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Chapter 05

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Chapter 05

Uploaded by

MIraz Hasan Emon
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Chapter 5

Short-term Financing

Slide Prepared by:


Abdullah Al Yousuf Khan
Assistant Professor – IUBAT

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
5.1 INTRODUCTION
• “Short term” refers to financing that will be
repaid in 1year or less.
• Short-term financing may be used to meet
seasonal and temporary fluctuations in a
company’s funds position as well as to meet
permanent needs of the business.
• For example, short-term financing may be used to
provide extra net working capital, finance current
assets, or provide interim financing for a long-term
project.
Advantages and Disadvantages
• Advantages;
• Easier to arrange
• Less expensive
• Affords more flexibility
• Disadvantages;
• Fluctuations of interest rates
• Frequent refinancing needs
• Delinquent repayment is detrimental to firms with
liquidity problems.
Sources of Short-term Financing
• Trade Credit,
• Bank Loans,
• Bankers’ Acceptances,
• Finance Company Loans,
• Commercial Paper,
• Receivable Financing, And
• Inventory Financing.
Factors Considered for Short-term
Financing
• Cost.
• Effect on credit rating.
• Risk. The firm must consider the reliability of the source of
funds for future borrowing.
• Restrictions. Certain lenders may impose restrictions, such
as requiring a minimum level of net working capital.
• Flexibility. Certain lenders are more willing than others to
work with the borrower, for example, to periodically adjust
the amount of funds needed.
• Expected money market conditions.
• The inflation rate.
• Corporate profit ability and liquidity positions.
• The stability of the firm’s operations.
5.2 TRADE CREDIT
• Trade credit (accounts payable) refers to balances owed to suppliers.
• Trade credit is the least expensive form of financing inventory.
• The benefits of trade credit are:
• It is readily available, since suppliers want business;
• Collateral is not required;
• Interest is typically not demanded or, if so, the amount is minimal;
• It is convenient; and
• Trade creditors are frequently lenient in the event of corporate
financial problems.
• A company having liquidity problems may stretch its accounts payable;
however, among the disadvantages of doing so are the giving up of any
cash discount offered and the probability of lowering the firm’s credit
rating.
EXAMPLE 5.1
• Tristar Corporation purchases $475 worth of
merchandise per day from suppliers. The
terms of purchase are net/45, and the
company pays on time.
• How much is Tristar’s accounts payable
balance?
$475 per day X 45 days = $21,375
5.3 BANK LOANS
• To be eligible for a bank loan, a company must
have sufficient equity and good liquidity.
• When a short-term bank loan is taken, the debtor
usually signs a note, which is a written statement that
the borrower agrees to repay the loan at the due date.
• A note payable may be paid at maturity or in
installments.
• Bank loans are not spontaneous financing as is trade
credit.
• Borrowers must apply for loans, and lenders must
grant them.
Forms of Bank Loan

• Bank financing may take any of


the following forms:
1. Unsecured loans
2. Secured loans
3. Lines of credit
4. Installment loans
Unsecured Loans
• Most short-term unsecured loans are
self-liquidating.
• This kind of loan is recommended for use by
companies with excellent credit ratings for
financing projects that have quick cash flows.
• The disadvantages of this kind of loan are that;
• Because it is made for the short term,
• It carries a higher interest rate than a secured loan
and
• Payment in a lump sum is required.
Secured Loans
• If a borrower’s credit rating is deficient, the
bank may lend money only on a secured basis,
that is, with some form of collateral behind the
loan.
• Collateral may take many forms including;
• Inventory,
• Marketable securities, or
• Fixed assets.
Lines of Credit
• The bank agrees to lend money to the borrower on a
recurring basis up to a specified amount. Credit lines are
typically established for a 1-year period and may be
renewed annually.
• Advantages;
• Easy and immediate access to funds
• Borrow only as much as needed
• Repay immediately when cash is available
• Disadvantages;
• Collateral required
• Additional financial information must be provided
• ceiling on capital expenditures
• Maintenance of a minimum level of working capital
• Commitment fee on the amount of the unused credit line
EXAMPLE 5.2
• A company borrows $200,000 and is required
to keep a 12 percent compensating balance. It
also has an unused line of credit in the amount
of $100,000, for which a 10 percent
Compensating balance is required.
• What amount is the minimum balance that the
business must maintain?

($200,000 X 0.12) + ($100,0000 X 0.10) = $24,000 + $10,000 =


$34,000
Installment Loans
• An installment loan requires monthly payments.
• When the principal on the loan decreases sufficiently,
refinancing can take place at lower interest rates.
• The advantage of this kind of loan is that it may be
tailored to satisfy a company’s seasonal financing
needs.
• Computation of Interest;
• Interest on a loan may be paid either at maturity
(ordinary interest) or in advance (discounting the
loan).
• When interest is paid in advance, the proceeds from
the loan are reduced and the effective (true) interest
cost is increased.
EXAMPLE 5.3
Acme Company borrows $30,000 at 16 percent interest per
annum and repays the loan 1 year hence.
The interest paid is $30,000 X 0.16 = $4,800.
The effective interest rate is 16 percent.
• EXAMPLE 5.4
Assume the same facts as in Example 5.3, except the note is
discounted. The proceeds of this loan are smaller than in the
previous example.
Proceeds = principal - interest = $30,000 - $4,800 = $25,200
The true interest rate for this discounted loan is:

Effective interest rate =Interest/proceeds = $4,800/$25,000


= 19%

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