Short Term

Financing
Decision

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 Learning Objectives
• The need for short-term financing.
• The advantages and disadvantages of
short-term financing.
• Three types of short-term financing.
• Computation of the cost of trade credit,
commercial paper, and bank loans.
• How to use accounts receivable and
inventory as collateral for short-term loans.

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Why Do Firms Need Short-term Financing?
• Cash flow from operations may not be sufficient
to keep up with growth-related financing needs.
• Firms may prefer to borrow now for their
inventory or other short term asset (current
asset) needs rather than wait until they have
saved enough.
• Firms prefer short-term financing instead of
long-term sources of financing due to:
– easier availability
– usually has lower cost
– matches need for short term assets, like inventory
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 Sources of Short-term Financing
• Short-term loans / Overdrafts.
– borrowing from banks and other financial institutions
for one year or less.

• Trade Credit.
– borrowing from suppliers

• Commercial Paper.
– Issued by large credit- worthy businesses.

• Banker’s Acceptance
– An agreement by a bank to pay a sum of money.4
 TYPES OF SHORT-TERM LOANS:
• Promissory note
– A legal IOU that spells out the terms of the
loan agreement, usually the loan amount,
the term of the loan and the interest rate.
– Often requires that loan be repaid in full
with interest at the end of the loan period.
– Usually with a Bank or Financial
Institution; occasionally with suppliers or
equipment manufacturers

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 TYPES OF SHORT-TERM LOANS:
• Line of Credit
– The borrowing limit that a bank sets for a
firm after reviewing the cash budget.
– The firm can borrow up to that amount of
money without asking, since it is pre-
approved
– Usually informal agreement and may
change over time
– Usually covers peak demand times, growth
spurts, etc.
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 Estimation of Cost of Short-Term Loan /
Credit
• Calculation is easiest if the loan is for a one year
period:
• Effective Interest Rate is used to determine the cost
of the credit to be able to compare differing terms.

Effective Annual = Interest you pay

Interest Rate Amount you get to use
Example: You borrow $10,000 from a bank, at a stated rate
of 10%, and must pay $1,000 interest at the end of the year.
Your effective annual rate is the same as the stated rate:
$1,000/$10,000 = .10 = 10% 7
 Variations in Loan Terms
• A discount loan requires that interest be
paid up front when the loan is given.
• This changes the effective cost in the
previous example since you only get to
use:
($10,000 - $1,000) = $9,000.
• Effective annual rate (APR) =
$1,000/$9,000 = .1111 = 11.11%.

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 Variations in Loan Terms
• Sometimes lenders require that a minimum
amount, called a compensating balance be kept
in your bank account. It is taken from the
amount you want to borrow.
• If your compensating balance requirement is
$500, then the amount you can use is reduced
by that amount.
• Effective Annual Rate (APR) for a $10,000
simple interest 10% loan with a $500
compensating balance = $1,000/($10,000-
$500) = .1053 = 10.53%.
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Variations in Loan Terms :Both Discount
Interest and Compensating Balance

• Sometimes, lenders will require both

discount interest (paid in advance) and a
compensating balance.
• If the interest is $1,000 and the
compensating balance is $500, then the
effective annual rate (APR) becomes:
• $1,000 / ($10,000 - $1,000 - $500)
• $1,000 / $8,500 = 11.76% 10
 Calculating (Effective Annual Rate ) APR
• $1000 loan is extended @6% for 90 days? What
would be APR?

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 TRADE CREDIT
• Trade credit is the act of obtaining funds by
delaying payment to suppliers, who typically
grant 30 days to pay.
• The cost of trade credit may be some interest
that the supplier charges on the unpaid balance.
• More often, it is in the form of a lost discount
that would be given to firms who pay earlier.
• Credit has a cost. That cost may be passed
along to the customer as higher prices, or borne
by the seller as lower profits, or some of both.
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 Cost of Trade Credit
• Cost of Trade Credit
– Typically receive a discount if you pay
early.
– Stated as: 2/10, net 60
• Purchaser receives a 2% discount if
payment is made within 10 days of the
invoice date, otherwise payment is due
within 60 days of the invoice date.
– The cost is in the form of the lost
discount (2%)if you don’t take it. 14
 Cost of Trade Credit 2/10 net 60
• QS: Assume your purchase is $100 list price.
• If you take the discount, you pay $98. If you don’t take the
discount, you pay $100. what would be APR?
• SOLUTION: Therefore, you (buyer) are paying $2 for the
privilege of borrowing $98 for the additional 50 days.
(Note: the first 10 days are free in this example).

•APR = $2/$98 x 360/50 = 14.7% (If you pay in 60 days)

•What if 2/10, net 30 (list price is same $100). What

would be the APR? 15
•APR = $2/$98 x 360/20 = 36.7% (If you pay in 30 days)
COMMERCIAL PAPER
Commercial paper consists of short-term notes issued
by large and highly rated firms. Typically these notes are
of short maturity, ranging up to 270 days.

CP trades in the market at rates just above T-bill rate.

CP is bought with surplus cash by banks and other

companies, then held as a marketable security for
liquidity purposes.

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 COMMERCIAL PAPER
• Commercial paper is quoted on a discount basis,
meaning that the interest is subtracted from the
face value to arrive at the price. See 3 steps
below for calculation:
• Step 1: Compute the discount (D) from face value
of the commercial paper
• Discount (D) = Discount rate x par value x DTG/360
DTG = days to go (to maturity)
• Step 2: Compute the price = Face value - Discount

• Step 3: Compute Effective Annual Rate (APR):

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 Cost of Commercial Paper
• QS: A company issued 90 day commercial paper with
face value $1 million quoted at 4% discount rate.
Calculate amount of discount, price and APR (or the
cost of Commercial paper ?

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 Cost of Commercial Paper
• QS: A company issued 90 day commercial paper with
face value $1000 at a discount $985. The credit rating
expenses are 0.5%, IPA charges being 0.35% and
stamp duty 0.5% of the size of issue. Calculate APR
or the cost of Commercial paper ?
• SOLUTION:
The discount is Tk 15 and rating and IPA and stamp
duty amounts to : 1.35% X Tk 1000 = Tk 13.5

Effective rate (APR)/ Cost of CP

15 + 13.5 360
= ---------------- X --------
$985 90
= 11.6% 19
BANKER’S ACCEPTANCE
•A Banker’s Acceptance is an agreement by a bank to
pay a sum of money.
•These agreements typically arise when a seller sends a
bill or draft to a customer. The customer’s bank accepts
this bill and notes the acceptance on it, which makes it
an obligation of the bank.
•In this way, a firm that is buying something form a
supplier can effectively arrange for the bank to pay the
outstanding bill. The bank charge’s the client a fee for
this service.

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ACCOUNTS RECEIVABLE AS COLLATERAL
• A pledge is a promise that the borrowing firm will
pay the lender (bank or other finance companies)
any payments received from the accounts
receivable collateral in the event of default.
• Since accounts receivable fluctuate over time, the
lender may require certain safeguards to ensure
that the value of the collateral does not go below
the balance of the loan.
• So, normally a bank/finance companies will only
loan you 70 -75% of the receivable amount.
• Accounts receivable can also be sold outright.
This is known as factoring.
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 Cost of Borrowing against Receivables
• Example: Average monthly sales of any firm is
$100,000. Firm offers 60 day terms of credit to
customers, so average Account Receivable balance of
firm is $200,000 (i.e. for 2 months)
• Suppose Bank offers loan 70% of Accounts
Receivable which is $140,000
• Interest is 3% over prime rate ( 8%),So amount of
interest would be = 11% x $140,000 = $15,400
• Suppose Bank charges 1% annual processing fee on
the amount of all receivable balance i.e. = 1% x
$12,00,000 = $12,000
• APR = $15,400 + $12,000 x 1 year = 19.57%
$140,000 22
 Cost of Borrowing against Receivables
• Example: Average monthly sales of any firm is
$200,000. Firm offers 30 day terms of credit to
customers, so average Account Receivable balance of
firm is $200,000. Bank offers loan 75% of Accounts
Receivable. Interest charged is 10%. If Bank charges
0.05% annual processing fee on the amount of all
receivable balance, Calculate APR?
• SOLUTION: Bank offers loan 75% of Accounts Receivable
which is $150,000.
• Amount of interest is = 10% x $150,000 = $15,000
• Suppose Bank charges 0.05% processing fee on the amount of
all receivable balance i.e. = 0.05% x $24,00,000 = $12,000
• APR = $15,000 + $12,000 x 1 year = 18%
$150,000 23
DEBT FACTORING
Debt factoring is a service offered by a financial institution
known as a factor. Many of the large factors are subsidiaries
of commercial banks. Debt factoring involves the factor
taking over the debt collection for a business. In addition to
operating normal credit control procedures, a factor may
offer to undertake credit investigations and advise on the
creditworthiness of customers. It may also offer protection for
approved credit sales. Two main forms of factoring
agreement exist:

 Recourse factoring, where the factor assumes no

responsibility for bad debts arising from credit sales.

 Non-recourse factoring, where, for an additional fee, the

factor assumes responsibility for bad debts up to an agreed
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amount.
The factor is usually prepared to make an advance to
the business of up to around 80 per cent of approved
trade debtors (although it can sometimes be as high as
90 per cent). This advance is usually paid immediately
after the goods have been supplied to the customer.

 The balance of the debt, less any deductions for fees

and interest, will be paid after an agreed period or when
the debt is collected. The charge made for the factoring
service is based on total turnover and is often around 2–
3 per cent of turnover.

 Any advances made to the business by the factor will

attract a rate of interest similar to the rate charged on
bank overdrafts. 25
Debt factoring is, in effect, outsourcing the trade debtors control
to a specialist subcontractor. Many businesses find a factoring
arrangement very convenient. It can result in savings in credit
management and can create more certain cash flows.

However, there is a possibility that some will see a factoring

arrangement as an indication that the business is experiencing
financial difficulties. This may have an adverse effect on
confidence in the business.

Not all businesses will find factoring arrangements the answer

to their financing problems. Factoring agreements may not be
possible to arrange for very small businesses.

In addition, businesses engaged in certain sectors such as

retailers or building contractors, where trade disputes are part of
the business culture, may find that factoring arrangements are
simply not available. 26
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INVOICE DISCOUNTING
Invoice discounting involves a business approaching a
factor or other financial institution for a loan based on a
proportion of the face value of credit sales outstanding. If
the institution agrees, the amount advanced is usually
75–80 per cent of the value of
the approved sales invoices outstanding.

The business must agree to repay the advance within a

relatively short period –perhaps 60 or 90 days. The
responsibility for collecting the trade debts outstanding
remains with the business and repayment of the
advance is not dependent on the trade debts being
collected.
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Invoice discounting will not result in such a close
relationship developing between the business and the
financial institution as occurs with factoring. It may be a
one-off arrangement whereas debt factoring usually
involves a longer-term arrangement between the client
and the financial institution.
Nowadays, invoice discounting is a much more
important source of funds to businesses than factoring.

There are three main reasons for this:

i) It is a confidential form of financing which the business’s
customers will know nothing about.

ii) The service charge for invoice discounting is only about

0.2–0.3 per cent of turnover compared to 2.0–3.0 per cent of
turnover for factoring. 29
iii) Many businesses are unwilling to relinquish control of
their customers’ records. Customers are an important
resource of the business and many businesses wish to
retain control over all aspects of their relationship with
their customers.

Factoring and invoice discounting are forms of asset-

based finance as the assets of debtors are, in effect,
used as security for the cash advances received by the
business.

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 INVENTORY AS COLLATERAL
• A major problem with inventory financing is
valuing the inventory.
• For this reason, lenders will generally make a
loan in the amount of only a fraction of the
value of the inventory. The fraction will differ
depending on the type of inventory.
• If inventory is long lived, they (lender or a
customer) may loan you up to 75% of the
resale value.
• If inventory is perishable, you won’t get much
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SOURCES OF MEDIUM TERM FINANCE
LEASING
Leasing enables a business to acquire the use of
assets such as plant and machinery without having to
pay large sums of money for ownership of the
equipment, initially. Instead a business simply leases
the equipment from a leasing company who retain
ownership.
There are two main forms of lease:
Operating lease
Finance lease

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Operating Lease - in which the company pays for use
of the equipment for a set period of time after which it is
returned to the leasing company.

Finance Lease - where at the end of the lease period

there is the option to purchase the equipment outright for
a further nominal amount.

Whilst leasing does not inject money directly into the

business, and in the long term usually costs more than
buying the equipment outright, in cash flow terms its an
effective method of a business getting the equipment it
needs when its cash flow is tight.

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Hire Purchase
A hire purchase agreement enables a business to
purchase ownership of plant and machinery from a supplier,
by paying by installments to a third party i.e. a finance
house.
The buyer will normally place a down payment with the
supplier who will then deliver the equipment, the finance
house then pays the supplier the remaining amount owed for
equipment. Finance Co. collects installments from the buyer
over a set period of time for this amount plus interest.

Hire purchase agreements are interesting, in that ownership

of the equipment first passes to the finance house, and will
not pass to the buyer until the last installment is paid. If the
business fails to pay installments the equipment will be
repossessed by the finance house. 34
Advantages Short-term Financing
A short-term credit can be obtained much faster than the
long-term credit, while long term credit requires thorough
examination of the financial condition of the firm.

Firm’s in need of seasonal or cyclical fund, may look to

short-term markets (money market). Because floatation cost
are higher for long term debt; long term debt can be prepaid
early but prepayment penalties are expensive and long term
debt have covenants or provision which constraints the firm’s
future actions.

Since yield curve are normally upward slopping indicating

that interest rates are generally lower on short term than long
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term debt.
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Disadvantages of Short-term Financing
Short-term debt is often less expensive than long-term
debt, but shot term credit subjects the firm to more risks.
This occurs for two reasons:
i) If a firms borrows on a long-term basis, its interest
costs will be relatively stable over time. But if it uses
short-term credit, its interest expense will fluctuate
widely with market interest rate, at times going quite
high.
ii) If a firm borrows heavily on short-term basis, it may
find itself unable to repay this debt and it may be in such
a weak financial position that the lender will not extend
the loan, this too could force the firm into bankruptcy.
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