Short term financing

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Basics of short term financing are studied, several examples are used and walk us through the
cash cycle. This lecture is essentially the 1st of a two part lecture while will cover the short term
financing in this video. In the next video I'll discuss how to manage short-term assets and ensure
accounts receivable are paid by customers.
Why should you know about short-term cash management?
Well it's because everyone in a business should have some knowledge of how cash moves
through an organization.
 If you're a salesperson you should know about the impact of certain types of sales and
their impact on cash flow of firm.
 If your manager, you should absolutely understand why stock-outs or liquidity issues are
so damaging to firm’s bottom line and solvency.
What will be studied in the video?
1. First, both the operating cycle and the cash cycle will be explained then I'll drill down
into detail on the cash cycle and operating cycle
2. I'll discuss the pros and cons of different asset financing policies
3. I'll talk about the most common types of short-term financing
4. finally we will compute the cost of various forms of short-term financing essentially
going through EAR and APR
Short-term financing involves a firm raising cash. It is important to know about the relationship
that other line items have on the cash position of a firm.
Cash can be calculated using the formula:
Cash= long term debt+ equity+ current liabilities – current assets other than cash – fixed
assets
In this formula here, whatever cash is equal to whatever you've borrowed, long term debt will be
used, whatever cash raised via equity will be used and any current liabilities will be used and
added since they are all going to raise cash for you. If cash is used for other current assets like
inventory production or to buy a production facility or piece of land cash will be taken away
from your cash item on your balance sheet so we subtract those amounts. The items on the
liability and equity side of the balance sheet are added and the increases in the other current and
fixed assets on the asset side of the balance sheet are subtracted.
An example that illustrates why cash position is important.
The manager of java haute purchases 3 tons of cocoa beans from Colombia. Thee manager has
five days left to pay for these beans. Last night the manager realised the firm does not have
enough cash on hand to pay off its accounts payable. How could the manager resolve this
problem?

Java who could do several things:

It could sell off some fixed assets in order to raise cash. The drawback there is that fixed assets
take a fairly long time to sell so maybe five day is not enough time to raise cash.
The firm could also get a loan from a bank or issue bonds to investors. I would say that probably
a loan would be the most likely alternative here.
It could also run a promotion to raise cash quickly with a low profit margin. There's a couple of
drawbacks to doing that but that's definitely a possibility.
There are a lot of things the manager of Java could do but the best thing is to hopefully never
find one in such a situation. This can be done by following standard working Capital
Management practices and check the amount of liquidity available.
Working Capital Management
Working Capital Management is the management of short-term assets and liabilities. Working
capital is a firm’s investment in short term assets.
A firm’s working capital policy refers to their decisions regarding the target levels for each
current asset and current liability. The policy is closely tied to two cycles called the operating
cycle and the cash cycle.
Net working capital = Current asset – Current Liabilities
The operating cycle
It is time required to receive inventory, sell it and collect on the receivables.
The operating cycle of a business indicates the time from which raw materials are received until
the time that customers pays the business in cash. If the operating cycle is shortened, then we can
reduce the amount of debt we need to issue. When this is done, better credit terms from our
suppliers can be earned and the additional money can be used for additional capital budgeting
projects.

The Operating and Cash Cycle

This is how inventory would move through firm in which inputs are taken to produce a finished
good.
First, an order for an input is placed and eventually input is received. At that point in time when
stock arrives, if the bill hasn’t been received the firm would probably receive the bill. The
inventory period is the time between receiving the stock and selling it. It is time when stock
arrives to the time till finished goods are made and sold. This period is found out by using the
inventory turnover formula.
The accounts receivable period is just the average amount of time until we receive payment for
our sale. This is the period that starts from the time finish goods are sold to the time cash is
received for finished goods sold by the firm. With firms like Java Haute that sell coffee and
bakery products like pastries, the accounts receivable is going to be very short. The entire
operating cycle tells us how long we're taking from the time that we receive our stock until that
time we get paid cash by our customers. For paid in cash we probably won't need to borrow as
much to pay our suppliers assuming we can get good credit terms from them.
There are a number of terms that we can use to calculate the length of the operating cycle:
1. The inventory turnover
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Cost of goods sold is divided by average inventory.
Inventory inventory at the end of the years can be added with the inventory at the
beginning year and this can be divided by two to get an average measure.
Beginning inventory +ending inventory
Average Inventory=
2
2. The inventory conversion period- First period to calculate the operating cycle.
360
Inventory coversion period=
Inventory turnover
 It’s really one of the two periods that is going to be used to calculate the operating cycle.
This inventory turnover measure will be taken and divided into 360 because there's really
360 days in a year that are not major Holidays so this is why some people use 360. Others
will actually use 365 days that are actual days in a year. What is important when using
these days is to make sure one is consistent anytime when we use this measure.

3. Account Receivable Turnover

(Credit ) Sales Revenue
Account Recievable Turnover=
Average Account Receivable
Account receivable turnover tells us how many times a year our accounts receivable will
completely turn over. The sales revenue from sales when the sale was made on credit will
be used. In other words, our customer has bought the item but they still have to pay what
they owe in cash at a later date. Sales revenue will then be divided that by the average
accounts receivable. Account receivable turnover is just sales revenue divided by
accounts receivable.
4. Account Receivable period - Second period to calculate the operating cycle
360
Account Receivable Period =
Receivable Turnover
AR period is going to be the number in which 360 is divided by receivables turnover.
5. Operating Cycle
Operating Cycle=Inventory Conversion Period + AR period
The sum of account receivable period and inventory conversion periods is going to be
our operating cycle.
An example where we can calculate the operating cycle
In the real world we can calculate these line items from the balance sheet and an income
statement at any point in time. When we calculate these numbers, it is always best to calculate
these ratios based on average numbers over the course of the year because if we're only using
accounts payable at one point in time or accounts receivable at one point in time this point in
time may not be representative of the actual turnover period.
Beginning inventory +ending inventory
Average Inventory=
2
For example, there is a number like inventory on the balance sheet. We are going to use
inventory at the end of this fiscal year and average it with the inventory on the balance sheet in
the end of the last fiscal year and divide the sum of this by two and that's how we would get
average numbers.
We want to do it more accurately than just taking the number the number directly off the last
balance sheet.

Operating Cycle is calculated by:

1. Calculate the inventory conversion
2. Calculate the accounts receivable
3. Calculate the operating cycle
Inventory Turnover
Cost of Goods Sold
Inventory Turnover =
Average Inventory
7,000
Inventory Turnover =
750
Inventory Turnover=9.33
Inventory Conversion Period
360
Inventory coversion period=
Inventory turnover
360
Inventory coversion period=
9.33
Inventory coversion period=38.57 days∨39 days
Account Receivable Turnover
(Credit ) Sales Revenue
Account Recievable Turnover=
Average Account Receivable
10,000
Account Recievable Turnover=
500
Account Recievable Turnover=20
Account Receivable Period
360
A ccount Receivable Period =
Receivable Turnover
 360
Account Receivable Period =
20
Account Receivable Period =18 day s
Operating Cycle
Operating Cycle=Inventory Conversion Period + AR period
Operating Cycle=18+38.57
Operating Cycle=56.57 days

Interpretation
1. Inventory Conversion Period
Inventory turnover is 9.3 which that tells us that this firm turns over all of its inventory on
its shelves about 9.3 three times a year. Inventory turnover period or inventory
conversion period tell us the average number of days it takes us to sell all of our
inventory so about 38.5 seven days is taken to sell all of our inventory. This is an
unrealistic example since imaginary values are taken by us.
2. Account Receivable Period
The sales revenue or credit sales revenue is taken and divided by average accounts
receivable. An issue here is that a lot of times when this period is calculated not all of
these sales are going to be credit. Some people will pay cash immediately and so not all
sales can be stated as credit and we won't often have the total credit sales revenue. This is
the reason that a lot of times what people do is just go ahead and use total sales revenue.
The account receivable turnover is 20 days which means that 20 times a year our
accounts receivable will completely turn over.Our AR period is calculated by dividing
that 20 in to 360. This accounts receivable period of 18 tells us it takes us on average 18
days to get paid by our customers. This amount is unrealistic since imaginary number that
are number made by us are taken.
3. The operating cycle
The operating cycle is going to be firm’s AR period plus inventory period. This value is
56.57 days which means is that this entire process from the time when your stock arrives
or your raw inputs arrive until you receive cash from your customers is about 56.57 days.
The shorter operating cycle is the better for us because generally we don't want to be
 suffering and waiting a long time to receive to receive our cash that were owed by our
buyers.

The cash cycle

This is the most important part of the operating cycle. The cash cycle is the time for when your
firm pays for materials until that time that your firm is paid by customers. For example, if your
firm is paid at the end of the accounts payable period. The cash cycle would be the time that
takes you to get cash from your customers. The gap is usually a big concern because we have to
fund our accounts payable using something for example short term debt could be used tofund
account payable.
The cash cycle tells us the number of days between when we have to pay our creditors and when
we receive payment for the sales we have. The shorter this period, the better it is for the firm.
The cash cycle is the time between payment for inventory and receipt from sale of
inventory.
It measures how long we need to finance inventory and receivables.
The cash cycle represents a combination of three components:
1. The inventory Conversion Period (ICP): It is the time until the inventory is sold.
2. Day Sales Outstanding (DSO): Basically it's AR period. It indicates the amount of time
you until you get paid for the inventory you sold. The amount of day sales outstanding is
added to inventory conversion period.
3. Days Payable Outstanding: The day payable outstanding is subtracted from ICP and
DSO. This is accounts payable period. Account payable period indicates the amount of
time it takes for firm to pay for the inputs that you purchased.
Cash Cycle=Inventory Conversion Period ( ICP ) + Day SalesOutstanding ( DSO )+ Days Payable Outstandin
These three periods are discussed in detail below:
1. The inventory conversion period or ICP
 It is the average length of time it takes to convert materials into finished goods and then
sell those goods.
Different Variation of formulas are:
Inventory
ICP=
Cost of Goods Sold per day

Inventory
ICP=
Cost of Goods Sold /360
360
ICP=
Cost of Goods Sold /inventory
360
ICP=
inventory turnover

2. The Account receivables collection period or Day Sale Outstanding (DSO)

This is the average length of time it takes to convert the firm's receivables into cash.
Different Variation of formulas are:

Receivables
DPO=
Daily Credit Sales
Receivables
DPO=
Annual Credit Sales /360
360
DPO=
Receivable Turnover
3. The payables deferral period or Day Payable Outstanding (DPO)
It is the average length of time between the purchase of the raw materials and the actual
payment for in cash for these materials.
It is the average length of time between the purchase of raw material and labour
and the actual payment of cash for them.
Total Purchases
Account payable turnover=
Average Accounts Payable
Accounts Payable
DPO=
Daily Credit Purchases
Payable
DPO=
Cost of Goods Sold /360
 360
DPO=
Payable Turnover

An example
IBM has an inventory conversion period of 45 days, a receivables collection period of 30
days and payables deferral period of 20 days.
a) What is the length of IBM’s cash conversion cycle?
The cash conversion cycle
Cash Cycle=Inventory Conversion Period ( ICP ) + Day SalesOutstanding ( DSO )+ Days Payable Outstandin
Cash Cycle=45+30+ 20
Cash Cycle=55 days

55 days of the cash cycle tells us that for this firm it'll take this firm on average 55 days
to get cash after it sells products recieved. In other words, firm has a 55 day gap on
average between the time it owes its its suppliers for the inputs and the time it actually
receives the cash from its customers.
b) If IBM's annual sales are 1.8 million an all sales are on credit what is the average balance
in accounts receivable?
IBM has 1.8 million in sales and everything is on credit. The firm has a receivables
collection period of 30 days which means it turns over all of its credit, all of its accounts
receivable every 30 days.
Now the way we could calculate the average balance in accounts receivable using this
information is to just find out how much this firm is earning in sales every single day and
then scale that up over 30 days and that will give us our total sales in total receivables
every 30 days.
The firm has annual sales of 1.8 million so I'll put 1.8 million sales and divide that by the
360 days and multiply that by 30 because we want to know the average balance in
accounts receivable and AR collection or DSO is 30 days.
Annual Sales
Average balance ∈account receivable= × account receivable collection∨DSO
360
 1.8 million ( 1,800,000 )
Average balance ∈account receivable= ×30
360
Average balance∈account receivable=150,000

We could use 360 or 365 but regardless of which measure which number we use we need
to be consistent.
This firm IBM has an accounts receivable on its balance sheet of $150,000 on average.
c) How many times per year does IBM turn over its inventory?
The inventory conversion is 45 days and we also know that the inventory conversion is
equal to 360 divided by inventory turnover.
ICP for IBM is 45 days and we can calculate inventory turnover using this formula to
solve for inventory turnover:
360
ICP=
inventory turnover
360
Inventory turnover =
ICP
360
Inventory turnover =
45
Inventory turnover =8 days
It takes eight days to sell our inventory.

Why do we care about the length of the cash cycle?

This is because the longer cash cycle, the more cash we have to come up with by borrowing or
holding cash on hand like backup cash on our balance sheet. If we wanted to reduce our
dependency on short-term debt and hold less cash on hand, we would need to make some
changes to our short-term Financial Policy.
 The longer cash cycle, the more cash on hand we need.
 The decision of how much cash and other NWC ( net working capital) to hold if called
the firm’s short-term financial policy.
 Financial policy is how a firm manages its assets, liabilities and SE( shareholder equity)
Short term financial policy refers to how a firm manages its short-term assets or its current assets
and its current liabilities. If we want to cut down on the amount of cash that we need to borrow
for short periods of time, we could alter the credit terms we offer our borrowers. This means that
we would alter our management of accounts receivable. If we wanted to reduce our reliance on
short-term debt to pay our suppliers, we might also issue new equity and raise additional cash
thatwe could liston balance sheet.
There's a lot of different ways that we can adjust our short-term financial policy.
Now, different financial managers are going to prefer different financial policies. Some are going
to prefer a more flexible or risk averse financial policy while others are going to prefer more
restrictive financial policy that reduces the cash cycle. Now there's a big benefit to reducing the
cash cycle but we would have to give up some nice advantages which come along with more
flexible Financial Policy.
How we develop a firm's short term Financial Policy?
When discussing a firm’s short-term Financial Policy one of major question is about the amount
of or how much in terms of short-term or current assets should we be funding.
Current Asset Financing Policies
Permanent Current Assets
Some firms like to hold a large amount of permanent current assets. The permanent current
assets are assets like cash or inventory that just stay on the balance sheet throughout the year.
Permanent current assets refers to current asset balances that remain stable no matter the
seasonal or economic conditions firms.
Firms that have stable sales throughout the year need to be able to pay off their accounts payable
year round and that's why those firms will typically have more permanent current assets. On the
other hand, firms in cyclical industries like landscaping firms or any company working in the
tourism sector can see massive swings in sales from month to month. These firms are less likely
to want to carry large permanent current asset balances like inventory or cash on hand. This is
because some current assets like inventory can get spoiled before they're used or sold.
Three Current Asset Financing Policies
There are major differences in different working capital policies and way they affect firms. Each
describe a different scenario and depending on the personality and the desires of the management
of a firm, firm is going to take one of these approaches or something similar to one of these
approaches. There are 3 major current asset financing policies:
1. Maturity Matching Approach
The first example of a current asset financing policy would be maturity matching approach.
With this approach, financing policy is going to match assets and liability maturities. This is
typically considered a moderate current asset financing policy. For example, a firm could use
short-term debt that matures in 60 days to fund raw material purchases where it's expected to
be paid by customers within 60 days. It could then use debt with a for example a 10 year
maturity fund purchases of equipment that are expected to last for 10 years. In other words,
the maturity of the assets are matched with the maturity of liabilities.
2. Aggressive Approach
The aggressive approach involves financing all of the fixed assets of the firm with long term
capital but all of the other short-term assets and even some of the the permanent current
assets are going to be funded with short term liabilities like notes payable or a bank loan.
3. Conservative Approach
The conservative approach means that the firm finances all asset purchases with long term
capital. Anything that can be financed with long term capital will be financed with long term
capital. The problem with this approach is that firms that follow the conservative approach
will have cash, inventory or any other current assets they have inactive on their balance sheet
during off-seasons when they could be using that cash for investing or other purposes.
Comparatively to the aggressive approach, conservative approach will be more expensive
from manager’s perspective since in the aggressive approach firm is only borrowing what
they need to borrow. It would however be less likely that a firm using conservative approach
would be unable to pay off its suppliers.
Now a firm can use a lot of tools to pursue either of these approaches:- the aggressive
approach or the conservative approach.
Sources of Short Term Debt Financing
The tools that firms use to raise short-term debt are known as sources of short term debt
financing. A list of short-term funding sources are:
 Accruals
 The first source is often used when a firm pays wages periodically like every two weeks or
when the firm withholds taxes on sales it's called accruals. Basically accruals are those
payments like wages that the firm pays every two weeks and that are going to accrue until
they are paid. They represent short-term liabilities that change depending on whether the
firm's operations are expanding or contracting.
1) Commercial Paper
The next type of short-term financing is commercial paper.
2) Commercial paper are unsecured, short-term promissory notes issued by large,
financially sound firms to raise funds.
Commercial paper represents the short-term debt of low risk firms and has a maximum
maturity of 270 days. This is a short term debt. Commercial paper is issued either privately or
to the public. Firms that ever issue commercial paper are firms like Apple or Berkshire
Hathaway and the reason they issue commercial paper is because it's a low cost method to
raise cash for short amount of time.
3) Account Payable or Trade Credit
Accounts payable or trade credit is the credit created when one firm buys on credit from
another firm. The buyer will have a short amount of time to pay their supplier.
4) Short term bank loans
Short-term bank loans is a source of finance which involves a firm entering into some
agreement with the commercial bank.

Short Term Bank Loans

Short-term bank loans are found in many shapes and sizes but most of them have a 90 day
maturity. This this means that the firm will have 90 days to pay the face value of the loan or
get loan renewal from the bank. The bank will monitor the firms credit every time the firm
tries to renew the loan. If the firm's credit rating falls, this means firm is less likely to be able
to repay that loan and might not be able to renew that loan.
Promissory note
It is an agreement in which the firm signs the loan agreement with the bank. It identifies the
amount borrowed- the interest rate, the repayment schedule and other terms and conditions
associated with the loan
Compensating Balance
Many times short-term bank loans will also come with a compensating balance.
Compensating balance is a minimum checking account balance that the firm has to maintain
with its lender. Compensating balance helps to ensure that bank from which firm is
borrowing funds from is paid back. This balance usually is going to be between 10 and 20%
of the loans outstanding. Compensating balance is a way for a bank to ensure that there is
something for them to recoup in case the firm that they lent loan defaults and is unable to pay
the bank back.

This balance usually is going to be between 10 and 20% of the loans outstanding. 10 to 20%
compensating balance can be stated as the lowest amount of compensating balance if we look
globally. For example, in countries like Japan or Germany a lot of times this compensating
balance will be a lot higher.
Lines of Credit
Some bank loans are known as lines of credit. An arrangement in which bank agrees to lend
up to a specific maximum amount of funds during a designated period is known as lines of
credit. Sometimes these lines of credit are called revolving lines of credit or just revolvers.
There's a lot of different types of these loans and differences in the loan terms but generally
the firm will have to clean up its loan balance at least once a year. In other words, the firm
will have to ensure that it owes nothing on its line of credit once a year. The line of credit
will be specified in the contract that the bank and the firm sign.
 Commitment Fee
The revolver often has a commitment fee. This fee is charged on the unused
balance of the revolving credit agreement. This fee compensates the bank for
ensuring that the funds will be available for company when the company needs
it. This fee is disadvantageous for the bank since if bank is just waiting for a
firm to borrow money and that firm never borrows money, it is a bad thing for
the bank because it has all this cash sitting on their balance sheet.
5) Secured Loans

The final method of short term financing is a secured loan. These are for short term loans.
Secured loans are loans backed by collateral. The collateral often is inventory, receivables or
both. This means that if the firm borrowing money defaults, the bank is entitled to account
receivable or inventory listed in the loan indenture agreement.
There are three ways in which Account receivable financing is done:
1. Pledging Receivables
Account receivables are used as collateral for a loan.
2. Recourse
The lender can seek payment from the borrowing firm when receivables’ account used to
secure a loan are uncollectible.
3. Factoring
Factoring is the outright sale of receivables. One of the ways this is done is through the use
of factoring where the firm that defaults on its loan can be forced to sell its receivables to a
third party at a discount for cash and then that cash is used to pay the bank that made the
loan.
Secured Loans
Blanket Lien
A blanket lien gives the lending institution a lien against all of the borrower’s inventories
without limiting the borrower’s ability to sell inventories. If the bank loan is secured by
inventory, this loan gives the bank the ability to file a blanket lien against the borrowing firm’s
inventory. This type of lean generally is used when the inventory put up a collateral that is
relatively low priced, fast moving and difficult to identify individually. For example a
commodity could be taken as an example. An example of this might be anything bought at
Walmart. Although it's unlikely that Walmart will default on its secured loans anytime in the
near future.
Trust Receipt
Trust receipt is an arrangement in which the goods are held in trust for the lender If the inventory
securing the loan is more high priced or less liquid then a trust receipt is often used. A trust
receipt is an arrangement in which the goods are held in trust for the lender and goods held in
this trust are sold and then proceeds from the sale must be given to the lender to repay a portion
of the loan that the firm defaulted on.

How to calculate the costs associated with short term borrowing?

Cost of Short-term credit
There are many rates that could be discussed but three of them are main that should be
understood. These three rates can be used in a variety of scenarios.
1. Percentage cost per period
$ Cost of Borrowing
Percentage cost per period ( r PER )=
$ Amount of Usable Funds
This percentage is just the dollar value or the dollar cost of borrowing so all of the expense paid
when firm borrow over the period and that's going to be divided by the dollar amount of usable
funds.
Loans will often come with fees plus the quoted interest rate. All of these costs - the quoted rate
plus any fees will be included in cost of borrowing. This cost of borrowing is used in commercial
paper.
The amount of usable funds includes only the usable funds borrowed. If there are any restrictions
that prevent the borrower from using the entire amount of a loan then the effective rate that the
borrower is going to pay for the loan is going to be higher than the stated interest rate. This is
why we use this amount of usable funds instead of just the amount borrowed.
The usable funds can be calculated in several different ways. Two of the main ways that they're
calculated are:
1) Usable Funds=Principal amount −( $ reductions¿ principal amount)
The first way of calculating usable funds is to just take the principle the amount that the
borrower is borrowing and subtract any reductions from the principle amount. For example, the
firm has to make a payment on debt immediately that payment is going to be plugged in
the reduction from principal area.
2) Usable Funds=Principal ×(1−%reduction¿ principal amount)
Usable Funds=Principal ×(1−20 %)
We can find the usable funds by using this example. If we know that the firm that borrowed
money is only going to be able to use 80% of principal amount immediately then what we would
do is plug 20% in reduction from principal amount area and so result would be principal*( 1 -
20%). The usable funds would be 80% of the principle.
2. The EAR or effective annual rate
EAR ( r EAR ) =( 1+r PER )m−1
This is also compound interest rate.
M = no. of compounding period per year
3. the APR or annual percentage rate
APR (r simple )=r PER ×m
APR is going to be just our periodic interest rate. APR is a simple interest rate unlike EAR which
is compound interest rate.

Cost of Trade Credit

Trade credit comes with terms like 3/15 net 45. In this example, this means that the buyer that
receives the trade credit has 45 days to pay what they owe to their supplier but if they can pay
what they owe within the first 15 days then they get a 3% discount on what they owe. The cost
of trade credit assumes that firm does not take the discount within the first period during the
discount window and instead go to or wait until the 45 day window expires to pay the trade
credit.
 “Free” Trade Credit
The credit received in the 15 day window is referred to as the free trade credit. This is the credit
received during the discount period.
 “Costly” Trade Credit
The credit taken in excess of the free trade credit is called the costly treat credit. This is because
its cost is equal to the discount lost when the buyer doesn't pay its bills within this 15 day
window. This cost is equal to the discount lost.
The percentage cost per. Period, APR of Costly and Free Trade Credit is calculated. And
Calculate the cost of the Costly trade credit
It is the cost of not paying off bills early.
Example
The terms for this trade credit were 3/15 net 45. This means that 3% is discount paid in the first
15 days and then no discount will be paid after the 15 day period ends that is by the time one
actually owes debt. The time one actually owes debt in this example is at the end of day 45.
Calculate percentage cost per period.

Given Data:
Cost of borrowing= $3
Reduction from principal amount =3%
Principal amount =$100
Usable Funds =$97
$ Cost of Borrowing
Percentage cost per period ( r PER )=
$ Amount of Usable Funds
$3
Percentage cost per period ( r PER )=
$ 97
Percentage cost per period ( r PER )=0.0309∨3.09 %
Usable Funds=Principal ×(1−%reduction¿ principal amount)
Usable Funds=100×(1−3 %)
Usable Funds=$ 97

The percentage cost per period is used in calculation the costly trade credit. It shows cost costly
trade credit when a firm lose its discount after day 15. Cost of borrowing is divided by the
amount that would be usable in that window between 15 and 45 days.
The 3% discount has been lost. We will have to pay cost of losing that discount. We lost that
discount since we didn't pay what we owe within the first 15 days so we will use 1-3% for the
calculation of usable funds.
Interpretation
The percentage cost per period is 3.09% if we pay off our off our accounts payable between day
15 and a 45. The number 3.09% represents the interest rate that we'd be paying in window of 15
to 45 days.
The 3.09% tells the cost of not taking the discount before day 15 and instead waiting until day 45
to pay off what is owed. In other words, this is the percentage rate that will be paid by simply not
exercising the option of pay debt early and taking the discount of3%
Calculation of APR
APR is just going to be the percentage cost per period scaled up to one year. APR gives annual
percentage rate. M is how many days it takes to get from 30 days to 360 days.
Given Data
M= 30
Percentage cost per period (rper )=0.0309 or 3.09%

APR (r simple )=r PER ×m

360
( r simple )=3.09 % ×( 45−15 )
APR ( r simple ) =3.09 % ×(30)
APR ( r simple ) =37.11 %

Calculation of EAR

EAR ( r EAR ) =( 1+r PER )m−1

EAR ( r EAR ) =( 1+3.09 )360/30−1

EAR ( r EAR ) =44.12 %
M is number of compounding years per year. It tells us how many times percentage cost
per period interest rate would be compounding over the year.
There's a large difference between simple interest rate, APR and effective interest rate, EAR
This is because in EAR, interest rate is compounded not monthly but every 30 days.
Some other forms of short-term debt
How we calculate the EAR&APR in those forms of debt?
Bank Loan
Another type of short-term debt issuance is a bank loan. A bank loan can take 3 forms:
1. a simple interest loan
2. a discount loan or
3. an installment loan
Simple interest loan
A simple interest loan is a loan in which both the amount borrowed and the interest charge on
that amount are paid at maturity and interest rate quoted is a simple annual interest rate.
Although, there can be possibility that loan can mature sooner than one year but because the
interest rate quoted is an annual rate, we can calculate the periodic interest rate.

Periodic interest rate can be calculated by multiplying simple interest rate by the percentage of
the year until that loan matures.
For example, a bank loan of $10,000 matured in nine months and had a 12% quoted annual
interest rate. Calculate the periodic interest rate.
Calculate Rper
Given Data
APR = 12%
No. of Months =9 If we have loan outstanding for nine months, we substitute 9 in number
of months.

No . of months
Periodic Interest Rate(r per )= APR ×( )
12
9
Periodic Interest Rate=0.12×( )
12
Periodic Interest Rate=9 %
Calculate APR
APR or annual percentage rate is quoted rate by the portion of the year until that loan matured.
APR on a simple interest loan mean our quoted rate always. It's periodic interest rate multiplied
by amount that is scaled up to an annual rate basis.
Given Data
Rper = 0.09
M= 9/12
APR (r simple )=r PER ×m
9
APR=0.09 ×( )
12
APR=12 %
Calculate EAR.
EAR is calculated using the EAR formula.
In EAR, scaling is done up to a year and then subtraction is done to get rid of the principle.
Given data
Rper = 0.09
M= 12/9

EAR ( r EAR ) =( 1+r PER )m−1

EAR ( r EAR ) =( 1+9 % )12/9 −1

EAR ( r EAR ) =13.19 %

Discount Interest Loan

The second type of bank loan is the discount interest loan. In this loan, the interest is calculated
based on the principle and paid in advance.
Example
Dell receives $10,000, 9 month loan with a 12% quoted rate. What are the PER, APR AND
EAR?
Calculation of Rper or periodic interest rate
Rper or periodic interest rate is the amount that owed to lender by borrower.

$ Cost of Borrowing
Percentage cost per period ( r PER )=
$ Amount of Usable Funds
9
Percentage cost per period ( r PER )=
10,000 ×(0.12 × ( 12 )
)

9
10,000−(10,000 ×( 0.12× ( )))
12
900
Percentage cost per period ( r PER )=
10,000−(900)
900
Percentage cost per period ( r PER )=
10,000−(900)
Percentage cost per period ( r PER )=9.89 %
The numerator gives amount that the borrower owes to lender. The amount that we're actually
going to be paying to our lenders is found out by multiplying amount received by lender with
APR multiplied by the number of months in a year. For example, a frim has a $10,000 loan and
Apr is 12% and number of months in a year is 9/12. $900 is actual amount that firm is going to
have to pay to lenders associated with this loan.
The amount of usable funds is found by subtracting the principle amount with the amount of
principle that's not actually usable. This basically means that everything which is cost is
subtracted from the principle amount to get amount of usable funds.
Calculate APR
Given data
Rper = 9.89%
M=12/9

APR (r simple )=r PER ×m

12
APR=9.89 % ×( )
9
APR=13.19 %
Interpretation
In APR, we're scaling up the nine month loan to an annual loan. 13.19% is the amountscaling up
the nine month loan to an annual loan
Calculate EAR
Given data
Rper = 9.89%
M= 12/9
EAR ( r EAR ) =( 1+r PER )m−1

EAR ( r EAR ) =( 1+9.89 % )12 /9−1

EAR ( r EAR ) =13.40 %
Instalment Bank Loan
The third type of bank loan is the instalment loan with add on interest. This loan involves
calculating interest that has been added to the amount borrowed to obtain the total dollar amount
to be paid back in equal instalments.
The periodic interest rate is the total add-on interest divided by the average loan balance
The cost of commercial paper
Commercial paper is the short term debt issued by firms with high credit ratings Commercial
papers can be issued by large companies like like Apple, Berkshire Hathaway. Commercial
paper come with transaction fees. The way we factor those fees in is by adding up the total costs
over the period in the numerator of the periodic rate.
Example
GM issues 270 day commercial paper with face value equal to $10,000. The quoted interest rate
is 12% and the total transaction fee is 0.5% of the amount of the issuance
Calculation of Rper or periodic interest rate
Rper or periodic interest rate is the amount that is owed to lender by borrower. APR is quoted
interest rate compensation to our lender plus the fee that we have to pay to borrow the money.

$ Cost of Borrowing
Percentage cost per period ( r PER )=
$ Amount of Usable Funds
9

Percentage cost per period ( r PER )=

(
10,000 × 0.12 ×( 12 ) )
+50

9
10,000−(10,000 ×( 0.12× ( ) )+ 50)
12
900+50
Percentage cost per period ( r PER )=
10,000−( 900 ) +50
950
Percentage cost per period ( r PER )=
10,000−(950)
Percentage cost per period ( r PER )=10.50 %
Transaction Fee= 0.5%*10,000 = $50
This is a piece of commercial paper that matures in nine months making it a 270 day commercial
paper. 950 is the total amount that we're going to have an interest on. The amount of usable
funds is principle that a firm borrows minus the fees that firm is going to be paying for
commercial paper.
Calculate APR
Given data
Rper = 10.50%
M= 12/9

APR (r simple )=r PER ×m

12
APR=10.50 % ×( )
9
APR=0.1400∨14 %

APR is scaled up to one year so 12 / 9 is used since a nine month interest rate is being quoted.
Calculate EAR
Given data
Rper = 10.5%
M= 12/9
EAR ( r EAR ) =( 1+r PER )m−1

EAR ( r EAR ) =( 1+10.50 % )12/ 9−1

EAR ( r EAR ) =0.1424∨14.24 %
Summary
What has been covered?
 The cash cycle represents the length of time funds are tied up in current assets.
 We can calculate the cash cycle along with the operating cycle.
 The impact a longer cash cycle has on a firm is important to know. The longer
the cash cycle, the more outside financing the firm will need.
 Outside financing can be obtained through different means. There are many
ways to raise short-term financing. Each method to raise short term financing
has its pros and cons.
 The percentage cost of credit factors in both the quoted rate and any fees that
are being charged to the borrower is calculated then this amount found is
divided by the usable funds. Usable funds is the principle amount minus any
fees or interest that is paid to lender.