Short-Term

FINANCING
GROUP 6
After Studying this Chapter,
you should be able to:
1. Understand the sources and types of spontaneous
financing.
2. Calculate the annual cost of trade credit when trade
discounts are forgone.
3. Explain what is meant by "stretching payables" and
understand its potential drawbacks.
4. Describe various types of negotiated (or external)
short-term borrowing.

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Short-Term Financing

Spontaneous Financing

Negotiated Financing

Factoring Accounts Receivable

Composition of Short-Term
Financing

3
 Spontaneous Financing
Types of spontaneous financing

Accounts Payable (Trade

Credit from Suppliers)
Accrued Expenses

4
 Spontaneous Financing
Types of spontaneous financing

Accounts Payable (Trade

Credit from Suppliers)
Accrued Expenses

Trade Credit – credit granted from one business to another.

Examples of trade credit are:

• Open Accounts: the seller ships goods to the buyer with an invoice specifying goods shipped, total amount due,
and terms of the sale.
• Notes Payable: the buyer signs a note that evidences a debt to the seller.
• Trade Acceptances: the seller draws a draft on the buyer that orders the buyer to pay the draft at some future time
period.
Draft – A signed, written order by which the first party (drawer) instructs a second party (drawee) to pay a specified
amount of money to a third party (payee). The drawer and payee are often one and the same. 5
 Terms of the Sale
 COD and CBD - No Trade Credit: the buyer pays cash on delivery or cash before delivery. This
reduces the seller’s risk under COD to the buyer refusing the shipment or eliminates it completely
for CBD.

 Net Period - No Cash Discount – when credit is extended, the seller specifies the period of time
allowed for payment. “Net 30” implies full payment in 30 days from the invoice date.

 Net Period - Cash Discount – when credit is extended, the seller specifies the period of time
allowed for payment and offers a cash discount if paid in the early part of the period. “2/10, net 30”
implies full payment within 30 days from the invoice date less a 2% discount if paid within 10 days.

 Seasonal Dating – credit terms that encourage the buyer of seasonal products to take delivery
before the peak sales period and to defer payment until after the peak sales period.

6
 Trade Credit as a Means of
Financing

What happens to accounts payable if a firm

purchases $1,000/day at “net 30”?

$1,000 x 30 days = $30,000

account balance

What happens to accounts payable if a firm

purchases $1,500/day at “net 30”?

$1,500 x 30 days = $45,000

account balance

A $15,000 increase from operations!

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 Cost to Forgo a Discount

What is the approximate annual cost to forgo the cash

discount of “2/10, net 30” after the first ten days?

Approximate annual interest cost =

x
% discount 365 days
(100% - % discount) (payment date - discount period)

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 Cost to Forgo a Discount

What
What is the
is the approximate annual
approximate annual cost
costtotoforgo
forgothethe
cash
cash
discount
discount of of
“2/10, net net
“2/10, 30,” 30”
and after
pay atthe
thefirst
end ten
of the credit
days?
period?

Approximate annual interest cost =

x
2% 365 days
(100% - 2%) (30 Days – 10 Days)

= (2/98) x (365/20) = 37.2% 9

 Cost to Forgo a Discount

What
What
The is is the
the approximate
approximate
approximate annual
annual
interest cost overcost
cost totoforgo
a variety ofthe
forgo cash
the
paymentcash
discount
discount of of
“2/10, net net
decisions
“2/10, 30,” and
for 30” pay net
“2/10,
after atthe
the end ten
____.”
first of the credit
days?
period?

Payment Date* Annual rate of interest

11 744.9%
20 74.5
30 37.2
60 14.9
90 9.3 * days from invoice
10
date
“Stretching Accounts Payable”
Postponing payment beyond the end of the net
period is known as “stretching accounts
payable” or “leaning on the trade.”

Possible costs of “stretching accounts payable”

• Cost of the cash discount (if any) forgone
• Late payment penalties or interest
• Deterioration in credit rating
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 Advantages of Trade Credit

Compare costs of forgoing a possible cash discount against the

advantages of trade credit.

• Convenience and availability of trade credit

• Greater flexibility as a means of financing

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Who Bears the Cost of Funds for Trade Credit?

• Suppliers – when trade costs cannot be

passed on to buyers because of price
competition and demand.
• Buyers – when costs can be fully passed
on through higher prices to the buyer by
the seller.
• Both – when costs can partially be passed
on to buyers by sellers.

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 Spontaneous Financing
Types of spontaneous financing

Accounts Payable (Trade

Credit from Suppliers)
Accrued Expenses

Accrued Expenses – Amounts owed but not yet paid for wages, taxes,
interest, and dividends. The accrued expenses account is a short-term
liability.

 Wages – Benefits accrue via no direct cash costs, but costs can
develop by reduced employee morale and efficiency.
 Taxes – Benefits accrue until the due date, but costs of penalties
and interest beyond the due date reduce the benefits. 14
 Spontaneous Financing
Types of negotiated financing:
• Money Market Credit • Unsecured Loans
• Commercial Paper • Line of Credit
• Bankers’ Acceptances • Revolving Credit Agreement
• Transaction Loan
 “Stand-Alone” Commercial
Paper
Commercial Paper -- Short-term, unsecured promissory notes, generally
issued by large corporations (unsecured corporate IOUs).

• Commercial paper market is composed of the

(1) dealer and (2) direct-placement markets.
• Advantage: Cheaper than a short-term business
loan from a commercial bank.
• Dealers require a line of credit to ensure that the
commercial paper is paid off.
 “Bank-Supported” Commercial Paper
 A bank provides a letter of credit, for a fee, guaranteeing
the investor that the company’s obligation will be paid.

*Letter of credit (L/C) – A promise from a third party

(usually a bank) for payment in the event that certain
conditions are met. It is frequently used to guarantee
payment of an obligation.
*Best for lesser-known firms to access lower cost funds.
 Bankers’ Acceptances
Bankers’ Acceptances – Short-term promissory trade notes for which a
bank (by having “accepted” them) promises to pay the holder the face
amount at maturity.

• Used to facilitate foreign trade or the shipment of

certain marketable goods.
• Liquid market provides rates similar to commercial
paper rates.
Short Term Business Loan

• Unsecured Loans – A form of debt for money

borrowed that is not backed by the pledge of
specific assets.

• Secured Loans – A form of debt for money

borrowed in which specific assets have been
pledged to guarantee payment.

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Unsecured Loans

LINE OF CREDIT TRANSACTION

LOAN LOAN
REVOLVING CREDIT
AGREEEMENT
LOAN
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Unsecured Loans
 Line of Credit (with a bank) – An informal arrangement
between a bank and its customer specifying the
maximum amount of credit the bank will permit the firm
to owe at any one time.
• One-year limit that is reviewed prior to renewal to
determine if conditions necessitate a change.
• Credit line is based on the bank’s assessment of the
creditworthiness and credit needs of the firm.
• “Cleanup” provision requires the firm to owe the bank
nothing for a period of time.
Unsecured Loans
Revolving Credit Agreement – A formal, legal commitment
to extend credit up to some maximum amount over a
stated period of time.

• Firm receives revolving credit by paying a commitment

fee on any unused portion of the maximum amount of
credit.
• Commitment fee – A fee charged by the lender for agreeing
to hold credit available.
• Agreements frequently extend beyond 1 year.
Unsecured Loans
 Transaction Loan – A loan agreement that
meets the short-term funds needs of the
firm for a single, specific purpose.
• Each request is handled as a separate transaction
by the bank, and project loan determination is
based on the cash-flow ability of the borrower.
• The loan is paid off at the completion of the project
by the firm from resulting cash flows.
DETOUR: COST
OF BORROWING Interest Rates
An interest rate is the amount of interest due
per period, as a proportion of the amount lent,
deposited, or borrowed (called the principal
sum)

Compensating Balances
A compensating balance is a minimum
deposit that must be maintained in a bank
account by a borrower

Commitment Fees
A commitment fee is a banking term used to
describe a fee charged by a lender to a
borrower to compensate the lender for its
commitment to lend.

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 Differential from prime depends on:
INTEREST • Cash balances

RATE • Other business with the bank

• Cost of servicing the loan

Computing Interest Rates

Interest Rates Collect Basis – interest is paid at maturity of the note.
Example: $100,000 loan at 10%
Prime Rate – Short-term stated interest rate for 1 year.
interest rate charged by
banks to large,
creditworthy customers.
$10,000 in interest
= 10.00%
$100,000 in usable funds

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 INTEREST
RATE
Computing Interest Rates
Interest Rates Discount Basis – interest is deducted from the initial loan.
Prime Rate – Short-term Example: $100,000 loan at 10%
stated interest rate for 1 year.
interest rate charged by
banks to large,
creditworthy customers.
$10,000 in interest
$90,000 in usable funds
= 11.11%

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COMPENSATING
BALANCE
Example: $1,000,000 loan at 10% stated interest rate for
Compensating 1 year with a required $150,000 compensating balance.

Balance
Demand deposits $100,000 in interest
$850,000 in usable funds
= 11.76%
maintained by a firm to
compensate a bank for
services provided, credit
lines, or loans.
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COMMITMENT Example:
FEES
$1 million revolving credit at 10% stated
interest rate for 1 year; borrowing for the year
Commitment Fees was $600,000; a required 5% compensating
balance on borrowed funds; and a .5%
The fee charged by the commitment fee on $400,000 of unused credit.
lender for agreeing to .
hold credit available is
WHAT IS THE COST OF BORROWING?
on the unused portions
of credit.

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COMMITMENT COST OF BORROWING
FEES Interest: ($600,000) x (10%) = $60,000

Commitment ($400,000) x (0.5%) = $2,000

Commitment Fees Fee:

Compensating ($600,000) x (5%) = $30,000

The fee charged by the Balance:
lender for agreeing to
Usable Funds: $600,000 - $30,000 = $570,000
hold credit available is
on the unused portions
of credit. $60,000 in interest +
$2,000 in commitment fees
= 10.88%
$570,000 in usable funds
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 Detour: Cost of Borrowing
Effective Annual Rate of Interest (generally) =
Total interest paid + total fees paid 365 days .
Usable funds # ofXdays loan is outstanding

Assume the same loan described on slide 11-29 except that the loan is for 270 days and
the 10% rate is on an annual basis. What is the EAR?
$44,384 in interest, $2,000 in commitment fees, and $570,000 in usable funds. $44,384
interest = 10% x $600,000 x (270/365).

$44,384 + $2,000 365

$570,000 X
270
= 8.137% x 1.3519 = 11.00%
Secured
(or Asset-Based) Loans

Security ( Collateral) Inventory-Backed

LOAN LOAN
Accounts-Recievable-Backed
LOAN
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SECURED LOANS
Security (collateral) – Asset (s) pledged by a borrower to
ensure repayment of a loan. If the borrower defaults, the lender may
sell the security to pay off the loan.
Collateral value depends on:

MARKETABILITY LIFE RISKINESS

SECURED LOANS
Uniform Commercial Code
Model state legislation related to many aspects of commercial transactions that went
into effect in Pennsylvania in 1954. It has been adopted with limited changes by most
state legislatures.
Article 9 of the Code deals with:
• Security interests of the lender
• Security agreement (device)
• Filing of the security agreement
SECURED LOANS
Accounts-Receivable-Backed Loans
Considered as one of the most liquid asset accounts. Loans by commercial banks or
finance companies (banks offer lower interest rates).
Loan evaluations are made on:
• Quality: not all individual accounts have to be accepted (may
reject on aging).
• Size: small accounts may be rejected as being too costly
(per dollar of loan) to handle by the institution.
SECURED LOANS
Types of receivable loan arrangements:

 Nonnotification – firm customers are not notified that their accounts have been
pledged to the lender. The firm forwards all payments from pledged accounts to
the lender.
Notification – firm customers are notified that their accounts have been
pledged to the lender and remittances are made directly to the lending
institution.
SECURED LOANS
Inventory-Backed Loans
-Relatively liquid asset accounts
Loan evaluations are made on:
• Marketability
• Perishability
• Price stability
• Difficulty and expense of selling for loan
satisfaction
• Cash-flow ability
SECURED LOANS
Types of Inventory-Backed Loans
Floating Lien – A general, or blanket, lien against a group of assets, such as
inventory or receivables, without the assets being specifically identified.
Chattel Mortgage – A lien on specifically identified personal property
(assets other than real estate) backing a loan.
Trust Receipt – A security device acknowledging that the borrower holds
specifically identified inventory and proceeds from its sale in trust for the lender.
Terminal Warehouse Receipt – A receipt for the deposit of goods in a
public warehouse that a lender holds as collateral for a loan.
SECURED LOANS
Field Warehouse Receipt – A receipt for goods segregated and
stored on the borrower’s premises (but under the control of an
independent warehousing company) that a lender holds as collateral
for a loan.
Factoring
Accounts Receivable
Factoring – The selling of receivables to a financial
institution, the factor, usually “without recourse.”
• Factor is often a subsidiary of a bank holding
company.
• Factor maintains a credit department and performs
credit checks on accounts.
• Allows firm to eliminate their credit department and
the associated costs.
• Contracts are usually for 1 year, but are renewable.

39
FACTORING COST
• Factor receives a commission on the face value of
the receivables (typically <1% but as much as 3%).
• Cash payment is usually made on the actual or
average due date of the receivables.
• If the factor advances money to the firm, then the
firm must pay interest on the advance.
• Total cost of factoring is composed of a factoring
fee plus an interest charge on any cash advance.
• Although expensive, it provides the firm with
substantial flexibility.

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SOURCES OF
SHORT TERM
FINANCING
 TRADE CREDITORS
Trade creditors are probably the most important single source of short term credit.
Trade creditors are those business establishments which sell good to others on
credit. That is, they do not require payment on the spot; rather they are to be paid
after some days from the date of sale.

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CUSTOMERS ADVANCES
Customers often finance the seller through
advance payment for the goods. The
prices of the goods to be purchased are
paid in advance, i.e. before the receipt of
the goods. This practice is prevalent where
the seller does not wish to sell goods
without prepayment and the buyer also
can not purchase goods form other
sources. The seller might require advance
it the quantity of goods ordered is so large
that he cannot afford to tie up more fund
in raw materials or in good-in-process.
Special type machine manufactures often
demand advance payment in order to
protect them from the loss caused by
cancellation of contract at a time when the
machine has been built up or is in work in
process.
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COMMERCIAL BANKS
The commercial banks of a
country generally supply funds to
the business concerns on a short-
term basis, either with security
or without security if the
customer is financially
established. The banks, collecting
scattered savings of the people,
invest a portion of the deposits in
the business for a short period of
time.

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 FINANCE COMPANIES COMMERCIAL PAPER HOUSE
Finance companies usually lend They are specialized financial agencies
money to business. They are and they are created to purchase
promissory notes and to sell them, in
specialized financial institutions turn, to other investors who desire to
and their primary function is to have some shot of short-term liquid
advance funds to the business assets. The firm having high credit
standing can use this source for obtaining
short-term funds.

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 PERSONAL LOAN COMPANIES

These companies make small loans to individual

generally for consumption purposes. The small
business undertakings can procure fund form There are some governmental and semi-
such companies governmental corporations which are authorized
to advance short term funds to business
concerns. Their importance is of course not so
much less than other sources.

GOVERNMENTAL INSTITUTIONS

46
 FACTORS OR BROKERS
In one basic respect, factoring is different from other forms of financing. In other
forms funds are granted to one individual largely on the basis of his property.
Factoring is based on a different philosophy. In considering a company’s request for
funds we are more interested in the men behind the company their ability, their
hopes and aspirations for the future.

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MISCELLANEOUS
SOURCES
There are many more sources
from which can secure funds for
short period. They are—friend
and relatives, public deposits,
loan from officer and the
company directors and foreign
exchange banks

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