6 Short Term Financing VGU SUMMER 2023

6 Short-Term Financing
Prof. Dr. Leef H. Dierks – Corporate Finance – Summer 2023 © VGU (2023) 437
6.1 Working Capital Management
6.2 Short-Term Financial Planning
6.1 Working Capital Management
Overview of Working Capital
§ most projects require firm to invest in net working capital
§ main components of net working capital are cash, inventory, and

payables
§ working capital includes cash that is needed to run firm on day-

to-day basis
§ does not include excess cash, which is cash that is not required
to run business and can be invested at market rate
Source: adopted from Berk and DeMarzo, 2014

Overview of Working Capital
§ excess cash is part of firms capital structure, offsetting firm debt
§ any increase in net working capital represents investment that

reduces cash available to firm
§ working capital alters firm’s value by affecting its free cash flow

Cash Cycle
§ level of working capital reflects length of time between when
cash goes out of firm at beginning of production process and
when it comes back in
§ company first buys inventory from suppliers, in form of either raw

materials or finished goods
§ firm typically buys inventory on credit, i.e. firm does not have to
pay cash immediately at time of purchase

Cash Cycle
§ when inventory is ultimately sold, firm may extend credit to
customers, delaying when it will receive cash
§ cash cycle as “length of time between when firm pays cash to

purchase initial inventory and when it receives cash from sale of
output produced from that inventory”

Cash and Operating Cycles of Firm
Firm buys Firm pays Firm sells Firm receives

inventory inventory product payment
Inventory Accounts Receivable
Accounts Payable Cash Out Cash In
„Cash Cycle“
„Operating Cycle“
Cash Conversion Cycle
§ cash cycle can be measured by calculating cash conversion cycle
(CCC):
Accounts Receivable Days

+ Inventory Days
- Accounts Payable Days
= Cash Conversion Cycle

Cash Conversion Cycle
with:
Accounts Receivable Days
= Accounts Receivable / Average Daily Sales
Inventory Days
= Inventory / Average Daily Cost of Goods Sold
Accounts Payable Days

= Accounts Payable / Average Daily Cost of Goods Sold

Operating Cycle
§ firm‘s operating cycle is average length of time between when
firm originally purchases its inventory and when it receives cash
back from selling its product
§ if firm pays cash for its inventory, this period is identical to firm’s
cash cycle
§ most firms buy inventory on credit, i.e. they reduce amount of

time between cash investment and receipt of cash from that
investment
Rule of Thumb
§ the longer a firm‘s cash cycle, the more working capital it has,
and the more cash it needs to carry to conduct its daily
operations
§ example:
in 2022, Apple (AAPL) featured accounts receivable days of 19,
inventory days of 5 and accounts payable days of 74; CCC thus
stood at a negative 50

Trade Credit
§ when firm allows customer to pay for goods at some date later
than date of purchase, it creates account receivable for firm and
account payable for customer
§ accounts receivable represent credit sales for which firm has yet
to receive payment

Trade Credit
§ accounts payable balance represents amount that firm owes its
suppliers for goods that it has received but for which it has not
yet paid
§ credit that firm is extending to customers is known as trade

credit

Trade Credit
§ example:
if supplier offers its customers terms of “Net 30”, payment is not
due until 30 days from date of invoice, i.e. essentially, supplier is
letting customer use its money for an extra 30 days
sometimes, selling firm will offer buying firm discount if payment

is made early; terms “2/10, Net 30” mean that buying firm will
receive 2% discount if it pays goods within 10 days; otherwise
full amount is due in 30 days

Trade Credit
§ in perfectly competitive market, trade credit just another form of
financing
§ under Modigliani-Miller assumptions of perfect capital markets,

amounts of payables and receivables are therefore irrelevant
§ in reality, however, product markets are rarely perfectly

competitive, so firms can maximise their value by using their
trade credit options effectively

Cost of Trade Credit
§ trade credit is, in essence, loan from the selling firm to its
customer with price discount representing interest rate
§ suppose firm sells product for $100 but offers customer terms of
2/10 Net 30
§ customer does not have to pay anything for first ten days, so
effectively has zero-interest loan for this period

§ if customer takes advantage of discount and pays within 10-day
discount period, customer pays only $98
§ cost of discount to selling firm is equal to discount percentage

times selling price, i.e. in this case 0.02 times $100 (or $2.00)
§ rather than pay within 10 days, customer has option to use $98
for an additional 20 days (30 - 10 = 20 days)
§ interest rate for 20-day term of loan is $2 / $98 = 2.04%

§ with 365-day year, this rate of 2.04% over 20 days corresponds
to effective annual rate of EAR = (1.0204) 365 / 20 - 1 = 44.6%
§ thus, by not taking discount, firm is effectively paying 2.04% to

borrow money for 20 days, which translates to an effective
annual rate of 44.6%
§ if firm can obtain bank loan at lower interest rate, it would be

better off borrowing at lower rate and using cash proceeds of
loan to take advantage of discount offered by supplier
6.2 Short-Term Financial Planning
Forecasting Short-Term Financing Needs
§ first step in short-term financial planning is to forecast company’s
future cash flows
§ two distinct objectives:
• first, company forecasts its cash flows to determine whether

it will have surplus cash or cash deficit for each period
• second, management needs to decide whether that surplus

or deficit is temporary or permanent (if permanent, it may
affect firm’s long-term financial decisions)

Forecasting Short-Term Financing Needs
§ if company anticipates ongoing surplus of cash, it may choose to
increase its dividend payout
§ deficits resulting from investments in long-term projects are

often financed using long-term sources of capital, such as equity
or long-term bonds
§ firms typically require short-term financing for three reasons:
1. seasonalities,
2. negative cash flow shocks, and
3. positive cash flow shocks
Seasonalities
§ for many firms, sales are seasonal
§ when sales are concentrated during few months, sources and

uses of cash are also likely to be seasonal
§ firms in this position may find themselves with surplus of cash

during some months (that is insufficient to compensate for
shortfall during other months)
§ because of timing differences, such firms often have short-term

financing needs
Seasonalities
§ two effects of seasonality on cash flow
• first, while cost of goods sold fluctuates proportionally with

sales, other costs (such as administrative overhead and
depreciation) do not, leading to large changes in firm’s net
income by quarter
• second, net working capital changes are more pronounced

as a result of production (uniform), sales (seasonal), and
inventory (seasonal)

Negative Cash Flow Shocks
§ occasionally, company will encounter circumstances in which
cash flows are temporarily negative for unexpected reason, i.e.
so-called negative cash flow shock
§ like seasonalities, negative cash flow shocks can create short-

term financing needs

Positive Cash Flow Shocks
§ despite being good news, positive cash flow shock affects short-
term financing needs as it could create demand for short-term
financing needs
§ positive cash flow effects could arise from increased sales, for
example, which could lead to higher net income (as well as
potentially higher accounts receivable and accounts payable)

Matching Principle
§ in perfect capital market, choice of financing is irrelevant; thus,
how firm chooses to finance its short-term cash needs cannot
affect value (Modigliani/Miller)
§ in reality, however, important market frictions exist, including

transaction costs, e.g. opportunity cost of holding cash in
accounts that pay little or no interest
§ firms also face high transaction costs if they need to negotiate

loan on short notice to cover cash shortfall
Matching Principle
§ firms can increase their value by adopting policy that minimizes
these kinds of costs
§ one such policy is known as matching principle
§ matching principle states that “short-term needs should be

financed with short-term debt and long-term needs should be
financed with long-term sources of funds”

Permanent Working Capital
§ permanent working capital is amount firm must keep invested in
its short-term assets to support continuing operations
§ as this investment in working capital is required so long as firm

remains in business, it constitutes long-term investment
§ matching principle indicates that firm should finance this

permanent investment in working capital with long-term sources
of funds
§ such sources have lower transaction costs than short-term

sources of funds, which need to be replaced more often
Temporary Working Capital
§ another portion of firm’s investment in its accounts receivable
and inventory is temporary and results from seasonal fluctuations
in firm’s business or unanticipated shocks
§ this temporary working capital is difference between actual level

of investment in short-term assets and permanent working
capital investment
§ because temporary working capital represents short-term need,

firm should finance this portion of its investment with short-term
financing
Financing Policy Choices
§ following matching principle should, in the long run, help
minimise firm’s transaction costs
§ what if, instead of using matching principle, firm financed its

permanent working capital needs with short-term debt?
§ when short-term debt comes due, firm will have to negotiate

new loan; new loan will involve additional transaction costs (and
it will carry whatever market interest rate exists at the time)
§ firm thus exposed to interest rate risk

§ financing part or all of permanent working capital with short-
term debt is known as aggressive financing policy
§ ultra-aggressive financing policy would involve financing even

some of the plant, property and equipment with short-term
sources of funds
§ when yield curve is upward sloping, interest rate on short-term

debt is lower than rate on long-term debt, i.e. short-term debt
may appear cheaper than long-term debt
§ with perfect capital markets, however, Modigliani and Miller
show that benefit of lower rate from short-term debt is offset by
risk that firm will have to refinance debt in future at higher rate
§ risk is borne by equity holders, so that firm’s equity cost of

capital will rise to offset any benefit from lower borrowing rate
§ why would firm thus choose aggressive financing policy?

§ aggressive financing policy might be beneficial if market
imperfections such as agency costs or asymmetric information,
are relevant
§ value of short-term debt is less sensitive to firm’s credit quality

than long-term debt; i.e. its value will be less affected by
managements actions or information
§ short-term debt could have lower agency costs than long-term

debt, and aggressive financing policy can benefit shareholders
§ on the other hand, by relying on short-term debt, firm exposes
itself to funding risk, i.e. risk of incurring financial distress costs,
should the firm not be able to refinance its debt in timely
manner or at reasonable rate
§ alternatively, firm could finance its short-term needs with long-

term debt, i.e. so-called conservative financing policy
§ when following such conservative financing policy, firm would

use long-term sources of funds to finance its fixed assets,
permanent working capital and some of its seasonal needs
§ while conservative financing policy reduces funding risk, it entails
other costs:
1. excess cash may earn below market interest rate, thereby

reducing firm’s value
2. even if cash is invested at competitive rat, interest income

on cash will be subject to double taxation (additional costs)
3. holding excess cash with firm increases possibility that

managers of firm will use it non-productively

Short-Term Financing …
§ once firm determines short-term financing needs, it must choose
which instruments it will use for this purpose
§ in the following, we distinguish between
1. short-term financing with bank loans,

2. short-term financing with commercial paper, and
3. short-term financing with secured financing

… with Bank Loans
§ one of primary sources of short-term financing (especially for
SMEs) is commercial bank
§ bank loans are typically initiated with promissory note, i.e. written
statement indicating amount of loan, date payment is due, and
interest rate
§ three types of bank loans:

1. single, end-of-period payment loans,
2. lines of credit, and
3. bridge loans

Single, End of Period Payment Loan
§ most straightforward type of bank loan
§ requires firm to pay interest on loan and pay back principal in

one lump sum at end of loan
§ interest rate may be fixed or variable:

• with fixed interest rate, specific rate that commercial bank
will charge is stipulated at time loan is made
• with variable interest rate, terms of loan may indicate that
rate will vary with some spread relative to benchmark
Line of Credit
§ bank agrees to lend firm any amount up to stated maximum
§ flexible agreement allows firm to draw upon line of credit

whenever it chooses
§ uncommitted line of credit is an informal agreement that does

not legally bind bank to provide funds

Line of Credit
§ committed line of credit consists of written, legally binding
agreement that obligates bank to provide funds regardless of
financial condition of firm (unless firm is bankrupt), as long as
firm satisfies any restriction in agreement

Line of Credit
§ arrangements typically accompanied by compensating balance
requirement (i.e. requirement that firm maintains minimum level
of deposits with bank) and restrictions regarding level of firm’s
working capital
§ firm pays commitment fee based on percentage of unused

portion of line of credit plus interest on amount borrowed
§ line of credit agreement may stipulate that at some pint in time,

outstanding balance must be zero – to ensure that firm does not
use short-term financing to finance its long-term obligations
Line of Credit
§ banks usually renegotiate terms of line of credit on annual basis
§ revolving line of credit (also: revolver) is committed line of credit

that involves solid commitment from bank for longer period of
time, typically two to three years
§ revolving line of credit with no fixed maturity is referred to a

evergreen credit

Bridge Loan
§ another type of short-term bank loan, which is often used to
“bridge gap”
§ bridge loans often quoted as discount loans with fixed interest

rate
§ borrower is required to pay interest at beginning of loan period
§ lender deducts interest from loan proceeds when loan is made

… with Commercial Paper
§ commercial paper is short-term, unsecured debt used by large
corporations that is usually a cheaper source of funds than short-
term bank loan
§ in case of direct paper, firm sells security directly to investors
§ in case of dealer paper, dealers sell CP to investors in exchange

for spread (fee) for their services
§ spread decreases proceeds that issuing firm receives
§ like long-term debt, CP is rated by credit rating agencies

… with Secured Financing
§ short-term financing by using secured loans, i.e. loans
collateralised with short-term assets such as the firm‘s accounts
receivables or inventory
§ most common sources for secured short-term loans are

commercial banks, finance companies, and so-called factors

Accounts Receivable as Collateral
§ pledging of accounts receivable
• lender reviews invoices that represent credit sales of
borrowing firm and decides which credit accounts it will
accept as collateral for loan based on its credit standards
• lender typically lends borrow some percentage of value of
accepted invoices, e.g. 75%
§ factoring of accounts receivable

• firm sells receivables to lender (i.e. factor) and lender agrees
to pay firm amount due from its customers art end of firm’s
payment period
Accounts Receivable as Collateral
§ factoring agreement with recourse: lender can seek payment
from borrower should borrower’s customer default with their
bills
§ factoring agreement without recourse: lender bears risk of bad-

debt losses, i.e. factor will pay firm amount due regardless of
whether factor receives payment from firm’s customers

Inventory as Collateral
§ inventory can be used as collateral for loan in three ways:
1. floating lien
2. trust receipt
3. warehouse arrangement
a. public warehouse
b. field warehouse

Floating Lien
§ in floating lien (also: general lien or blanket lien arrangement), all
of inventory is used to secure loan
§ arrangement is riskiest setup from standpoint of lender because

value of collateral used to secure loan declines as inventory is
sold
§ in case of firm becoming financially distressed, management

could sell inventory without repaying loan (loan could then
become under-collateralised)

Trust Receipt
§ with trust receipts loan (also: floor panning), distinguishable
inventory items are held in trust as security for loan
§ as items are sold, firm remits proceeds from sale to lender in

repayment of loan
§ lender will periodically assess specified inventory to ensure

borrower has not sold some of specified inventory and failed to
make repayment on loan

Warehouse Arrangement
§ inventory that serves as collateral for loan is stored in warehouse
§ least risky collateral arrangement from lender’s standpoint
§ arrangement can be set up in two ways:
• public warehouse, i.e. business that exists for sole purpose

of storing and tracking inflow and outflow of inventory
• field warehouse, i.e. operated by third party but set up on

borrower’s premises in separate area
The end.

6 Short Term Financing VGU SUMMER 2023

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6 Short-Term Financing

§ main components of net working capital are cash, inventory, and

§ working capital includes cash that is needed to run firm on day-

Source: adopted from Berk and DeMarzo, 2014

§ any increase in net working capital represents investment that

Source: adopted from Berk and DeMarzo, 2014

§ company first buys inventory from suppliers, in form of either raw

Source: adopted from Berk and DeMarzo, 2014

§ cash cycle as “length of time between when firm pays cash to

Source: adopted from Berk and DeMarzo, 2014

Firm buys Firm pays Firm sells Firm receives

Inventory Accounts Receivable

Accounts Payable Cash Out Cash In

Accounts Receivable Days

Source: adopted from Berk and DeMarzo, 2014

Accounts Payable Days

Source: adopted from Berk and DeMarzo, 2014

§ most firms buy inventory on credit, i.e. they reduce amount of

Source: adopted from Berk and DeMarzo, 2014

Source: adopted from Berk and DeMarzo, 2014

§ credit that firm is extending to customers is known as trade

Source: adopted from Berk and DeMarzo, 2014

sometimes, selling firm will offer buying firm discount if payment

Source: adopted from Berk and DeMarzo, 2014

§ under Modigliani-Miller assumptions of perfect capital markets,

§ in reality, however, product markets are rarely perfectly

Source: adopted from Berk and DeMarzo, 2014

Source: adopted from Berk and DeMarzo, 2014

§ cost of discount to selling firm is equal to discount percentage

§ interest rate for 20-day term of loan is $2 / $98 = 2.04%

§ thus, by not taking discount, firm is effectively paying 2.04% to

§ if firm can obtain bank loan at lower interest rate, it would be

§ two distinct objectives:

• first, company forecasts its cash flows to determine whether

• second, management needs to decide whether that surplus

Source: adopted from Berk and DeMarzo, 2014

§ deficits resulting from investments in long-term projects are

§ firms typically require short-term financing for three reasons:

§ when sales are concentrated during few months, sources and

§ firms in this position may find themselves with surplus of cash

§ because of timing differences, such firms often have short-term

• first, while cost of goods sold fluctuates proportionally with

• second, net working capital changes are more pronounced

Source: adopted from Berk and DeMarzo, 2014

§ like seasonalities, negative cash flow shocks can create short-

Source: adopted from Berk and DeMarzo, 2014

Source: adopted from Berk and DeMarzo, 2014

§ in reality, however, important market frictions exist, including

§ firms also face high transaction costs if they need to negotiate

§ one such policy is known as matching principle

§ matching principle states that “short-term needs should be

Source: adopted from Berk and DeMarzo, 2014

§ as this investment in working capital is required so long as firm

§ matching principle indicates that firm should finance this

§ such sources have lower transaction costs than short-term

§ this temporary working capital is difference between actual level

§ because temporary working capital represents short-term need,

§ what if, instead of using matching principle, firm financed its

§ when short-term debt comes due, firm will have to negotiate

§ firm thus exposed to interest rate risk

§ ultra-aggressive financing policy would involve financing even

§ when yield curve is upward sloping, interest rate on short-term

§ risk is borne by equity holders, so that firm’s equity cost of