Chapter 4

Working Capital
Management

Assoc. Prof. Dr. Hoang Thi Thu

4-1

Chapter 4

I. Overview of Working Capital

Management

II. Working Capital Management

4-2

I. Overview of Working
Capital Management

 Working Capital Concepts

 Working Capital Issues
 Financing
Current Assets: Short-Term
and Long-Term Mix
 Combining Liability Structure and
Current Asset Decisions

4-3

4-1
 The Balance Sheet of the Firm
The Net Working Capital Decision (Asset Management Decision)

Current
Liabilities
Current
Assets Net
Working Long-Term
Capital
Debt

How much short-

Fixed Assets term cash flow
1 Tangible does a company
need to pay its Shareholders’
2 Intangible bills? Equity

4-4

1. Working Capital Concepts

 Gross Working Capital
The firm’s total current assets
 Net Working Capital
= Current Assets - Current Liabilities
 Net operating working capital (NOWC):
= Operating CA – Operating CL
= (Cash + Inv. + A/R) – (Accruals + A/P)
= (Current Assets – Excess cash) – (Current
Liabilities – Notes payable)
4-5

Working Capital Concepts

 Working Capital Management
The administration of the firm’s current
assets and the financing needed to support
current assets as well as establishing
working capital policy
 Working capital policy:
 The level of each current asset
 How current assets are financed
4-6

4-2
 Significance of Working
Capital Management
 In a typical manufacturing firm, current
assets exceed one-half of total assets.
 Excessive levels can result in a substandard
Return on Investment (ROI).
 Current liabilities are the principal source of
external financing for small firms.
 Requires continuous, day-to-day managerial
supervision.
 Working capital management affects the
company’s risk, return, and share price.
4-7

2. Working Capital Issues

Optimal Amount (Level) of Current Assets

Assumptions
 50,000 maximum Policy A
ASSET LEVEL ($)

units of production Policy B

 Continuous Policy C
production
 Three different Current Assets
policies for current
asset levels are
possible 0 25,000 50,000
OUTPUT (units)
4-8

Impact on Liquidity

Optimal Amount (Level) of Current Assets

Liquidity Analysis
Policy Liquidity Policy A
ASSET LEVEL ($)

A High Policy B

B Average Policy C

C Low
Current Assets
Greater current asset
levels generate more
liquidity; all other
factors held constant. 0 25,000 50,000
OUTPUT (units)
4-9

4-3
 Impact on
Expected Profitability

Optimal Amount (Level) of Current Assets

Return on Investment
(ROI) = ASSET LEVEL ($)
Policy A

Net Profit Policy B

Total Assets Policy C
or
Net Profit Current Assets
Current + Fixed Assets

0 25,000 50,000
OUTPUT (units)
4-10

Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets

Profitability Analysis
Policy Profitability Policy A
ASSET LEVEL ($)

A Low Policy B

B Average Policy C

C High
Current Assets
As current asset levels
decline, total assets will
decline and the ROI will
rise. 0 25,000 50,000
OUTPUT (units)
4-11

Impact on Risk

Optimal Amount (Level) of Current Assets

 Decreasing cash
reduces the firm’s ability Policy A
ASSET LEVEL ($)

to meet its financial

obligations. More risk! Policy B
 Stricter credit policies Policy C
reduce receivables and
possibly lose sales and
customers. More risk! Current Assets
 Lower inventory levels
increase stockouts and
lost sales. More risk! 0 25,000 50,000
OUTPUT (units)
4-12

4-4
 Impact on Risk
Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk Policy A
ASSET LEVEL ($)

A Low Policy B
B Average Policy C
C High
Current Assets
Risk increases as the
level of current assets
are reduced.
0 25,000 50,000
OUTPUT (units)
4-13

Summary of the Optimal

Amount of Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High

1. Profitability varies inversely with

liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)
4-14

Classifications of
Working Capital

 Components
Cash, marketable securities, receivables,
and inventory

 Time
 Permanent
 Temporary

4-15

4-5
  Permanent working capital  Temporary working capital

4-16

3. Financing Current Assets:

Short-Term and Long-Term Mix

Spontaneous Financing: Trade credit, and

other payables and accruals, that arise
spontaneously in the firm’s day-to-day
operations.
 Based on policies regarding payment for
purchases, labor, taxes, and other expenses.
 We are concerned with managing non-
spontaneous financing of assets.
4-17

Hedging (Maturity Matching)

Approach

 A method of financing where each asset would be

offset with a financing instrument of the same
approximate maturity.
 Fixed assets and the non-seasonal portion of
current assets are financed with long-term debt and
equity (long-term profitability of assets to cover the
long-term financing costs of the firm).
 Seasonal needs are financed with short-term loans
(under normal operations sufficient cash flow is
expected to cover the short-term financing cost).

4-18

4-6
 a)Hedging Approach
(or Maturity Matching Approach)

4-19

Hedging Approach
(or Maturity Matching Approach)
* Less amount financed spontaneously by payables and accruals.
** In addition to spontaneous financing (payables and accruals).

Short-term financing**
DOLLAR AMOUNT

Current assets*

Long-term financing
Fixed assets

TIME
4-20

b)Risks vs. Costs Trade-Off

(Aggressive Approach)

4-21

4-7
 Aggressive Approach

 Short-Term Financing Benefits

 Financing long-term needs with a lower interest
cost than short-term debt
 Borrowing only what is necessary
 Short-Term Financing Risks
 Refinancing short-term obligations in the future
 Uncertain future interest costs
 Result
 Manager accepts greater expected profits in
exchange for taking greater risk.
4-22

c) Risks vs. Costs Trade-Off

(Conservative Approach)

4-23

Risks vs. Costs Trade-Off

(Conservative Approach)
 Long-Term Financing Benefits
 Less worry in refinancing short-term obligations
 Less uncertainty regarding future interest costs

 Long-Term Financing Risks

 Borrowing more than what is necessary
 Borrowing at a higher overall cost (usually)
 Result
 Manager accepts less expected profits in
exchange for taking less risk.
4-24

4-8
 Summary of Short- vs.
Long-Term Financing

Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary) Risk-Profitability Risk-Profitability

LONG-TERM High Moderate

(Permanent) Risk-Profitability Risk-Profitability

4-25

4. Combining Liability Structure

and Current Asset Decisions

 The level of current assets and the

method of financing those assets are
interdependent.
 A conservative policy of “high” levels of
current assets allows a more aggressive
method of financing current assets.
 A conservative method of financing
(all-equity) allows an aggressive policy
of “low” levels of current assets.
4-26

II. Working Capital

Management

 Cash Management
 A/R Management
 Inventory Management
 Short-term financing

4-27

4-9
 1. Cash Management

 Cash is the most liquid asset of all assets and is vital

for existence of any business firm
 The goal of cash management
 Ensure the cash outflows as and when required
 Minimizing the Cash Balance
 Cash management is concerned with the
managing of
 Cash flows into & out of the firm
 Cash flows within the firm
 Cash balances held by the firm at a point of time by
financing deficit or investing surplus cash
4-28

Motives for Holding Cash

 Transactions Motive
to meet payments arising in the ordinary course of
business
 Speculative Motive
to take advantage of temporary opportunities
 Precautionary Motive
to maintain a cushion or buffer to meet unexpected
cash needs
 Compensating balances:
for loans and/or services provided

4-29

Cash Management System

Collections Disbursements

Marketable securities
investment

Control through information reporting

= Funds Flow = Information Flow

4-30

4 - 10
 Ways to manage cash
 Accelerating cash collections
 Decelerating or delaying cash disbursements

4-31

Speeding up Cash receipts

 Accelerating Collections by
 Collection Float: the total time between the mailing of a check by a customer
and the availability of cash to the receiving firm
 Earlier Billing: Accelerated preparation and mailing of invoices will result in
faster payment because of the earlier invoice receipt and resulting earlier
discount and due dates.
 Lock-box system: post office boxes maintained by a firm’s bank that is used
as a receiving point for customer remittances. It includes traditional lock-box
arrangement and electronic lock-box.
 Collections improvements
 Accounts receivable conversion: paper check payments sent to a lock-box,
electronic funds transfer system
 Concentration Banking
 Concentration Services for Transferring Funds: depository transfer
checks, electronic transfer checks through automated clearinghouse and wire
transfers
4-32  Use credit cards, debit cards, direct deposits...

Collection float

4-33

4 - 11
 Slowing down Cash payouts
Delaying Disbursements by
 Playing the Float: the result of delays between the time checks are written
and their eventual clearing by the bank
 Control of Disbursements
 Payable through Draft (PTD)
 Payroll and Dividend Disbursements
 Zero Balance Account (ZBA)
 Remote and Controlled Disbursing

4-34

Cash balances to maintain

 Most business firms establish a target level of cash balances to

maintain. The optimal level of cash should be larger of the
transactions balances requires when cash management is
efficient or the compensating balance requirements of
commercial banks with which the firm has deposit accounts.
 There has been a marked trend toward paying cash for services
rendered by a bank instead of maintaining compensating
balances. The advantage to the firms is that it may be able to
earn more on funds used for compensating balances than the fee
for the services. Higher the interest rate in the money market, the
greater the opportunity cost of compensating balances and the
greater the advantage of service charges Where a service
offered can better be paid for by a fee, the firm should be alert to
take advantage of situation and to reduce its compensating
4-35 balances.

2. Accounts Receivable (A/R)

management
 Accounts receivable consist of the credit a
business grants its customers when selling
good and services
 A/R management refers to the optimal
decisions that a business makes regarding its:
 credit and collection policies
 the evaluation of individual credit applicants

4-36

4 - 12
 Credit policy

In determining an optimal extension credit

policy, a company’s financial managers discuss
three components of the credit policy as:
Credit standards: criteria used to screen
credit applications and control the quality of
accounts
Credit terms: conditions under which
credit extended must be repaid
Collection effort: methods used in
attempting to collect payment on past-due
4-37
accounts

Credit Standards

Credit Standards -The minimum quality of

credit worthiness of a credit applicant that is
acceptable to the firm.
Why lower the firm’s credit standards?
The financial manager should continually lower
the firm’s credit standards as long as
profitability from the change exceeds the extra
costs generated by the additional receivables.
4-38

Credit standards

 Quality of credit extended

 Time a customer takes to repay
 Probability a customer will fail to repay
Default risk
 Measures of quality
 Average collection period: average days waiting for
the customer’s payment after a firm made a credit
sale
 Bad-debt loss ratio = loss on credit / total credit sales

 Extend credit whenever the marginal returns

from extending credit exceed the marginal
costs
4-39

4 - 13
 Decision to relax credit standards
by extending credit to customer
A. Marginal profitability of additional sales
= Profit contribution ratio  Additional sales
B. Additional investment in A/R
= Additional average daily sales  Average collection period
C. Cost of additional investment in A/R
= Additional investment in A/R  Required Pretax of return
D. Additional bad-debt loss
= Bad-debt loss ratio  Additional sales
E. Cost of additional investment in inventory
= Additional investment in inventory  Required Pretax of return
F. Net change in pretax profits
= Marginal returns - Marginal costs = A – (C + D + E)
Decision: If Net change in pretax profits > 0, the firm should extend
4-40 credit to the customer.

Example 1:
Decision to relax credit standards

 Bassett Furniture Industries has the credit sales, average

collection period, and loss ratio data for various credit risk
groups as follows:

4-41

Example 1:
Decision to relax credit standards
 Under its current credit policy, Bassett extends unlimited credit to all
customers in Credit Risk Groups 1, 2, and 3, and no credit to customers
in Groups 4 and 5. As a result of this policy, Bassett estimates that it
“loses” $300,000 per year in sales from Group 4 customers and $100,000
per year in sales from Group 5 customers. Bassett also estimates that
its variable production, administrative, and marketing costs (including
credit department costs) are approximately 75 percent of total sales; that
is, the variable cost ratio is 0.75. The company’s required pretax rate of
return (that is, the opportunity cost) on its current assets investment is 20
percent.
 One alternative Bassett is considering is to relax credit standards by
extending full credit to Group 4 customers. Bassett estimates that an
additional inventory investment of $120,000 is required to expand sales
by $300,000.
How is the credit decision to the Group 4 customers?
4-42

4 - 14
 Example 2:
Relaxing Credit Standards
Basket Wonders is not operating at full capacity and wants to
determine if a relaxation of their credit standards will enhance
profitability.
 The firm is currently producing a single product with variable
costs of $20 and selling price of $25.
 Relaxing credit standards is not expected to affect current
customer payment habits.
 Additional annual credit sales of $120,000 and an average
collection period for new accounts of 3 months is expected.
 The before-tax opportunity cost for each dollar of funds “tied-up”
in additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise,
should Basket Wonders relax their credit standards?
4-43

Credit Terms
Credit Terms - Specify the length of time over which credit is
extended to a customer and the discount, if any, given for
early payment.
For example, credit terms of “2/10, net 30.” mean that the
customer can deduct 2% of the invoice amount if payment is
made within 10 days from the invoice date.
Credit Period - The total length of time over which credit is
extended to a customer to pay a bill.
For example, “net 30” requires full payment to the firm within
30 days from the invoice date. (credit terms of “net 30” mean
that the customer has 30 days from the invoice date within which
to pay the bill and that no discount is offered for early payment).
4-44

Credit terms (or terms of sale)

 Credit period
Time allowed for payment in full
 Cash discount
 Allowed if payment is made within a specific period of
time
 Specified as % of the invoiced amount
 Granted to speed up collection of A/R

 Seasonal dating (is special credit term)

 Offered to retailers on seasonal merchandise
 Accept delivery of the product well ahead of peak season
 Pay shortly after peak sales
4-45

4 - 15
 Decision to change its credit terms

A. Marginal profitability of additional sales

= Profit contribution ratio  Additional sales
B. Additional investment in A/R
= New average balance - Present average balance
= (New annual sales/365  New Average collection period)
- (Present annual sales/365  Present Average collection period)
C. Cost of additional investment in A/R
D. Additional bad-debt loss
E. Cost of additional investment in inventory
F. Net change in pretax profits
= Marginal returns - Marginal costs = A – (C + D + E)

Decision: If Net change in pretax profits > 0, the firm should change
4-46 its credit terms

Example 3: Change credit period

 Nike Company is considering changing its credit terms from

“net 30” to “net 60”.
 Nike’s Expectations: (1) Sales on credit to increase by about
10% from a current level of $2.2 million, and (2) Its average
collection period to increase from 35 days to 65 days.
 The bad-debt loss ratio should remain at 3 percent of sales.
 An additional inventory investment of $50,000 is required for
the expected sales increase.
 The company’s variable cost ratio is 0.75 its profit
contribution ratio (per dollar of sales) is 1.00 – 0.75 = 0.25
 Pretax rate of return on investments in receivables and
inventories is 20 percent.
How is Nike’s decision to change its credit terms?
4-47

Example 4:
Relaxing the Credit Period
 Basket Wonders is considering changing its credit period from “net
30” (which has resulted in 12 A/R “Turns” per year) to “net 60”
(which is expected to result in 6 A/R “Turns” per year).
 The firm is currently producing a single product with variable costs
of $20 and a selling price of $25.
 Additional annual credit sales of $250,000 from new customers are
forecasted, in addition to the current $2 million in annual credit
sales.
 The before-tax opportunity cost for each dollar of funds “tied-up” in
additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise, should
Basket Wonders relax their credit period?
4-48

4 - 16
 Example 5: Change cash discount

 Sony Music is considering instituting a cash discount. The

company currently sells to record distributors on credit terms of
“net 30” and wants to determine the effect on pretax profits of
offering a 1% cash discount on terms of “1/10, net 30” to record
distributors.
 The company’s average collection period is now 50 days and is
estimated to decrease to 28 days with the adoption of the 1%
cash discount policy. It also is estimated that approximately 40%
of the company’s customers will take advantage of the new cash
discount.
 Sony’s annual credit sales are $2.5 million, and the company’s
required pretax rate of return on receivables investment is 20%.

How is Sony Music’s decision to change its credit terms?

4-49

Example 6:
Using a Cash Discount
 A competing firm of Basket Wonders is considering changing
the credit period from “net 60” (which has resulted in 6 A/R
“Turns” per year) to “2/10, net 60.”
 Current annual credit sales of $5 million are expected to be
maintained.
 The firm expects 30% of its credit customers (in dollar
volume) to take the cash discount and thus increase A/R
“Turns” to 8.
 The before-tax opportunity cost for each dollar of funds “tied-
up” in additional receivables is 20%.
Ignoring any additional bad-debt losses that may arise,
should the competing firm introduce a cash discount?
4-50

Example 7: Default Risk and Bad-

Debt Losses

Present
Policy Policy A Policy B

Demand $2,400,000 $3,000,000 $3,300,000

Incremental sales $ 600,000 $ 300,000
Default losses
Original sales 2%
Incremental Sales 10% 18%
Avg. Collection Pd.
Original sales 1 month
Incremental Sales 2 months 3 months

4-51

4 - 17
 Example 7: Default Risk and Bad-
Debt Losses

Policy A Policy B
1. Additional sales $600,000 $300,000
2. Profitability: (20% contribution) x (1) 120,000 60,000
3. Add. bad-debt losses: (1) x (bad-debt %) 60,000 54,000
4. Add. receivables: (1) / (New Rec. Turns) 100,000 75,000
5. Inv. in add. receivables: (.80) x (4) 80,000 60,000
6. Required before-tax return on
additional investment: (5) x (20%) 16,000 12,000
7. Additional bad-debt losses +
additional required return: (3) + (6) 76,000 66,000

8. Incremental profitability: (2) - (7) 44,000 (6,000)

4-52 Adopt Policy A but not Policy B.

Collection Efforts
 Used methods
 Send notices/letters informing the customer of the
past-due status of the account and requesting
payment
 Telephone/visit the customer in an effort to obtain
payment
 Employ a collection agency
 Take legal action against the customer
 Monitoring status by Aging of accounts
 Classifying accounts into categories according to the
number of days they are past due
 Changes in the age composition of accounts may
reveal changes in the quality of A/R
4-53

Evaluation of Credit Applications

 Gathering information on the credit applicants
about
 Financial statements
 Credit reporting organizations
 Banks
 Prior experience with the customer

 Analyzing the information obtained to determine

the applicant’s creditworthiness based on “five
Cs of credit)
 Character
 Capacity
 Capital
 Collateral
 Conditions

4-54
 Making the credit decision

4 - 18
 3. Inventory Management
 Inventory
 Inventory is an essential part of virtually all business
operations and serves as a buffer in the procurement-
production-sales cycle
 Inventory provide Flexibility for the firm in
 timing the purchase of raw materials
 Scheduling production facilities & employees
 Meeting fluctuating & uncertain demand
 Holding of inventories constitutes an investment of funds
 Inventories form a link between production and sale
of a product
4-55

Types of Inventory
 Supplies
 Raw materials inventory
 Stores of items used in production
 Quantity discounts
 Assure supply in times of scarcity
 Work-in-process inventory
 Items at some intermediate state of completion
 Allows for asynchronous schedules
 Size related to length and complexity of
production cycle
 Finished goods inventory
 Items ready and available for sale
 Permits prompt filling of orders
4-56  Economies of scale

Costs Associated with an

Inventory Policy
 Ordering costs
Costs of placing and receiving an order of goods
 Carrying costs
Costs of holding inventory for a given period of time, including:
 Storage and handing costs
 Obsolescence deterioration costs
 Insurance
 Taxes
 The costs of funds invested in inventories
 Stockout costs
Incurred when a firm is unable to fill an order (Lost sales –
Rescheduling production – Placing and expediting special
orders)
4-57

4 - 19
 Inventory Control Models
 Classified into 2 types
 Deterministicmodel: if demand and lead time
are known with certainty
 Probabilistic model: if demand and lead time
are random variables with known probability
distributions

4-58

Inventory Control Models

 ABC method of inventory control

 Basic EOQ model
 Extensions of Basic EOQ model

4-59

ABC method of Inventory Control

If a firm were to rank inventory items by decreasing value
per item, we might get a cumulative distribution as the
Figure

 A: reflects that roughly 15% of

the items in inventory account
for 70% of inventory value.
 B: the next 30% of the items
account for 20% of inventory
value.
 C: 55% of the items explain
only 10% of total inventory
value.

4-60

4 - 20
 ABC Method of Inventory Control

ABC method of
100
inventory control Cumulative Percentage
of Inventory Value
90
Method which controls
expensive inventory
C
items more closely than 70 B
less expensive items.

 Review “A” items

most frequently A
 Review “B” and “C” 0 15 45 100
items less rigorously Cumulative Percentage
and/or less frequently. of Items in Inventory
4-61

Basic Economic order quantity (EOQ)

Model
 The objective of the economic order quantity (EOQ) model is to find the
order quantity that minimizes total inventory costs
 Let: Q = order quantity (in units); D = annual demand for the item (in units);
S = cost of placing and receiving the order (or setup cost); C = cost of
carrying 1 unit of the item in inventory; Q* = EOQ (or optimal quantity); T*
= the optimal cost.
Then:
 Ordering costs = number of orders per year  Cost per order = D/Q x S
 Carrying costs = Average INV  annual carrying cost per unit =Q/2 x C
 Total costs (T) = Ordering costs + Carrying costs = ( D/Q  S ) + (Q/ 2 C)

4-62

Total Inventory Costs

Q
Average
INVENTORY
(in units)

Inventory
Q/2

TIME

Total inventory costs (T)

= Ordering costs + Carrying costs
= ( D/Q x S ) + ( Q/2 x C)
4-63

4 - 21
 Economic Order Quantity

The quantity of an inventory item to order so that total

inventory costs are minimized over the firm’s planning period.

The EOQ or
optimal 2SxD
quantity Q* = C
(Q*) is:

D = annual demand for the item (in units)

S = cost of placing and receiving the order (or setup cost)
C = cost of carrying 1 unit of the item in inventory
4-64

Example 8: EOQ Model

 Marshall Field’s sells Simmons mattresses through its

department stores located in the Chicago metropolitan area.
All inventories are maintained at the firm’s centrally located
warehouse.
 Annual demand for the Simmons standard-size mattress is
3,600 units and is spread evenly throughout the year.
 The cost of placing and receiving an order is $31.25.
 Marshall Field’s annual carrying costs are 20 percent of the
inventory value
 Wholesale cost is $50 per mattress
What is optimal inventory cycle?
4-65

Example 9: EOQ Model

Basket Wonders is attempting to determine the

economic order quantity for fabric used in the
production of baskets.
 10,000 yards of fabric were used at a constant rate
last period.
 Each order represents an ordering cost of $200.
 Carrying costs are $1 per yard over the 100-day
planning period.

What is the economic order quantity?

4-66

4 - 22
 Extensions of the EOQ model

EOQ (Q*) represents the minimum point

in total inventory costs.

Total Inventory Costs

Costs

Total Carrying Costs

Total Ordering Costs

Q* Order Size (Q)

4-67

4. Short-term Financing
 Spontaneous Financing
 Accounts Payable:
 open accounts

 Notes Payable

 Trade Acceptances

 Accrued Expenses: expenses of wages, taxes,

interest, and dividends
 Negotiated Financing
 Money Market Credit:
 Commercial Paper issued by large corporation (IOU)
and issued by a bank (letter of credit L/C)
 Bankers’ Acceptances

 Unsecured Loans:
 Line of Credit
 Revolving Credit Agreement
 Transaction Loan
4-68

Spontaneous Financing
 Accounts Payable: Trade Credit from Suppliers
(Trade Credit : credit granted from one business to
another)
 Open Accounts: the seller ships goods to the buyer with
an invoice specifying goods shipped, total amount due,
and terms of the sale.
 Notes Payable: the buyer signs a note that evidences a
debt to the seller.
 Trade Acceptances: the seller draws a draft on the
buyer that orders the buyer to pay the draft at some
future time period.
 Accrued Expenses: Amounts owed but not yet paid for
wages, taxes, interest, and dividends. The accrued
expenses account is a short-term liability.
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 Negotiated financing
 Money Market Credit
 Commercial Paper:
- Short-term, unsecured promissory notes, generally issued by
large corporations (unsecured corporate IOUs).
- A bank provides a letter of credit (L/C), for a fee, guaranteeing
the investor that the company’s obligation will be paid.
 Bankers’ Acceptances: Short-term promissory trade notes for
which a bank (by having “accepted” them) promises to pay the
holder the face amount at maturity.
 Unsecured Loans
 Line of Credit (with a bank): An informal arrangement between a
bank and its customer specifying the maximum amount of credit
the bank will permit the firm to owe at any one time.
 Revolving Credit Agreement: A formal, legal commitment to
extend credit up to some maximum amount over a stated period
of time
 Transaction Loan: A loan agreement that meets the short-term
funds needs of the firm for a single, specific purpose
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Composition of
Short-Term Financing
The best mix of short-term financing
depends on:
 Cost of the financing method
 Availability of funds
 Timing
 Flexibility
 Degree to which the assets are
encumbered

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