paying the supplier as late as possible against the costs of passing up
the discount for early payment.
cost of giving up a cash discount
• The implied rate of interest paid to delay payment of an account payable for an additional number of days.
• when a firm gives up a discount, the results are
o it pays a higher cost for the goods that it orders. The higher cost that the firm pays is like interest on a
loan, and the length of this loan is the number of additional days that the purchaser can delay payment
to the seller.
stretching accounts payable
• strategy that is often employed by a firm is stretching accounts payable, that is, paying bills as late as possible
without damaging its credit rating
accruals
• second spontaneous source of short-term business financing
• Liabilities for services received for which payment has yet to be made.
Unsecured Sources of Short-Term Loans
Unlike the spontaneous sources of unsecured short-term financing, bank loans and commercial paper are
negotiated and result from actions taken by the firm’s financial manager. Bank loans are more popular because they are
available to firms regardless of their sizes meanwhile Commercial paper tends to be available only to large business
organizations.
A. Bank Loans
Banks are a major source of unsecured short-term loans to businesses. The major type of loan made by banks to
businesses is the short-term, self-liquidating loan.
short-term, self-liquidating loan
• An unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism
through which the loan is repaid.
• Banks lend unsecured, short-term funds through these three basic ways:
i. single payment notes,
ii. lines of credit, and
iii. through revolving credit agreements.
Loan Interest Rates
prime rate of interest (prime rate)
• The lowest rate of interest charged by leading banks on business loans to their most important business
borrowers.
• fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally determine the
rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s
“riskiness.”
• The interest rate on a bank loan can be a:
o fixed-rate loan - A loan with a rate of interest that is determined at a set increment above the prime rate
and remains unvarying until maturity.
o floating-rate loan - A loan with a rate of interest initially set at an increment above the prime rate and
allowed to “float,” or vary, above prime as the prime rate varies until maturity.
discount loan
• Loan on which interest is paid in advance by being deducted from the amount borrowed.
Method of Computing Interest
a. interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an
assumed 1-year period is equal to
b. The effective annual rate for a discount loan, assuming a 1-year period, is calculated as
I. single payment note
• A short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short
period.
II. Lines of Credit
• an agreement between a commercial bank and a business, specifying the amount of unsecured short-
term borrowing that the bank will make available to the firm over a given period of time
• such as MasterCard, Visa, and Discover, extend preapproved credit to cardholders.
• is not a guaranteed loan; rather, it indicates that if the bank has sufficient funds available, it will allow
the borrower to owe it up to a certain amount of money.
• Interest Rates
o The interest rate on a line of credit is normally stated as a floating rate: the prime rate plus a
premium
• compensating balance
o A required checking account balance equal to a certain percentage of the amount borrowed
from a bank under a line-of-credit or revolving credit agreement.
o To ensure that the borrower will be a “good customer,”
o compensating balance not only forces the borrower to be a good customer of the bank but may
also raise the interest cost to the borrower.
III. Revolving Credit Agreements
• nothing more than a guaranteed line of credit.
• A line of credit guaranteed to a borrower by a commercial bank regardless of the scarcity of money.
• commitment fee
o The fee that is normally charged on a revolving credit agreement; it often applies to the average
unused portion of the borrower’s credit line.
B. Commercial Paper
• form of financing that consists of short-term, unsecured promissory notes issued by firms with a high credit
standing
• Generally, only large firms of unquestionable financial soundness are able to issue commercial paper
• A large portion of the commercial paper today is issued by finance companies; manufacturing firms account
for a smaller portion of this type of financing.
• Interest on Commercial Paper
o Commercial paper is sold at a discount from its par, or face, value
o The size of the discount and the length of time to maturity determine the interest paid by the issuer
of commercial paper.
C. International Loans
International Transactions
• The important difference between international and domestic transactions is that payments are often made or
received in a foreign currency. It also is exposed to exchange rate risk
Financing International Trade
• letter of credit
o A letter written by a company’s bank to the company’s foreign supplier, stating that the bank
guarantees payment of an invoiced amount if all the underlying agreements are met.
Secured Sources of Short-Term Loans
secured short-term financing
• Short-term financing (loan) that has specific assets pledged as collateral.
• The collateral commonly takes the form of an asset, such as accounts receivable or inventory
security agreement
• The agreement between the borrower and the lender that specifies the collateral held against a secured loan.
• the terms of the loan against which the security is held form part of the security agreement
• The filing requirement protects the lender by legally establishing the lender’s security interest.
Characteristics of Secured Short-Term Loans
Lenders recognize that holding collateral can reduce losses if the borrower defaults, but it has no impact on the
risk of default.
A. Collateral and Terms
Lenders of secured short-term funds prefer collateral that has a duration closely matched to the term of the loan.
the short-term lender of secured funds generally accepts only liquid current assets as collateral. Typically, the lender
determines the desirable percentage advance to make against the collateral. interest rate that is charged on secured
short-term loans is typically higher than the rate on unsecured short-term loans. Lenders do not normally consider
secured loans less risky than unsecured loans.
percentage advance
• The percentage of the book value of the collateral that constitutes the principal of a secured loan.
B. Institutions Extending Secured Short-Term Loans
The primary sources of secured short-term loans to businesses are commercial banks and commercial finance
companies. Both institutions deal in short-term loans secured primarily by accounts receivable and inventory.
commercial finance companies
• Lending institutions that make only secured loans—both short-term and long-term—to businesses.
Use of Accounts Receivable as Collateral
Two commonly used means of obtaining short-term financing with accounts receivable are: (1) pledging
accounts receivable and (2) factoring accounts receivable.
A. Pledging Accounts Receivable
o often used to secure a short-term loan.
o The use of a firm’s accounts receivable as security, or collateral, to obtain a short-term loan
1. The Pledging Process
When a firm requests a loan against accounts receivable, the lender first evaluates the firm’s accounts receivable to
determine their desirability as collateral. After selecting the acceptable accounts, the lender normally adjusts the value
of these accounts for expected returns on sales and other allowances. For protection from such occurrences, the lender
normally reduces the value of the acceptable collateral by a fixed percentage.
2. Notification
Pledges of accounts receivable are normally made on a:
• Non-notification basis
o The basis on which a borrower, having pledged an account receivable, continues to collectthe account
payments without notifying the account customer.
• notification basis
o The basis on which an account customer whose account has been pledged (or factored) is notified to
remit payment directly to the lender (or factor).
3. Pledging Cost
The stated cost of a pledge of accounts receivable is normally 2 to 5 percent above the prime rate. In addition to the
stated interest rate, a service charge of up to 3 percent may be levied
B. Factoring Accounts Receivable
The outright sale of accounts receivable at a discount to a factor or other financial institution. involves selling them
outright, at a discount, to a financial institution.
factor
• A financial institution that specializes in purchasing accounts receivable from businesses.
1. Factoring Agreement
Factoring agreement normally states the exact conditions and procedures for the purchase of an account. Typically,
the factor is not required to pay the firm until the account is collected or until the last day of the credit period,
whichever occurs first. Factoring is normally done on a notification basis
• The basis on which accounts receivable are sold to a factor with the understanding that the factor
accepts all credit risks on the purchased accounts.
2. Factoring Cost
Factoring costs include commissions, interest levied on advances and interest earned on surpluses. The factor
deposits in the firm’s account the book value of the collected or due accounts purchased by the factor, less the
commissions.
PROBLEMS
Formula Guide
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐹𝑜𝑟𝑔𝑜𝑖𝑛𝑔 𝑡ℎ𝑒 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 % 𝑁𝑜. 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
= 𝑥
(100% − 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 %) (𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑐𝑢𝑠𝑡𝑜𝑚𝑒𝑟 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑑𝑎𝑦 − 𝐿𝑎𝑠𝑡 𝑑𝑎𝑦 𝑜𝑓 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡)
1. Wood Corp. is offered by its supplier a trade credit term of 3/15, n/45. Wood Corp. does not take advantage of
the discount instead pay the account affect 67 days. Use 365 days per year. What is Wood Corp.’s nominal
annual cost of not taking the discount? 21.71%
2. Calculate the approximate and effective annual cost of foregoing the cash discount for both of the suppliers of
Mouse Corp.
Supplier CAT 4/10, n/50
Supplier DOG 3/10, n/60
Assuming the firm needs short-term financing, recommend whether it would be better to give up the cash
discount or take the discount and borrow from a bank at 25% annual interest. Evaluate each supplier separately.
Use 360 days per year. Supplier CAT: 37.5%, borrow money and take discount; Supplier DOG: 22.27%, Forgo
the discount
Formula Guide – INSTALLMENT LOANS
𝐴𝑚𝑜𝑢𝑛𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑
𝐴𝑚𝑜𝑢𝑛𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 +
𝑁𝑜. 𝑜𝑓 𝐼𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐿𝑜𝑎𝑛 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 =
2
𝐴𝑚𝑜𝑢𝑛𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 ∗ 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 (𝑓𝑜𝑟 𝑒𝑠𝑡𝑖𝑚𝑎𝑡𝑒 𝑎𝑛𝑑 𝑖𝑛𝑠𝑡𝑎𝑙𝑙𝑚𝑒𝑛𝑡 𝑙𝑜𝑎𝑛𝑠) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐿𝑜𝑎𝑛 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟
Installment loans
Golem Inc. borrowed an amount of P1,000,000 from a bank. The bank charges a 12% stated rate in an add-on
arrangement, payable in 12 equal monthly instalment. What is the estimated effective interest rate on this installment
loan? 22.15%
Formula Guide – EFFECTIVE ANNUAL RATE (EAR)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑
𝐸𝐴𝑅 (𝑖𝑓 𝑡ℎ𝑒 𝑙𝑜𝑎𝑛 𝑖𝑠 𝑓𝑜𝑟 1 𝑦𝑟; 𝑔𝑒𝑛𝑒𝑟𝑎𝑙 𝑓𝑜𝑟𝑚𝑢𝑙𝑎) =
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑
Interest Earned = Principal * Nominal Interest
𝑛
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 ∗ 12 12
𝐸𝐴𝑅 (𝑖𝑓 𝑡ℎ𝑒 𝑙𝑜𝑎𝑛 𝑖𝑠 𝑙𝑒𝑠𝑠 𝑡ℎ𝑎𝑛 1 𝑦𝑟) = 𝑛 ∗ 𝑛
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 − (𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 ∗ 12)
Note: the interest earned in the formula is computed using the annual nominal or stated rate
𝐸𝐴𝑅 (𝑖𝑓 𝑡ℎ𝑒𝑟𝑒 𝑖𝑠 𝑎 (1)𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑎𝑛𝑑 (2) 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑡𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝑏𝑎𝑙𝑎𝑛𝑐𝑒)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑
=
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 − 𝑐𝑜𝑚𝑝𝑒𝑛𝑠𝑎𝑡𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 + 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑡𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝑏𝑎𝑙𝑎𝑛𝑐𝑒
Note: compensating balance can be a fixed amount or a percentage of the principal
Discounting of Loans
2. Panda Co. plans to borrow P10,000 from BDI Bank which offers to lend Panda Co. the fuds needed at 10%
nominal or stated rate for a one-year loan.
a. What is the effective rate if the loan is a discounted loan? 11.11%
b. Assuming the loan is good only for 6 months, what is the effective rate if the loan is a discounted loan?
10.53%
3. Matte Corp. plans to borrow P250,000 for one year at 12% from Balita Bank. There is a 20% compensating
balance requirement.
a. What is the effective rate of interest? 15%
b. What is the effective rate of interest assuming Matte Corp. keeps a minimum transaction balance of
P10,000? 14.29%
Formula Guide – LINE OF CREDIT
𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (𝑙𝑖𝑛𝑒 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡 𝑢𝑛𝑢𝑠𝑒𝑑)
= (1 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑 𝑓𝑟𝑜𝑚 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ)!" − 1
𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (𝑙𝑖𝑛𝑒 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡 𝑖𝑠 𝑢𝑠𝑒𝑑)
= (1 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑖𝑛𝑒 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ)!" − 1
Line of Credit
1. Excel Corp. received a P300,000 line of credit at an interest rate of 12% from Metro Bank and drew down the
enter amount on February 1. The line of credit requires that an amount equal to 15% of the loan be deposited
into a compensating balance account. What is the effective annual cost of credit for this loan agreement?
14.12%
2. Spanish Bank offers Phil Trading a P2,000,000 line of credit with an interest rate of 2.25% per month. The credit
line also requires that 2% of the unused portion of the credit line be deposited in a non-interest bearing account
as an compensating balance. Phil Trading’s short-term investments are paying 1% per month. Any funds
borrowed and invested are computed using compound interest.
a. What is the effective annual interest rate on this agreement if the line of credit goes unused all year?
12.68%
b. What is the effective annual interest rate on the line of credit if Phil Trading borrows the entire
P2,000,000 for one year? 30.60%
Revolving Credit Agreement
Disney Cola arrange a revolving credit agreement amounting to P10,000,000 with a group of small banks. The firm paid
an annual commitment fee of ½% of the unused balance of the loan commitment. On the used portion of the loan,
Disney Cola paid 1.5% above prime for the funds actually borrowed on an annual simple interest basis. The prime rate
was 9% for the year.
a. If Disney Cola borrowed P10,000,000 immediately after the agreement was signed and repaid at the end of one
year, what was the total peso cost of the loan agreement for one year? 1,050,000
b. If Disney Cola borrowed P6,000,000 immediately after the agreement was signed and repaid at the end of one
year, what was the total peso cost of the loan agreement for one year? 650,000
c. If Disney Cola does not borrow at all, what was the total peso cost of the loan agreement for one year? 50,000
Formula Guide – COMMERCIAL PAPER
𝑓𝑎𝑐𝑒 𝑣𝑎𝑙𝑢𝑒
𝑃𝑟𝑜𝑐𝑒𝑒𝑑 =
𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑖𝑛 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑚𝑜𝑛𝑡ℎ𝑠
1 + (𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 ∗ 12 )
Commercial Paper
James Inc. issues P5,000,000 of commercial paper with a maturity of 3 months at an annual interest rate of 8%.
a. How much is the proceeds? 4,901,960.78
b. How much should James Inc. pay at the end of the 3-month period? 5,000,000
