CHAPTER 14 SHORT-TERM SOURCES FOR FINANCING CURRENT ASSETS Eypected

Larning Outeomes Affer studying Chapter 14, you should be able to: 1. Understand the need for
short-term financing. 2. Know the factors in selecting the source of short-term funds. 3.
Compute.the estimated cost of short-term credit. 4. ldentify and understand the different sources
of short-term funds and how they can be availed of.

CHAPTER 14 SHORT-TERM SOURCES FOR FINANCING CURRENT ASSETS

INTRÒDUCTION Shor-term financing refers to debt originally scheduled for repayment within
one year. Short-term financing is used to finance all or part of the firm's working capital
requirements and sometimes to meet permanent financing needs. The amount of short-term
versus intermediate and long-term financing used to provide funds to meet a firm's needs
depends largely on management's risk-return strategies. However., short-term financing is often
less expensive and more flexible than longer-term financing. There are two basic problems
encountered in managing the firm's use of short- term financing. These are determining the
level of short-term financing the firm should use, and selecting the source of short-term
financing. 2. FACTORS IN SELECTING A SOURCE OF SHORT-TERM FUNDS In general, the
basic factors to be considered in selecting among alternative short- m financing opportunities
are the effective cost of credit, the availability of credit in the amount needed and for the period
of time when financing is required, the influence of the use of a particular credit source on the
cost and availability of other sources of financing, and 1. 2. 3. 4. any additional covenants of the
loans that are unique to the sources mentioned previously.

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SOURCES OF SHORT-TERM FUNDS Short-term funds can be obtained through either

unsecured credit ór secured loans. They are either spontaneous or negotiated. ÜNSECURED
CREDIT VERSUS SECURED CREDIT Unsecured credit includes all those sources that have
as their security only the lender's faith in the ability of the borrower to repay the funds when due.
Unsecured short-term financing is an obligation without specific assets pledged as collateral.
Collateral is the asset that the borrower pledges to a lender until a loan is repaid. The stronger
the firm's overall credit rating, the more likely it will borrow on an unsecured basis. Both
borrowers and lenders prefer to do business on an unsecured basis. Unsecured loans are more
risky to lenders, but provide maximum flexibility to borrowers and are less costly to administer
than secured loans. The lender depends on the cash-generating ability of the firm to repay the
debt. However, if the borrower defauts on the loan or goes into bankruptcy, the unsecured
lender's chance of receiving full or partial payment is diminished because secured creditors
have a prior claim to the fim's assets. The major sources of unsecured short-term credit are
accruals, trade credit, bank loans, commercial papers, business firms and individuals.

Secured loans involve the pledge of snecifc assets as collateral in the borrower defauts in
payment of principal or interest. Accounts reo inventory are the most common sources of
collateral for short-term lender expects the loan to be repaid from the cash-generatin8 borrower
at maturity. If the borrower defaults. the lender has the legal rign t he collateral and sell it to pay
off the loan. and The Spontane0us Short-term Financing versus Nonspontaneous/Negotiated so
hort- term Financing Spontaneous Source of short-term financing are sources that arise
automaticaiy from ordinary business transaction. They do not require special eno negotiation on
the part of the finance officer. Spontaneously generated funds will be provided by accounts
payable and accruals. As sales increase, S0 W purchases of raw naterials that will lead to
higher levels of accounts payable. Similarly, a higher level of operations will require more labor
while higher sales will result in a higher taxable income. Therefore, the spontaneous liability
accounts payable will follow the movement of sales. r Nonspontaneous negotiated or short-term
financing are sources that require special effort or negotiation. The major sources of negotiated
short-term credit are bank loans, commercial paper and accounts receivable/inventory Joan.
ACCRUALS As the firm's sales increase, so does its labor expense, value-added taxes, income
taxes, and so on. Since most businesses pay their employces only periodically (weekly,
biweckly, or monthly) they accrue a wages payable account that is, in essence, a loan from the
firm's employees. Income taxes are likewise paid quarterly, VAT, withholding taxes, electricity
and other expenses are paid on a deferred basis. The longer the period of time that the firm
holds these payments. the greater the amount of financing they provide. These sources of
financing arise spontaneously with the fim's sales. accrued expense items provide the firm with
automatic or spontaneous sources of financing. These

TRADE CREDIT Irade credit provides one the most flexible sources of financing available to the
firm. It is also a primary source of spontaneous financing because it arises from ordinary
business transactions. For example, suppose a firm makes an average purchase of P5,000 a
day on terms of net 30, meaning it must settle the account 30 days after the invoice date. On
the average, it will owe the suppliers P150,000 (P5,000 x 30) per month. The firm would have
generated P150,000 of financing. If the terms under which the goods were purchased were
extended from 30 to 40 days, the accounts payable would expand from PI50,000 to P200,000.
Thus. lengthening the credit period as well as increasing the firm's purchases, generate
additional financing. Thus, Many firms attempt to stretch the payment period' to receive
additional short- term financing. This is an acceptable form of financing as long as it is not
carried to an abusive extent because such practice may alienate suppliers and cause a
diminished credit rating. A major variable in determining the payment period is the possible
existence of a cash discount. If the firm chooses to forego a possible cash discount opportunity
and utilize the funds made available to finance its working capital, then the resulting cash, as an
annualized percent, can be very high indeed. For example, if the seller offers terms of 2/10, n/30
which means a 2% discount from purchase price if paid in full within ten days of the receipt of
the bill, or the net amount due within thirty days, then the buyer incurs an opportunity cost of
36.7% per year if the cash discount is not taken. This is computed using Approximate Discount
Rate 360 Effective Cost of, = X Discount rate Credit period Discount period Trade Credit 100% -
2% 100% - 2% 360 30 - 10 X 36.7% The major advantage of trade credit lies in its rather quick
availability. In fact, during periods of tight money, trade credit may be the only source of working
capital for many small companies. The relatively high cost of trade credit makes it a less
desirable source of short-term financing when compared to other alternatives. Chronic reliance
on trade credit may in fact, impair the credit rating of the user firm in the long run due to its
greater impact on the liquidity risk of the business.

SHORT-TERM BANK LOANS Commercial banks are second in importance to trade credit as a
source of short- ng needs the term financing. Banks provide nonspontaneous funds. As a firm's
tinano incrcase, it requests additional funds from its bank. If the request 1s de firm may be
forced to abandon attractive business opportunities. Short-term loans vary in type, availability
and cost. The most common type i commercial bank loan that is for a specific purpose, short-
term and self-liquidatng Cash flow forecasts showing repayment ability are of prime importance.
financial statements may be required before the loan is granted. Since the Daik loan has a fixed
maturity date, the finance mảnager must be sure that the cash TlowS of the firm will be
sufficient to meet the short-term obligations when they become due. ailed When a bank loan is
approved, the agreement is executed by signing a promissory note. The note specifies the 1)
amount borrowed, 2) percentage interest rate, 3) repayment schedule, any collateral that might
have to be put up as security for the loan, and 4) any other terms and conditions to which the
bank and the borrower may have agreed. When the note is signed, the bank credits the
borrower's checking account with the proceeds of the loan. LINE OF CREDIT If the firm does
not wish to borrow until the working capital is actually required, it may arrange a credit
arrangement with a large commercial bank. arrangements often take either of the two forms:
These 1. The line of credit which is generally an informal arrangement in which a bank agrees to
lend up to a specified maximum amount of funds during a designated period. Interest is charged
on the amount açtually borrowed and a fee may be charged by the bank on the remaining line-
of-credit not in service. 2. Revolving credit agreement which is a legal commitment by the bank
to extend credit up to some maximum amount for a few months or several years. This is a
formal line of credit often used by large firms who pay an annual commitment of about 174 of
1% on the unused balance to compensate the banks for making the commitment. As
drawdowns are made, interest as the loan is charged which is usually pegged to the prime rate.
As payments are made on the loan, the credit line is restored back to the original maximum
amount. The distinguishing feature of this revolving credit agreement is that the bank has a legal
obligation to honor the agreement and it receivesa commitment fee. COMMERCIAL PAPER
Commercial paper is an unsecured short-term (six months or less) promissory note sold in he
money market by highly credit-worthy firms. Approval of the Securities and Exchange
Commission is necessary before such promissory notes can be issued. Süch high-credit
companies discover that their cash flows permit the creation of a financial instrument that has
about the same features as a treasury bill at a somewhat higher yield. Big firms use commercial
paper to finance their working capital because it is much less expensive than the costs of trade
credit. Other companies buy the commercial paper as part of their near-cash holdings for cash
management purposes. In addition, commercial paper costs are lower than most bank loans
and are not subject to the possibly restrictive covenants contained in many bank loans. Some
potential disadvantages of commercial paper relative to trade credit are 1. the fixed maturity
date which raises the liquidity risk and 2. its lack of user availability except for very large firms.
Secured sources of short-term credit have certain assets of the firm pledged as collateral to
secure the loan. Upon default of the loan agreement, the lender has first claim of the pledged
assets in addițion to its claims as a general creditor of the firm. Hence, the secured credit
agreement offers an added margin of safety to the lender. Short-term financing is obtainable
through: Pledging or assignment of accounts receivable Factoring of accounts receivable
Inventory loans with 1. 2. 3. a) floating or blanket lien b) chattel mortgage c) field warehouse
financing agreement d) terminal warehouse receipt

Pledging or Assignment of Accounts Receivable secured loan. Under pledging arrangement the
borrower simply pledges o value of the receivables pledged. secured loan. Under pledoi ered by
many lenders to be prime collateral for a accounts receivable as security for a loan obtained
from either a commer Accounts receivables are considered by many lenders to be prime
collateral for a or a finance company. The amount of the loan is stated at a ercent of the face If
all the accounts receivable are pledged as collateral for the loan and tne le has no contrơl over
the quality of the accounts receivable being pledged, ue loanable value is set at a relative low
percent generally ranging downward maximum of around 75 percent. However., if the lender
could select and assess the creditworthiness of each individual account being pledged, the loan
value mignt reach as high as 85% or 90% of the face value. er Cost of Financing A
disadvantage associated with this method of financing is its relatively high cost owing to the
interest rate charged on loans which is 2% to 5% higher than the bank's prime rate and
processing or handling fee of about 1% to 2% on pledged accounts. Illustrative Problem: The
XYZ Company sells plumbing supplies to building contractors on terns of net 60. The firm's
average monthly sales are 200,000; thus its average accounts receivable balance is P400,000,
based on the two months credit period. The company pledges all its receivables to a local bank,
which in turn advances up to 70% of the face value of the receiyables at 3% over prime and
witha 1% processing charge on all receivables pledged. XYZ Company follows a practice of
borrowing the maximum amount possible. The current prime rate is 12%. What is the effective
cost of using this source of financing for a full year?

The effective cost of this loan is computed as follows: (P400,000x 70% x 15%) + 1% x
P200,000x 12, mos.) 70% x P400,000 Effective annual rate = 360 360 X P42,000 + P24,000
P280,000 360 360 X 23.57% If the lender would provide biling and collection services, the value
of these services would be considered as a reduction of the cost of credit. In the preceding
example, XYZ Company may save credit department expenses of P1S,000 per year by
pledging all its accounts and letting the lender provide those services. In this case, the cost of
short-term credit will be: P42,000 + P24,000 - PIS,000 P280,000 Effective annual rate = 360
360 PSI,000 P280,000 X 360 360 18.21% Advantages and Disadvantages of Pledging One
primary advantage of pledging of accounts receivable as a source of short- term financing is its
flexibility. Financing is available on a continuous başis because as new accounts arise out of
credit sales, additional collateral is provided for the financing of new production, The primary
disadvantage associated with this method of financing is its cost, which can be relatively higher
compared with other sources of short-term credit.

Factoring Accounts Receivable Factoring receivables involves the outright sale of the firm's
accounts receivable to the finance company. The customer may be instructed to remit the p
eeds directly to the purchaser of the account. The factoring firm generaly o recourse against the
seller of the receivables. In practice, the finance conp may do part or all of the credit analysis
directly to ensure the quality O ccounts. 1he factoring or finance company forwards funds
immediately o the seller when accounts are accepted. The factoring company not only abSorDs
risk of non-collection but also advances the funds to the seller a imonth or So eario than the
seller would normally receive them. the Cost of Financing For assuming the risk, the factoring
firm is generally charged å fee or commission ranging from 1% to 3% of the invoices accepted.
In addition, it charges interest on funds advanced to the seller of the accounts. For example,
ifP200,000 a month is processed at a 1% commission and a 15% annual borrowing rate is
charged, what is the total effective annual cost of financing to the firm? The effective annual
cost of financing is computed as follows: 1.25% L.00% 2.25% X 12_months Interest for one
month Commission Total Monthly fee annual rate A variation in the practice is that the factor
does not make payment for factored accounts until the accounts have been collected as the
credit terms have been met. Should the firm wish to receive imnediate payment for its factored
accounts, it can borrow from the factor, using the factored accounts as collateral. The maximum
loan the firm can obtain is equal to the face value of its factored accounts less the factor's fee
(1% to 3%) less a reserve (6% to 10%) less the interest on the loan.

For exampie, ifP200,000 in receivable is factored which carry 30 day credit terms a 1% factor's
fee, a 69% reserve, an interest at 1% per month on advances, then the proceeds the firm can
receive is computed as follows: P200,000 (2,000) (12,000) (2,000) PI84,000 Face amount of
receivables factored.. Less: Fee (1% x P200,000). Reserve (6% x P200,000).. Interest (19%x
P200,000)..... Net proceeds ..... 1 30 360 P2,000 + P2,000 Effective annual financing cost X
P184,000 26.09% If one considers that the firn selling the accounts is transferring risk as well as
receiving funds early, which will enable it to take cash discounts on their own payables, the rate
may not be considered exorbitant. Furthermore, the firm is able to pass on much of the. credit-
granting costs to the financing company. Inventory Financing A fim may also borrow against
inventory to acquire funds. The extent to which inventory financing may be employed is based
on the marketability of the pledged g0ods, their associated price stability, and the perishability of
the product. Raw materials such as grains, oil, umber and chemicals are excellent sources of
collateral since they can easily be liquidated. Work in process investors however provide very
poor colateral because of their lack of materiality. Some of the typical arrangements by which
inventory can be used to secure short- term financing are (1) Blanket inventory lien (2) Trust
receipts / chattel mortgage agreement (3) Warehousing Blanket inventory lien. This gives the
lender a general lien or claim against the inventory of the borrower. The borrowing firm
maintains full control of the inventories and continues to sell and replace them as it sees fit. This
lack of physical control over the collateral greatly reduces the value of this type of security to the
lender.

Trust receipts / Chattel Mortgage Agreement. A trust receipt is an instrument acknowledging

that the borower holds the inventory and proceeds ho in trust for the lender. Each item is
carefully marked and specitied by sea number when sold, the proceeds are transferred to the
lender receipt is canceled. Although it provides tighter control than does tne va inventory lien, it
still does not give the lender direct control over inventoy only a better and more legally
enforceable system of tracing the goou financing device is very popular among auto and
industrial equipment lenoeis televisian and house appliance industries. This Warehousing.
Under this arrangement goods are physically identitied, segregated and stored under the
direction of an independent warehousing company. merchandise which carries title to the goods
represented therein. The receipt may be negotiable in which case title can be transferred
through sale of the warehouse receipt or nonnegotiable whereby title remains with the lender.
With a negotiable receipt arrangement the warehouse firm will only release the goods to
whoever holds the receipt, whereas with a nonnegotiable receipt the goods may be released
only on the written consent of the lender. The cost of such a loan can be quite high, since the
services of the field The. warehousing firm issues a. warehouse receipt for the warehouse
company must be paid by the borrower. Ilustrative Problem: Inventory financing The EBC
International Product follows a practice of obtaining short-term credit based on its seasonal
finished goods inventory. The firm builds up its inventories of furniture and other household
fixtures from July to October for sale in November and December. Thus, for the two-month
périod ended October, it uses the production of furniture as collateral for a short-term bank loan.
The bank lends. up to 70% of the value of the inventory at 14% interest plus a fixed fee of
P2,000 to cover the costs of a field warehousing agreement. During this period, the firm usually
has about P200,000 in inventories, which are used as collateral for the loan. What is the
effective annual cost of the short-term credit? Solution: Interest Warehousing Fee Net proceeds
of loan Rate X Term of loan P200,000 x 70% x 14% x 60/360) + P2,000) P140,000 x 60 360
22.57%