SHORT TERM FINANCING

Lesterlee Tomas
MBA Student
 DEFENITION

Short term financing refers to the

additional money a business requires for
doing its business for short terms, which
is usually a maximum period of one year. 
Short term financing is arranging of
available external funds to meet the
needs of a firm for a year or a less time.
 CHARACTERISTICS

Cost of Funds: Some forms of short-term fi nancing

may prove to be expensive than that of intermediate
and long-term fi nancing while some short-term
sources like Accruals and Payables provide funds at
no cost to the fi rm.
Rollover Eff ect: Short-term fi nance as the name
indicates must be repaid within a period of one year
– though some sources provide funds that are
constantly rolled over.
Clean-up: This happens when commercial banks or
other lenders demand the fi rm to pay-off its short
term obligation at one point in a fi nancial year.
 WHY DO FIRMS NEED SHORT TERM
FINANCING?
Cash fl ow from operations may not be
suffi cient to keep up with growth-related
fi nancing needs.
Firms may prefer to borrow now for their
inventory or other short term asset needs
rather than wait until they have saved enough.
Firms may prefer short-term fi nancing instead
of long-term sources of fi nancing.
 SOURCES

Trade credit
Commercial Paper
Accrued expenses
Bank financing
Factoring
 TRADE CREDIT

It is a credit that a customer gets from

supplier of goods.
A ‘delay of payment’ permitted by the
creditor or supplier of raw materials,
consumables and so on.
It is the spontaneous source of
financing.
Deferral of payments is a short- term
 financing called “Trade Credit.”
 ADVANTAGES

For Buyers
Low- Cost Finance
Discounts on early Payments
Easily Maintainable
No Legal and Banking Botheration
For Suppliers
Improved Sales
Improved Margins
 DISADVANTAGES

For Buyers
Opportunity Loss of discount
Increase in Input Prices
Loss of Good Will
The Cost of Administration and
Accounting
Loss of Suppliers
 DISADVANTAGES

For Suppliers
Bad Debts
Cash Flow Mismatch As There Is No
Guarantee Of Timely Payment
The Cost of Funds Invested In Book
Debts / Accounts Payable
The Cost of Cash Discount
Running Special Departments
 COST OF TRADE CREDIT

Assume that the trade credit terms are 2/10, net

60. This means that the customer will get a
discount of 2% if paid within 10 days, and if
discount is not availed the amount is due in 60
days.
If the company pays on 30th day and on 50th
day, the cost of trade credit will be:
 COST OF TRADE CREDIT

Cost of trade credit (payment on day 30)

C=(1+0.02/0.98)^(365/20) – 1
= 44.58%

Cost of trade credit (payment on day 50)

C=(1+0.02/0.98)^(365/40) – 1
= 20.24%
The cost of trade credit reduces with increase in the
time of payment and it is the lowest on the last day of
the net period.
 COMMERCIAL PAPER

Commercial paper consists of short-term,

unsecured promissory notes issued by well-
known and fi nancially strong companies.
Commercial paper is traded mainly in the
primary market. Opportunities for resale in
the secondary market are more limited.
Commercial paper is rated prime,
desirable, or satisfactory, depending on the
credit standing of the issuing company.
 COMMERCIAL PAPER

Commercial paper can be issued for

maturities between a minimum of 7 days
and a maximum of up to one year from
the date of issue.
Commercial paper is quoted on a
discount basis, meaning that the interest
is subtracted from the face value to
arrive at the price.
 COST OF COMMERCIAL PAPER

STEP 1: Compute the discount (D) from the face value

of the commercial paper.
 Discount (D) = Discount rate * par * DTG)/360
 DTG = days to go (to maturity)
STEP 2: Compute the price= Face value – Discount
STEP 3:Compute Eff ective Annual Rate (APR)
 APR=Interest you pay/Money you get to use
 COST OF COMMERCIAL PAPER

Example: 1 million pesos issue of 90 days commercial

paper quoted at 4% discount rate.

Solution:
Step 1: Calculate D = .04 x 1 million x 90/360= P10,000
Step 2: Calculate price (amount you get)
=1,000,000-10,000
=990,000
Step 3: Calculate eff ective rate (APR)
=10,000/990,000=1.010% x 4 =4.04%
 ADVANTAGES

Commercial paper represents one way for

large fi rms to borrow money for the short
term.
Companies issue the commercial paper for
less than its face value and buy back the paper
at its face value.
Commercial paper are cheaper than a bank
loan.
 DISADVANTAGES

It is available only to a few selected blue chip

and profi table companies.
By issuing commercial paper, the credit
available from the banks may get reduced.
Issue of commercial paper is very closely
regulated by the RBI guidelines.
 ACCRUED EXPENSES

It represents the liability that a firm has

to pay for those services which have been
received earlier.
Interest free source of income.

Accrued wages and salaries

Accrued taxes and interest
 BANK FINANCING

Bank overdraft
 an agreement with a bank by which a current
account-holder is allowed to withdraw more
than the balance to his credit up to a certain
limit.
Cash credit
  an arrangement by which a bank allows his
customer to borrow money up to a certain
limit against some tangible securities or
guarantees.
 BANK FINANCING

Short term loan

 when a bank makes an advance in lump-sum
against some security it is called a loan. In
case of a loan, a specified amount is
sanctioned by the bank to the customer.
Purchasing and Discounting bills
 when a bank lends without any collateral
security.
 BANK FINANCING

Letter of credit
 A letter of credit popularly known as L/C is an
undertaking by a bank to honor the obligation
of its customer up to a specified amount,
should the customer fail to do so.
 It helps its customers to obtain credit from
suppliers because it ensures that there is no
risk of non-payment.
 TYPES OF LETTER OF CREDIT

Clean Letter of Credit:

It is a guarantee for the acceptance and
payment of bills without any conditions.
Documentary Letter of Credit:
It requires that the exporter’s bill of exchange
be accompanied by certain documents
evidencing title to the goods.
Revocable Letter of Credit:
It is one which can be withdrawn by the issuing
bank without the prior consent of the exporter.
 TYPES OF LETTER OF CREDIT

Irrevocable Letter of Credit:

 It cannot be withdrawn without the consent of the
benefi ciary.
Revolving Letter of Credit:
 In such type of letter of credit the amount of credit is
automatically reversed to the original amount after such an
amount has once been paid as per defi ned conditions of the
business transaction. There is no deed for further
application for another letter of credit to be issued
provided the conditions specifi ed in the fi rst credit are
fulfi lled.
Fixed Letter of Credit:
 It fi xes the amount of fi nancial obligation of the issuing
bank either in one bill or in several bills put together
 FACTORING

Factoring is a transaction in which a business

sells its invoices, or receivables, to a third-
party fi nancial company known as a “factor.”
The factor then collects payment on those
invoices from the business’s customers.
Factoring is known in some industries as
“accounts receivable fi nancing.”
It emphasizes on the receivable fi nancial
assets
It involves the purchase of fi nancial assets
 ADVANTAGES

Instead of having your cash tied up in unpaid

invoices, you can use it to obtain inventory,
upgrade equipment, pay employees or hire
new personnel.
Sometimes new businesses have trouble
getting loans or other forms of credit from
banks.
This form of fi nancing needs no collateral, so
small business owners do not risk their assets.
 ADVANTAGES

Investors often require equity in exchange for

their investments, but with accounts
receivable fi nancing, owners retain full
control of their businesses.
Additionally, small business owners can use
the time they would have spent collecting
their bills in growing their businesses.
 DISADVANTAGES

The fees and interest on accounts receivable

fi nancing may be more expensive than other forms
of fi nancing.
 Even if you have good credit, the rate is based not
on your own fi nancial reliability but that of your
clients.
If your customers are delinquent in paying or fail
to pay, the rate increases.
 An agreement with a factoring company may lock
you into a contract longer than you want, unless
you fi nd a company that off ers short-term
contracts.