Chapter 04: Short Term Financing

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 Short Term Financing

Definition: Capital required to buy raw material for production, giving wages and meeting

up the expenses for other administrative and marketing purpose is called short term

financing.

Characteristics:

 Time : Short term capital is usually used for one year or lesser period.

 Purpose: Short term financing is usually used to meet up the requirement of current

capital.

 Costly and risky: As the short term capital is given for a short period, the risk factor is

more. That is why the provider of short term capital charges higher interest.

 Security: The Short term financing does not need security as the short term money

can be adjusted by the sale proceeds of the product derived from the businesses’ day

to day operation and current property purchase within a short period of time.
 Short Term Financing

 Recycling: One advantageous characteristics of short term financing is that,

there is always a scope to collect money at a regular basis from this kind of
source.

 Renewal: If the short term loan which Institutional organization, such as

Commercial Banks and other financial institutions disburse is adjusted as
per the terms and conditions of the sanction advice, it gets easier to get
loan again. Even if the loan is not adjusted within the stipulated time of the
sanction advice , it can be renewed.

 Size and nature of the firm: Usually small, medium, big business firms
collect money from short term financing. But short term loan is required
more by the business firms than manufacturers.
Types of Short Term Financing
Spontaneous Short Term Financing
Spontaneous Short Term Financing

Trade credit (Page-292)

Small Firm Considerations

Types of Trade credit

1. Open Market
2. Trade Note Payable

Credit Terms

Advantages of Trade Credit

Cost of Trade Credit

 Spontaneous Short Term Financing

(i)Cost of trade credit:

A business can purchase materials for Tk.100000 on credit
terms 3/30, net 90. What is the cost of this trade credit?

Cost of trade credit or foregoing cash discount

= (% cash discount)/(100% - % cash discount)X

(365/Difference between due date and discount date or net
period)

= (3%/100%-3%)X(365/60)=18.81%
Spontaneous Short Term Financing

Accruals

Accrued Accrued
expenses Income Taxes
Spontaneous Short Term Financing

Accruals

Accrued Accrued
expenses Income Taxes
Negotiated Short Term Financing

Negotiated
short term
financing

Short Term Open Market

Bank Loan Loans

Commercial
Factoring A/R
Paper
Negotiated Short Term Financing

Short term bank loans

Establishing a bank relationship

Loan analysis

Types of short term bank loans

1. Single Loan

2. Line of Credit

3. Revolving Credit

Cost of Bank Loan 11

Negotiated Short Term Financing

Open market loans

1. Commercial paper

2. Secured loans

3. Factoring receivables

4. Pledging receivables, inventory

loans

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 Cost of Short term bank loans

(ii)Cost of short term bank loans:

National housing ltd. Has negotiated Tk.200000, 180 days, 8% loan
with Brac Bank ltd. Calculate the effective cost of this loan under loan
discounting, 10% compensating balance, considering 35% tax and
applying bankers’ year.

Interest amount = 200000X0.08X180/365=7890

Compensating balance = 200000X0.10=20000

Net loan proceed = 200000 - 7890 – 20000 = 172110

Effective cost before tax = (7890/172110)X(365/180)=9.30%

Effective cost after tax = 9.30% (1-0.35)= 6.05%

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 Cost of commercial paper

(iii)Cost of commercial paper:

A commercial paper with face value Tk.1000 sold for Tk.950
for 120 days. What is the cost or yield of this paper?

cost or yield of commercial paper= [(FV-SV)/SV]X(365/t)

= [(1000-950)/950]X(365/120)= 16.01%

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 Cost of factoring receivables

(iv)Cost of factoring receivables: (a) A company’s annual

credit sale is Tk.1000000 and average collection period is 72 days.
A factor is ready to pay advance by factoring the receivables @
16% interest rate for 85% face value. Factoring charge is 1.5%,
accounts receivable administration cost and bad debt loss is
Tk.5000 p/a. What is the effective cost factoring receivables?

Average level of accounts receivable= Annual credit sale X Average

collection period/360 days = 1000000X72/360 =200000

Reserve to be maintained = 200000X0.15= 30000

Periodic factoring commission = 200000X0.015=3000

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 Cost of factoring receivables

Periodic interest expense=[(200000-30000-

3000)X0.16X72]/360 = 5344
Net fund received = 200000-30000-3000-5344=161656
Accounts receivable turnover = 360/72= 5X
Annual interest expense = 5344X5= 26720
(+) Annual factoring commission = 3000X5= 15000
(-) Administration cost and bad debt loss 5000
Net cost of factoring receivables 36720
Effective interest cost = 36720/161656=22.71%.

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 Cost of factoring receivables

(b) A company needs Tk.80000 to meet working capital

requirement immediately. It has three alternative
sources such as to purchase required materials for
Tk.100000 on 3/30, net 90; to take loan Tk.100000 @
13% interest with 20% compensating balance; to sale
receivables to a factor that’s face value Tk.100000
p/m @ 12% interest by maintaining 20% reserve,
paying 2% commission where average collection
period is 60 days, receivable administration cost is
Tk.1000 p/m and 1% bad debt loss. Comment about
financing.

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 Cost of factoring receivables

Cost of trade credit= (3/97) X (360/60) = 18.56%

Cost of bank loan:
Interest amount = (100000X0.13) X(60/360)= 2167
Compensating balance = 100000X0.20= 20000
Net fund = 100000 – 20000 = 80000
Effective interest rate = (2167/80000) X ( 360/60) = 16.25%
Cost of factoring receivables:
Average level of receivable = 100000X12X60/360= 200000
Accounts receivable turnover = 360/60= 6X
Periodic factoring commission = 200000X0.02= 4000
Reserve to be maintained = 200000X0.20= 40000
Periodic interest expense = (200000-40000-4000)X0.12X60/360= 3120
Net fund = 200000-4000-40000-3120= 152880

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 Cost of factoring receivables

Annual interest expense= 3120X6 = 18720

Annual factoring commission =4000X6= 24000
Annual cost of credit administration =1000X12= 12000
Annual ad bad debt loss = 1200000X0.01= 12000
Net cost of factoring receivables = 18720
Effective interest rate = 18720/152880= 12.25%
Factoring receivables financing is recommended.

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