SHORT TERM FINANCING

MANAGEMENT OF WC
COMPONENTS
Receivables, Marketable securities, Payables
Receivables management
• Firms would, in general, rather sell for cash than on credit,
• but competitive pressures force most firms to offer credit for
substantial purchases, especially to other businesses.
• Thus, goods are shipped, inventories are reduced, and an
account receivable is created.
• Eventually, the customer will pay the account, at which time (1) the
firm will receive cash and (2) its receivables will decline.
• Carrying receivables has both direct and indirect costs, but selling
on credit also has an important benefit: increased sales.

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 Credit policy
• Receivables management begins with the firm’s credit policy.
• Credit policy, in turn, consists of the following four variables.
1. Credit period.
• A firm might sell on terms of “net 30,” which means that the customer must pay within 30
days.
2. Discounts.
• If the credit terms are stated as “2/10, net 30,” then buyers may deduct 2% of the purchase
price if payment is made within 10 days; otherwise, the full amount must be paid within 30
days. Thus, these terms allow a discount to be taken.
3. Credit standards.
• How much financial strength must a customer show to qualify for credit? Lower credit
standards boost sales, but they also increase bad debts.
4. Collection policy.
• How tough or relax is a company in attempting to collect slow-paying accounts? A tough
policy may speed up collections, but it might also anger customers and cause them to take
their business elsewhere
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Calculation of A/R

ADS= average daily sales or credit sales per day; DSO=Length of collection period

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Accruals & accounts payable
• Accruals:
• Firms generally pay employees on a weekly, biweekly, or monthly basis,
so the balance sheet will typically show some accrued wages.
• These accruals can be thought of as short-term, interest-free loans from
employees and taxing authorities, and they increase automatically (that
is, spontaneously) as a firm’s operations expand.

• Accounts Payable (Trade Credit):

• Firms generally make purchases from other firms on credit, recording the
debt as an account payable. It’s also known as “Trade credit”.
• Trade credit is a spontaneous source of financing in the sense that it arises from
ordinary business transactions.

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The cost of trade credit
• Firms that sell on credit have a credit policy that includes their terms
of credit.
• In periods of excess capacity, firms may be able to get away with
deliberately paying late, or stretching accounts payable.
• However, they will also suffer a variety of problems associated with being
a “slow payer.”

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Trade credit calculations

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = (1 + 𝑃𝑒𝑟𝑖𝑜𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 𝑐𝑟𝑒𝑑𝑖𝑡)𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒 𝑐𝑜𝑠𝑡 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 −1.0

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Trade credit
• Trade credit can be divided into two components:

1. Free trade credit

• It involves credit received during the discount period.

2. Costly trade credit

• It involves credit in excess of the free trade credit and whose cost is an implicit one
based on the forgone discounts.
• Firms should always use the free component, but they should use the costly component only
after analyzing the cost of this capital to make sure it is less than the cost of funds that could
be obtained from other sources.
• Under the terms of trade found in most industries, the costly component is relatively
expensive, so stronger firms generally avoid using it.

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Short-term investments---marketable
securities
• Short-term marketable securities are held for two separate and
distinct purposes:
1. To provide liquidity, as a substitute for cash;
2. As a non-operating investment, generally on a temporary basis while
awaiting deployment for long-term, permanent investments.

• Marketable securities typically provide much lower yields than

operating assets.

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Short-term investments---marketable
securities
• There are both benefits and costs associated with holding marketable
securities.
• The benefits are twofold:
1 The firm reduces risk and transaction costs, because it won’t have to issue
securities or borrow as frequently to raise cash.
2. It will have ready cash to take advantage of bargain purchases or growth
opportunities.
• Funds held for the second reason are called speculative balances. The
primary disadvantage is that the after-tax return on short-term
securities is very low. Thus, firms face a trade-off between benefits
and costs.

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Short-term financing- Advantages
Advantages of Short-Term Financing:
1. A short-term loan can be obtained much faster than long-term credit.
2. If its needs for funds are seasonal or cyclical, then a firm may not want to
commit itself to long-term debt.
• There are three reasons for this:
• Flotation costs are higher for long-term debt than for short-term credit.
• Although long-term debt can be repaid early (provided the loan agreement includes a
prepayment provision), prepayment penalties can be expensive.
• Long-term loan agreements always contain provisions, or covenants, that constrain the
firm’s future actions. Short-term credit agreements are generally less restrictive.
3. Under normal conditions, interest costs at the time the funds are
obtained will be lower if the firm borrows on a short-term rather than a
long-term basis.

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Short-term financing--Disadvantages
Disadvantages of Short-Term Debt:
Even though short-term rates are often lower than long-term rates, using short-
term credit is riskier for two reasons:
1. If a firm borrows on a long-term basis then its interest costs will be
relatively stable over time, but if it uses short-term credit then its interest
expense will fluctuate widely, at times going quite high.
2. If a firm borrows heavily on a short-term basis, a temporary recession may
render it unable to repay this debt. If the borrower is in a weak financial
position then the lender may not extend the loan, which could force the
firm into bankruptcy.

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Short term bank loans
Loans from commercial banks generally appear on balance sheets as
notes payable.
• Maturity:
• Bank loans to businesses are frequently written as 90-day notes, so the loan
must be repaid or renewed at the end of 90 days.
• Promissory Notes:
• When a bank loan is approved, the agreement is executed by signing a
promissory note. It specifies (1) the amount borrowed, (2) the interest rate,
(3) the repayment schedule, (4) any collateral that might have to be put up as
security for the loan, and (5) any other terms and conditions to which the
bank and the borrower have agreed.
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Short term bank loans
Loans from commercial banks generally appear on balance sheets as notes payable.
• Compensating Balances:
• Banks sometimes require borrowers to maintain an average demand deposit (checking
account) balance of 10% to 20% of the loan’s face amount. This is called a compensating
balance, and such balances raise the effective interest rate on the loans.
• Informal Line of Credit:
• A line of credit is an informal agreement between a bank and a borrower indicating the
maximum credit the bank will extend to the borrower.
• Neither the legal obligation nor the fee exists under the informal line of credit.
• Revolving Credit Agreement:
• A revolving credit agreement is a formal line of credit often used by large firms. The bank has
a legal obligation to honor a revolving credit agreement, and it receives a commitment fee.

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Commercial paper
• Commercial paper is a type of unsecured promissory note issued by
large, strong firms and sold primarily to other business firms, to
insurance companies, to pension funds, to money market mutual
funds, and to banks.

• Maturity and Cost:

• Maturities of commercial paper generally vary from 1 day to 9 months, with
an average of about 5 months.
• The interest rate on commercial paper fluctuates with supply and demand
conditions—it is determined in the marketplace, varying daily as conditions
change.

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Commercial paper
Use of Commercial Paper
• The use of commercial paper is restricted to a comparatively small
number of very large concerns that are exceptionally good credit
risks.
• One potential problem with commercial paper is that a debtor who is
in temporary financial difficulty may receive little help because
commercial paper dealings are generally less personal than are bank
relationships.
• Thus, banks are generally more able and willing to help a good
customer weather a temporary storm than is a commercial paper
dealer.
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Word Problems :
16-1: Cash Management
Williams & Sons last year reported sales of $10 million and an inventory turnover ratio of 2. The company is
now adopting a new inventory system. If the new system is able to reduce the firm’s inventory level and
increase the firm’s inventory turnover ratio to 5 while maintaining the same level of sales, how much cash will
be freed up?

Data:
Last Year
Sales $10 million
ITO 2

New Inventory System

Sales $10 million
ITO 5
How much cash will be freed up?

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Word Problems :
16-1: Cash Management (Continued)
Williams & Sons last year reported sales of $10 million and an inventory turnover ratio of 2. The company is
now adopting a new inventory system. If the new system is able to reduce the firm’s inventory level and
increase the firm’s inventory turnover ratio to 5 while maintaining the same level of sales, how much cash will
be freed up?

𝑺𝒂𝒍𝒆𝒔
Formula: 𝑰𝑻𝑶 =
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚

Solution:

$𝟏𝟎 𝒎 $𝟏𝟎 𝒎
Last Year 𝟐= ⇒ 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 = = $𝟓𝒎
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝟐

$𝟏𝟎 𝒎 $𝟏𝟎 𝒎
New Inventory System 𝟓= ⇒ 𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 = = $𝟐𝒎
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝟓

Cash that will be freed up = $5m -$2m = $3m

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Word Problems :
16-2: Cash Management
Medwig Corporation has a DSO of 17 days. The company averages $3,500 in credit sales each day. What is the
company’s average accounts receivable?

Data:
Av daily credit sales 3,500
DSO 17 days
Av A/R?

𝑨𝒄𝒄 𝑹𝒆𝒄
Formula: DS𝑶 =
𝑨𝒏𝒏𝒖𝒂𝒍 𝑺𝒂𝒍𝒆𝒔/𝟑𝟔𝟓

𝑨𝒄𝒄 𝑹𝒆𝒄
Solution: 𝟏𝟕𝒅𝒂𝒚𝒔 = ⇒ 𝑨𝒄𝒄 𝑹𝒆𝒄 = 𝟑, 𝟓𝟎𝟎/𝒅𝒂𝒚 𝒙 𝟏𝟕 𝒅𝒂𝒚 = $59,500
𝟑,𝟓𝟎𝟎/𝒅𝒂𝒚

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Word Problems :
16-3: Cost of Trade Credit
What is the nominal and effective cost of trade credit under the credit terms of 3/15, net 30?

Formula:

Data:
Discount percentage 3%
Days credit is outstanding 30
Discount period 15
Nominal Annual Cost of Trade Credit ?
Effective Cost of Trade Credit ?

Solution:
.𝟎𝟑 𝒙 𝟑𝟔𝟓 𝟏𝟎.𝟗𝟓
Nominal Annual Cost of Trade Credit = = = 75.26%
𝟏𝟎𝟎−𝟑 ∗ 𝟑𝟎−𝟏𝟓 𝟎.𝟗𝟕∗𝟏𝟓

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 Period cost of Number of time
Word Problems : trade credit cost incurred

16-3: Cost of Trade Credit (Continued)

What is the nominal and effective cost of trade credit under the credit terms of 3/15, net 30?

Formula:

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = (1 + 𝑃𝑒𝑟𝑖𝑜𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 𝑐𝑟𝑒𝑑𝑖𝑡)𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒 𝑐𝑜𝑠𝑡 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 −1.0
Data:
Discount percentage 3%
Days credit is outstanding 30
Discount period 15
Nominal Annual Cost of Trade Credit ?
Effective Cost of Trade Credit ?

Solution:
365ൗ
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = (1 + 3ൗ97) 15 −1.0 = 1.03093 24.33 − 1.0 = 2.0983 − 1 = 1.0983 = 109.83%
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Word Problems :
16-4: Cost of Trade Credit
A large retailer obtains merchandise under the credit terms of 1/15, net 45, but routinely takes 60 days to pay
its bills. (Because the retailer is an important customer, suppliers allow the firm to stretch its credit terms.)
What is the retailer’s effective cost of trade credit?

Formula:
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = (1 + 𝑃𝑒𝑟𝑖𝑜𝑑 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 𝑐𝑟𝑒𝑑𝑖𝑡)𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑡𝑖𝑚𝑒 𝑐𝑜𝑠𝑡 𝑖𝑛𝑐𝑢𝑟𝑟𝑒𝑑 −1.0

Data:
Discount percentage 1%
Days credit is outstanding 60
Discount period 15
Effective Cost of Trade Credit ?

Solution:
365ൗ
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = (1 + 1ൗ99) 45 −1.0 = 1.01010 8.11 − 1.0 = 1.08491 − 1 = 0.08491 = 8.49%
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Word Problems :
16-5: Accounts Payable
A chain of appliance stores, APP Corporation, purchases inventory with a net price of $500,000 each day. The
company purchases the inventory under the credit terms of 2/15, net 40. APP always takes the discount but
takes the full 15 days to pay its bills. What is the average accounts payable for APP?

Formula: Accounts Payable = Av Daily Purchase x No of days credit outstanding before payment

Data:
Av Daily Net Purchase $500,000
Credit Term 2/15, net 40
Discount Always takes the discount
No of days credit outstanding before payment 15 days
Av A/P ?

Solution:
Av A/P = $500,000 x 15 = $7,500,000
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 Word Problems :
16-6: Receivables Investment
Snider Industries sells on terms of 2/10, net 45. Total sales for the year are $1,500,000. Thirty percent of
customers pay on the 10th day and take discounts; the other 70% pay, on average, 50 days after their
purchases.
a. What is the days sales outstanding?
b. What is the average amount of receivables?
c. What would happen to average receivables if Snider toughened its collection policy with the result
that all nondiscount customers paid on the 45th day?

Formula:

Data:
Annual Sales $1,500,000
Credit Term 2/10 net 45
%Customers availing discount 30% and pay on 10th day
%Customers not availing discount 70% and pay on average 50th day

Solution:
(a) 𝑫𝑺𝑶 = 𝟑𝟎% ∗ 𝟏𝟎 𝒅𝒂𝒚𝒔 + 𝟕𝟎% ∗ 𝟓𝟎 = 𝟑𝟖
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 Word Problems :
16-6: Receivables Investment (Continued)
Snider Industries sells on terms of 2/10, net 45. Total sales for the year are $1,500,000. Thirty percent of
customers pay on the 10th day and take discounts; the other 70% pay, on average, 50 days after their purchases.
a. What is the days sales outstanding?
b. What is the average amount of receivables?
c. What would happen to average receivables if Snider toughened its collection policy with the result that
all nondiscount customers paid on the 45th day?

Formula:

Data:
Annual Sales $1,500,000
Credit Term 2/10 net 45
%Customers availing discount 30% and pay on 10th day
%Customers not availing discount 70% and pay on average 50th day

Solution:
𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 𝑫𝒂𝒊𝒍𝒚 𝑺𝒂𝒍𝒆𝒔 𝟏,𝟓𝟎𝟎,𝟎𝟎𝟎
(b) 𝑫𝑺𝑶 = 𝑫𝒂𝒊𝒍𝒚 𝑺𝒂𝒍𝒆
⇒ 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 = 𝑫𝑺𝑶 𝒙 𝑫𝒂𝒊𝒍𝒚 𝑺𝒂𝒍𝒆 = 𝑫𝑺𝑶 𝒙
𝟑𝟔𝟓
= 𝟑𝟖 𝒙
𝟑𝟔𝟓
= 𝟏𝟓𝟔, 𝟏𝟔𝟒

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 Word Problems :
16-6: Receivables Investment (Continued)
Snider Industries sells on terms of 2/10, net 45. Total sales for the year are $1,500,000. Thirty percent of
customers pay on the 10th day and take discounts; the other 70% pay, on average, 50 days after their purchases.
a. What is the days sales outstanding?
b. What is the average amount of receivables?
c. What would happen to average receivables if Snider toughened its collection policy with the result that
all nondiscount customers paid on the 45th day?

Formula:

Data:
Annual Sales $1,500,000
Credit Term 2/10 net 45
%Customers availing discount 30% and pay on 10th day
%Customers not availing discount 70% and pay on average 50th day

Solution:
c) 𝑫𝑺𝑶 = 𝟑𝟎% ∗ 𝟏𝟎 𝒅𝒂𝒚𝒔 + 𝟕𝟎% ∗ 𝟒𝟓 = 𝟑𝟒. 𝟓

𝑫𝒂𝒊𝒍𝒚 𝑺𝒂𝒍𝒆𝒔 𝟏, 𝟓𝟎𝟎, 𝟎𝟎𝟎

𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 = 𝑫𝑺𝑶 𝒙 𝑫𝒂𝒊𝒍𝒚 𝑺𝒂𝒍𝒆 = 𝑫𝑺𝑶 𝒙 = 𝟑𝟒. 𝟓 𝒙 = 𝟏𝟒𝟏, 𝟕𝟖𝟏
𝟑𝟔𝟓 𝟑𝟔𝟓 27
 Word Problems :
16-7: Cost of Trade Credit
Calculate the nominal annual cost of nonfree trade credit under each of the following terms. Assume that
payment is made either on the discount date or on the due date.
a. 1/15, net 20
b. 2/10, net 60
c. 3/10, net 45
d. 2/10, net 45
e. 2/15, net 40
Formula:

Solution:
𝟏 𝒙 𝟑𝟔𝟓 𝟑𝟔𝟓
a) Nominal Annual Cost of Trade Credit = = = 73.74%
𝟏𝟎𝟎−𝟏 ∗ 𝟐𝟎−𝟏𝟓 𝟗𝟗∗𝟓

𝟐 𝒙 𝟑𝟔𝟓 𝟕𝟑𝟎
b) Nominal Annual Cost of Trade Credit = = = 14.90%
𝟏𝟎𝟎−𝟐 ∗ 𝟔𝟎−𝟏𝟎 𝟗𝟖∗𝟓𝟎
c) 32.25%.
d) 21.28%.
e) 29.80%.
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 Word Problems :
16-8: Cost of Trade Credit
a. If a firm buys under terms of 3/15, net 45, but actually pays on the 20th day and still takes the discount,
what is the nominal cost of its nonfree trade credit?
b. Does it receive more or less credit than it would if it paid within 15 days?

Formula:

Data:
Discount percentage 3%
Credit period 45
Discount period 15
Pays on 20th day and also takes the discount
Nominal cost of its nonfree trade credit ?

Solution:
𝟑 𝒙 𝟑𝟔𝟓 𝟏𝟎𝟗𝟓
Nominal Annual Cost of Trade Credit = = = 45.15%
𝟏𝟎𝟎−𝟑 ∗ 𝟒𝟓−𝟐𝟎 𝟗𝟕∗𝟐𝟓

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Word Problems
• Class practice --- 19-2, 3, 4, 5, 6, 7, 8, & 11
• Home practice ---- 19-9, 10, 12 & 15.

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Reference
• Chapter 19 of our text book.

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