FINMNN1

FINANCIAL MANAGEMENT 1

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Prepared by:
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RHAD VIC F.
ESTOQUE, CPA, MBA,
RCA, CAT, MICB, AFA,
CMA
 CHAPTER 4
Financing Current Assets- Short Term Financing
a. Sources of short-term funds (trade credit, bank loans, commercial papers, receivable factoring)
b. Estimating cost of short-term funds (annual cost of trade credit, effective and nominal annual
rate of short-term funds)

At the end of the unit, the students must have:

1. formulated strategies for Spontaneous sources of liabilities(PLO 1; PI 6 )
2. created a plan utilizing Unsecured and Secured sources of Short-term financing.(PLO 1; PI 5 )
3. formulated a strategy for other sources of short-term financing(PLO1 ; PI 5 )

3.1 Short-Term Debt Explained

Short term refers to the time for which a loan is required and the period over which its
repayment is expected to take place. Short Term Loans usually take the form of operating term
loans (less than one year) and revolving lines of credit. These finance the day-to-day operations
of the business, including wages of employees and purchases of inventory and supplies.
Supplies are used up quickly and inventory is sold resulting in stock-turns. Also bridge financing
(interim loans with a short, fixed term) can be used to finance accounts receivable contracts,
which are relatively risk-free, but delayed for one to three months.

Short term operations money may be secured against first, any unencumbered physical assets
of the business; second, additional funds from shareholders or personal guarantees from
principals. On occasion, inventories can be used as temporary security for operations loans.
Bridge financing is normally secured by assignment of all the receivables and personal
guarantees. On the balance sheet the accounts receivable, inventory and supplies stocks show
up in the current assets section, while the counterpart loan information is displayed in the
current liabilities section.

Lenders normally charge a higher base rate of interest for operating loans reflecting this
relatively weaker security position. The amount of the operating line of credit, will be determined
from the projected cash flow information in the business plan. Lenders favor businesses that
exhibit strong management, steady growth potential and reliable projected cash flow (
demonstrating the business ability to pay the monthly interest payments on this line of credit
from its projected revenues in a written business plan).

In other words, the short-term debts are those debts that are payable within one-year from the
balance sheet date.

3.2 Operating Term Loans

Operating Term Loans for working capital are used to enable a retail, service or manufacturing
business to purchase raw materials, retail or parts inventories, process or promote these and

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pay monthly expenses including principal and interest on outstanding term loans, wages and
salaries, rentals, leases, utilities, etc.

If a business was able to sell all its inventory (stock) at full margin and collect the cash for it
immediately, realizing its profit before it had to pay suppliers for that stock and before it had to
pay its monthly expenses, that business might require no particular working capital loans.
However, most are not cash businesses and don't enjoy that luxury.

They face build-ups of day-to-day and monthly expenses such as stock parables, wages,
rentals, leases, etc., often in advance of collecting the cash sales revenues to pay the trade
suppliers, the labor commitments and the regular overhead expenses.

Operating Term Loans (Working Capital) are commonly offered by credit unions and non-
commercial lenders who are unwilling or unable to offer operating (revolving) lines of credit to
their customers. This term loan is made like any other term loan, and is fully secured against
unencumbered assets, personal guarantees and co-signers.

Spontaneous Liabilities
Financing that arises from the normal course of business; the two major short-term sources of
such liabilities are accounts payable and accruals. There is normally no explicit costs attached
to either of these current liabilities, although they have certain implicit costs. In addition, both
are form of unsecured short-term financing-short-term financing obtained without pledging
specific assets as collateral.

Accounts payable Management

Accounts payable- These are the major source of unsecured short-term financing for business
firms. They result from transactions in which merchandise is purchased but no formal note is
signed to show the purchaser’s liability to the seller. The purchaser in effect agrees to pay the
supplier the amount required in accordance with credit terms normally stated on the supplier’s
invoice.

Also important in understanding accounts payable are the following terms:

a. List price-seller’s quoted price before deducting the trade discount.
b. Trade discounts-deductions to the list price to arrive at the invoice price. These
discounts are not usually recorded at the books of the buyer or seller.
c. Cash discounts-deductions to the invoice price to arrive at the amount to be paid.
These are purchase discounts on the part of the buyer.

Illustration 1: Philipp Ka Tee Co, a grocery store, purchased P200,000 list price of merchandise
to Ram Meer Co on February 14. The terms are: 25, 10, 2/10, n/30.

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 Analysis:
List price=P200,000; Trade discounts=25%, 10%.
2/10= there is a 2% cash discount if paid within 10 days from the invoice date (in this case
invoice date is February 14)
n/30= the full invoice price is due and payable within 30 days if the discount is not taken.
Invoice price:
List price 200,000
Less: 1st trade discount
(25% X 200,000) 50,000
Total 150,000
Less: 2nd discount
(10% X 150,000) 15,000
Invoice price 135,000

The amount of accounts payable of Philipp Ka Tee Co on February 14 is P135,000 or equal to

the invoice price.
Cash discounts if paid within 10 days from February 14
Invoice price 135,000
Less: Cash discount
(2% X 135,000) 2,700
Cash paid to Rameer Co 132,300

3.3 Analyzing Credit Terms

The credit terms that a firm is offered by its suppliers enable it to delay payments for its
purchases. Because the supplier’s cost of having its money tied up in merchandise after it is
sold is probably reflected in the purchase price, the purchaser is already indirectly paying for
this benefit. The purchaser (buyer) should therefore carefully analyze credit terms to determine
the best credit strategy. The purchaser (buyer) has two options-to take the discount or to give
it up.

Taking the Cash discount. If the firm intends to take a cash discount, it should pay on the last
day of the discount period. There is no cost associated with taking a cash discount.

Let’s go back to the illustration above: If Philipp Ka Tee Co decides to take the cash discount,
he should pay on February 24 to have a discount (saving) of P2,700.

Giving up the Cash discount. If the firm chooses to give up the cash discount, it should pay
on the final day of the credit period. There is an implicit cost associated with giving up a cash

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discount. The cost of giving up a cash discount is the implied rate of interest paid to delay
payment of an account payable for an additional number of days.
(Nominal) Cost of giving up cash discount= CD_ X 360
100%-CD N
Where: CD=stated cash discount in percentage terms
N= number of days that payment can be delayed by giving up the
cash discount
= days credit outstanding minus discount period.

Let’s go back to the illustration again.

Substituting the values for CD (2%) and N (20 days= 30 days-10 days) The results are as
follows:
(Nominal )Cost of giving up cash discount = 2%/98% X 360/20
= 36.73 %

This example assumes that Philipp Ka Tee Co gives up only one discount during the year,
which costs 2.04 for 20 days ( that is, 2%/98%) when annualized. However, if Philipp Ka Tee
continually gives up the 2% cash discount, the effect of compounding will cause the annualized
cost to rise to 43.84%:
Annualized cost when discounts = (1+CD/100%-CD)360/N -1
= (1+2%/98%) 360/20 -1 = 43.84%

The higher the cost of giving up the discount, the more it is that the company should take the
discount.

Using the cost of Giving up a cash discount in Decision Making The financial manager
must determine whether it is advisable to take a cash discount. Financial managers must
remember that taking cash discounts may represent an important source of additional
profitability.

Illustration 2
Richie Co, has the following cost of giving up the discounts to its three suppliers:
Supplier A=40%
Supplier B=10%
Supplier C=25%
If the firm needs short-term funds, which it can borrow from its bank at an interest rate of 15%,
and if each of the suppliers is viewed separately, which if (any) of the suppliers’ cash discounts
will the firm give up?

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 Analysis:
In dealing with Supplier A, the firm should take the cash discount because the cost of giving it
up is 40% and then borrows the funds it requires from its banks at 15%.
With regards to Supplier B, the firm would do better to give up the cash discount, because the
cost of this action is less than the cost of borrowing money from the bank ( 10% versus 15%)
In dealing with Supplier C, the firm should take the cash discount because the cost of giving it
up is 40% and then borrows the funds it requires from its banks at 15%.

3.4 Effects of Stretching Accounts Payable

This is paying bills as late as possible without damaging its credit rating. Such a strategy can
reduce the cost of giving up a cash discount.

Using illustration 1 as an example: the cost of giving the cash discount is 36.73% but if the
company can extend its accounts payable to 70 days without damaging its credit rating, the
cost of giving up the cash discounts would be only 12.24% (2%/98% X 360/60).

Accruals
These liabilities for services received for which payment has yet to be made.

Examples: Accruals of rent expense, accruals of salaries/wages, accruals of taxes. Accruals

of wages are to be manipulated in some extent. This is accomplished by delaying payment of
wages, thereby receiving an interest-free loan from employees who are paid sometime after
they have performed the work.

Illustration 3
Tenney Co, a large janitorial service company, currently pays its employees at the end of each
work wee, The weekly payroll totals P800,000. If the firm were to extend the pay periods so as
to pay its employees 1 week later throughout an entire year, the employees would in effect be
lending the firm P800,000 for a year. If the firm could earn 10% annually on invested funds,
such a strategy would be worth P80,000 per year (0.10 X P800,000).

3.5 Unsecured Sources of Short-Term Loans

3.5.1 Bank Loans

Banks are major source of unsecured short-term loans to businesses. The major type of loan
made by banks to businesses is the short-term, self-liquidating loan. These loans are intended
merely to carry the firm through seasonal peaks in financing needs that are due primarily to
buildups of inventory and accounts receivable. As inventories and receivables are converted
to cash, the funds needed to retire these loans are generated. In other words, the use to which
the borrowed money is put provides the mechanism through which the loan is repaid-hence
the term self-liquidating.

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Three basic ways which the banks lends funds single payment notes, lines of credit, and
revolving credit agreements.

Interest on these loans

Prime rate- is the lowest rate of interest charged by leading banks on business loans to their
most important business borrowers. The prime rate fluctuates with changing supply-and-
demand relationships for short-term funds.

Fixed rate loan- the rate of interest is determined at a set increment above the prime rate on
the date of the loan and remains unvarying at that fixed rate until maturity.

Floating-rate loan- the increment above the prime rate is initially established, and the rate of
interest is allowed to “float”, or vary, above prime as the prime rate varies until maturity.

Method of computing interest

Formula 1 If interest is paid at maturity, the effective (or true) annual rate – the actual rate of
interest paid- for an assumed 1-year period is equal to
Interest
Amount borrowed

Formula 2 If interest is paid in advance, it is deducted from the loan so that the borrower
actually receives less money than is requested. Loans on which interest is paid in advance are
called discount loans. The effective annual rate for a discount loan, assuming a 1-year period
is equal to
Interest
Amount borrowed –Interest

Illustration 4:
Rock Kell Co, wants to borrow P100,000 at a stated rate of 12% interest for 1 year. Compute
for the interest assuming
a. Interest is paid at maturity
b. Interest is deducted in advance

Answers:
a. Interest= 12% X 100,000= 12,000
Substituting this to formula 1, interest rate= 12,000/100,000= 12%
b. Substituting this to formula 2, interest rate= 12,000/100,000-12,000
Or 12,000/88,000= 13.64%

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(Note: Paying interest in advance makes the effective annual rate (13.64%) greater than the
stated annual rate (10%))

Single payment note- this type of loan is usually a one-time loan made to a borrower who
needs funds for a specific purpose for a short period. The resulting instrument is a note, signed
by the borrower, that states the terms of the loan, including the length of the loan and the
interest rate.

Illustration 5
Kernel Co recently borrowed P150,000 from each of two banks- bank Ko and bank Mo. The
loans were incurred on the same day, when the prime rate of interest was 9%. Each loan
involved a 90-day note with interest to be paid at the end of 90 days.

Interest rate on Bank Ko-1..5% above the prime rate on its fixed-rate note
Interest rate on Bank Mo-1% above the prime rate on its floating-rate note
Increase in prime rates
after 30 days = 9.5%
after 60 days = 9.25%

Analysis:
Total interest cost on bank Ko loan=P3,937.50 [P150,000 X (10.5% X 90/360)]
Effective 90-day =3,937.50/150,000=2.625%

Assuming that the loan from bank Ko is rolled over each 90 days throughout the year under
the same terms and circumstances, the effective annual interest rate is computed as follows:
Effective annual rate = (1+i)360/N -1
= (1+0.02625)4 -1
= 1.1092 - 1
= 10.92%

Total interest cost on bank Mo loan:

Interest rate for the first 30 days=10% X 30/360=8.33%
Interest rate after 30 days=10.5% X 30/360=8.75%
Interest rate after 60 days=10.25% X 30/360=8.54%
So total interest cost=P150,000 X (0.8333% +0.875% + 0.854%)
=P3,843.50

Effective 90-day=P3,843.50/150,000=2.562%

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Assuming that the loan from bank Mo is rolled over each 90 days throughout the year under
the same terms and circumstances, the effective annual interest rate is computed as follows:
Effective annual rate = (1+I)360/N -1
= (1+0.02562)4 -1
= 10.65%

In this case, the floating rate loan would have been less expensive than the fixed-rate loan
because of its generally lower effective annual rate.

Lines of Credit
Lines of Credit-is an agreement between a commercial bank and a business specifying the
amount of unsecured short-term borrowing the bank will make available to the firm over a given
period of time. It is similar to the agreement under which issuers of bank credit cards, such as
MasterCard, Visa, and Discover, extend preapproved credit to cardholders. A line-of-credit
agreement is typically made for a period of 1 year and often places certain constraints on the
borrower.
It is not a guaranteed loan but indicates that if the bank has sufficient funds available, it will
allow the borrower to owe it up to a certain amount of money. The amount of a line of credit is
the maximum amount the firm can owe the bank at any point in time.

For example, on December 31, a bank loan officer might indicate to a financial manager that
the bank regards the firm as being good for up to P100,000 during the forth coming year,
provided the borrower’s financial condition does not deteriorate. If on January 10, the financial
manager signs a promissory note for P20,000 for 90 days, this would be called “taking down”
P20,000 of the total line of credit. This amount would be credited to the firm’s checking account
at the bank, and before repayment of the P20,000, the firm could borrow additional amounts
up to a total of P100,000 outstanding at any time.

Interest rates-it is usually stated as a floating rate-the prime rate plus a premium.

Operating-Change Restrictions In a line-of-credit agreement, a bank may impose operating-

change restrictions, which give it the right to revoke the line if any major changes occur in the
firm’s financial condition or operations.

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Compensating balances A required checking account balance equal to a certain percentage
of the amount borrowed from a bank under a line-of-credit or revolving credit agreement.
Generally, the rate is equal to 10 to 20 percent of the amount of loans outstanding.

Illustration 6
If a firm needs P100,000 to pay off outstanding obligations, but if it must maintain a 20 percent
compensating balance, then it must borrow P125,000 to obtain usable P100,000.

Illustration 7
Ara Co borrowed P1,000,000 under a line-of-credit agreement. It must pay a stated interest of
10% and maintain, in its checking account, a compensating balance equal to 20% of the
amount borrowed.
Amount received=P1,000,000 X (100%-20%) = P800,000
Interest=10% X P1,000,000=P100,000

Effective annual rate=Interest/Amount borrowed-Comp.

Balance = P100,000/1,000,000-200,000
= 100,000/800,000
= 12.5%

Annual cleanups The requirement that for a certain number of days during the year borrowers
under a line of credit carry a zero loan balance (that is, owe the bank nothing).

Revolving Credit Agreements

A line of credit guaranteed to a borrower by a commercial bank regardless of the scarcity of
money. It is not uncommon for a revolving credit agreement to be for a period greater than 1
year. Because the bank guarantees the availability of funds, a commitment fee is normally
charged on a revolving credit agreement. This fee often applies to the average unused balance
of the borrower’s credit line. It is normally about 0.5% of the average unused portion of the line.

Illustration 8
Aro Co has a P2,000,000 revolving credit agreement with its bank. Its average borrowing under
the agreement for the past year was P1,500,000. The bank charges a commitment fee of 0.5%.
Assuming that the stated interest for one-year is 10%.
Compute for the effective cost of the agreement.

Solution:
Commitment fee = (P2,000,000-1,500,000) X 0.5%
=P2,500

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 (This amount is also to be paid by the borrower)
Interest paid = (1,500,000 X 10% X 12/12)
= 150,000

Effective cost of the agreement = P150,000+2,500 / 1,500,000

= 10.167%

3.5.2 Commercial Paper

Commercial paper is a form of financing that consists of short-term, unsecured promissory
notes issued by firms with a high credit standing. Generally, only quite large firms of
unquestionable financial soundness are able to issue commercial paper. Most commercial
paper has maturities ranging from 3 to 270 days. Although there is no set denomination, it is
generally issued in multiples of P100,000 or more.

Interest on Commercial Paper

Commercial paper is sold at a discount from its par, or face value. The interest paid by the issuer
of commercial paper is determined by the size of the discount and the length of time of maturity.

Illustration 9
Mina Co has just sold an issue of 90-day commercial paper with a face value of P1,000,000. The
firm has received initial proceeds of P980,000.

What effective annual rate will the firm pay for financing with commercial paper, assuming that it is
rolled over every 90 days throughout the year.

Solution:
Effective 90-day rate = [(1,000,000-980,000)/980,000]
=2.04%

Assuming it is rolled over each 90 days throughout the year:

Effective rate = (1+i)360/N -1
= [(1+0.0204)360/90 –1
= 8.41%

An interesting characteristics of commercial paper is that its interest cost is normally 2 to 4 percent
below the prime rate. In other words, firms are able to raise funds more cheaply by selling
commercial paper than by borrowing from a commercial bank.

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3.6 Secured Sources of Short-Term Loans
This has a specific assets pledged as collateral. The collateral takes the form of accounts
receivable or inventory. The lender obtains a security interest in the collateral through the
execution of a security agreement with the borrower that specifies the collateral held against
the loan. If the borrower defaults, the lender may sell the security to pay off the loan.

Collateral value depends on:

 Marketability
 Life
 Riskiness

3.6.1 The Use of Accounts Receivable as Collateral

 Trade Accounts receivables refer to open accounts or claims arising from sale of
merchandise or services in the ordinary course of business operations.
 One of the most liquid asset accounts
 Loans by commercial banks or finance companies (banks offer lower interest rates).

Two commonly used means of obtaining short-term financing with accounts receivable are
pledging accounts receivable and factoring accounts receivable. Actually, only a pledge of
accounts receivable creates a secured short-term loan; factoring really entails the sale of
accounts receivable at a discount. Although factoring is not actually a form of secured short-
term borrowing, it does involve the use of accounts receivable to obtain needed short-term
funds.

Loan evaluations are made on:

 Quality: not all individual accounts have to be accepted (may reject on aging)
 Size: small accounts may be rejected as being too costly (per peso of loan) to handle by
the institution

3.6.2 Pledging of Accounts Receivable

Pledging Process
1. When a firm requests a loan against accounts receivable, the lender first evaluates the
firm’s accounts receivable to determine their desirability as collateral. The lender makes a
list of the acceptable accounts, along with the billing dates and amounts.
2. Selection of accounts for the loan. If the borrowing firm request for a fixed amount, the
lender needs to select only enough accounts to secure the funds requested. If the borrower
wants the maximum loan available, the lender evaluates all the accounts to select the
maximum amount of acceptable collateral.
3. After selecting the acceptable accounts, the lender normally adjusts the peso value of
these accounts for expected returns on sales and other allowances. The lender normally
reduces the value of the acceptable collateral by a fixed percentage.

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 4. The percentage to be advanced against the collateral must be determined. The lender
evaluates the quality of the acceptable receivables and the expected cost of their
liquidation. This percentage represents the principal of the loan and the typical ranges
between 50 and 90 percent of the face value of the acceptable accounts receivable.

Types of pledging of accounts receivable

 Non-notification- firm customers are not notified that their accounts have been pledged to
the lender. The firm forwards all payments from pledged accounts to the lender.
 Notification-firm customers are notified that their accounts have been pledged to the lender
and remittances are made directly to the lending institution.
Illustration 10
XYZ Co assigned P700,000 of accounts receivable to First Bank under a non-notification
arrangement. First Bank advances 80% less a service charge 2% service charge. XYZ Co
signed a promissory note that provides for interest of 3% per month on the unpaid loan balance.

Analysis
Cash to received by XYZ:
Accounts receivable pledged P 700,000
X Percentage of advance allowed
By First Bank 80%
Total (Amount of loans) 560,000
Less: Bank Service charge
(2% X 560,000) 11,200
Cash received by XYZ Co 548,800

Pledging cost The stated cost of a pledge of accounts receivable is normally 2 to 5 percent
above the prime rate. In addition to the stated interest rate, a service charge of up to 3 percent
may be levied by the lender to cover its administrative costs. Clearly, pledges of accounts
receivable are a high-cost source of short-term financing.

3.6.3 Factoring of Accounts Receivable

Involves selling of accounts receivable outright, at a discount, to a financial institution known
as factor. This is a sale of accounts receivable on a without recourse, notification basis.

Before merchandise is shipped to a customer, the selling company requests the factor’s credit
approval. If it is approved, the account is sold immediately to the factor after shipment of the
goods. The factor then assumes the credit function as well as the collection function.

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 Factoring cost Factoring costs include commissions, interest levied on advances, and interest
earned on surpluses. The factor deposits in the firm’s account book value of the collected or
due accounts purchased by the factor, less the commissions. The commissions are typically
stated as a 1 to 3 percent discount from the book value of factored accounts receivable. The
interest levied on the advances is generally 2 to 4 percent above the prime rate. It is levied on
the actual amount advanced. The interest paid by the factor on surpluses is generally between
0.2 and 0.5 percent per month.

Illustration 11
Assume accounts receivable of P500,000 with credit terms of 2/10, n/30 are factored
immediately after shipment of the goods to the customer. The factor charges a 3%
commissions based on the gross amount of the receivable factored. The factor made advance
to the seller.
Analysis
Gross amount P 500,000
Less: Sales discounts (2% X 500,000) 10,000
Commissions (3% X 500,000) 15,000 25,000
Cash received from factoring 475,000
The Use of Inventory as Collateral
 Floating inventory Liens
 Chattel mortgage Agreements
 Trust Receipt Inventory Loans
 Warehouse Receipt Loans
o Terminal Warehouse Arrangement
o Field Warehouse Arrangement

3.6.4 Other Techniques

The Use of Inventory as Collateral

Loan Evaluations are made on:
 Marketability
 Perishability
 Price stability
 Difficulty and expense of selling for loan satisfaction
 Cash-flow ability

Floating inventory Liens

A secured short-term loan against inventory under which the lender’s claim is on the borrower’s
inventory in general.

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Chattel Mortgage Agreement
A lien on specifically identified personal property (assets other than real estate) backing loan

Trust Receipt Inventory Loans

A secured short-term loan against inventory under which the lender advances 80 to 100 percent
of the cost of the borrower’s relatively expensive inventory items in exchange for the borrower’s
promise to repay the lender, with accrued interest, immediately after the sale of each item of
collateral.

Warehouse Receipt Loans

A secured short-term loan against inventory under which the lender receives control of the
pledged inventory collateral, which is stored by a designated warehousing company on the
lender’s behalf.
Terminal warehouse is a central warehouse that is used to store the merchandise of various
customers. The lender normally uses such a warehouse when the inventory is easily
transported and can be delivered to the warehouse when the inventory relatively inexpensive.

Terminal Warehouse Receipt

A receipt for the deposit of goods in a public warehouse hat a lender holds as collateral for a
loan.

Field warehouse under this arrangement, the lender hires a field warehousing company to set
up a warehouse arrangement on the borrower’s premises or to lease a part of the borrower’s
warehouse to store the pledged collateral.

Field Warehouse Receipt

A receipt for goods segregated and stored on the borrower’s premises (but under the control
of and independent warehousing company) that a lender holds as collateral for a loan.

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