CHAPTER 10

SHORT-TERM FINANCING: SOURCES

AND COSTS
 Short-Term Financing Concept
Working Capital = Current Assets – Current
Liabilities

Current Asset Investment Policies

• Conservative or relaxed
• Aggressive or restricted
• Moderate

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 Short-Term Financing Concept
Current Asset Financing Policies
• Conservative
• Aggressive
• Maturing or moderate matching

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 Short-Term Financing Concept
A financial officer must consider two important
factors:

• Sources of financing
• Cost of short-term financing

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 Sources of Short-Term Financing
Factors to consider in selecting the sources of
short-term funds:

• Availability of amount needed

• Cost of credit
• Repayment terms
• Financing requirements

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 Sources of Short-Term Financing
Common sources of short term funds:

• Accruals of expenses
• Suppliers’ trade credit
• Bank loans
• Commercial papers
• Pledging and Factoring of receivables

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 Accruals of Expenses
• Costs that have been incurred by the business
but are not yet paid
• When the business extends the payment of
accruals, the funds intended for payment are
temporarily used by the business in its
operations
• Not often used to finance funding
requirements of the working capital

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 Suppliers’ Trade Credit
• Generally bears no interest but provides
discount for prompt payment
• Longer discount period = Higher cost of trade
credit
• Effective annual cost is generally higher than
the annual nominal cost of trade credit

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 Suppliers’ Trade Credit
Net monetary benefit/loss:

Principal x Discount Rate

Discount
(Principal – Discount ) x
-Interest Expense Bank Interest Rate x Time

Net monetary benefit / loss

Note: If the interest cost of borrowing from banks is

lower than the cost of foregoing the discount, one
should avail of the discount
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 Bank Loans
Methods:

• Simple interest rate

• Discounted interest rate
• Add-on interest rate
• Interest rate with compensating balance

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Nominal vs. Effective Interest Rate
Nominal Interest Rate
• Refers to the interest rate that appears on the
face of the promissory note

Effective Interest Rate

• Refers to the real or true rate of interest

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Simple vs. Discounted Interest Method
Simple Interest
• Indicates that the borrower receives the face
value of the loan and pays the interest only at
the maturity date

Discounted Interest
• Means that the interest has been deducted in
advance from the amount of the loan
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Simple vs. Discounted Interest Method
Simple Interest
• If the term is 1 or more (equal to the effective
annual rate)
• If the term is less than 1 year

Discounted Interest
• If the term is 1 or more
• If the term is less than 1 year

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Simple vs. Discounted Interest Method
SIMPLE DISCOUNTED
Proceeds Equal to the amount of Less than the amount of
loan the loan
Time of interest On the date of maturity Upon the release of the
payment loan
Amount payable on Principal amount of loan Principal amount of loan
maturity date plus interest
Treatment of interest Interest not deducted in Interest deducted in
advance advance
Effective interest rate Equal to the nominal Higher than the nominal
annual rate if the term is annual rate even if the
one year term is one year

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 Commercial Papers
• Commercial papers are promissory notes
issued by authorized large companies
• Securities and Exchange Commission –
regulates the issuance of commercial papers

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 Pledging vs. Factoring of Receivables
Pledging
• Receivables are used as collateral when
borrowing

Factoring
• Involves the sale of receivables to the
financing company

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 Factoring of Receivables
Necessary data to be determined in factoring:

• Interest (I) – net of factor’s holdback

• Factoring Fee (FF) – for reserve in case of
owner’s default
• Factor’s Holdback (FH) – NOT included as part
of the numerator
• Net proceeds = Principal – I – FF - FH
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