Short Term Finances

8/2/2019 Short Term Finances

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Short Term

Financing

May 11, 2009



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Learning Objectives

The need for short-term financing.

The advantages and disadvantages of

short-term financing.

Three types of short-term financing.

Computation of the cost of trade credit,commercial paper, and bank loans.

How to use accounts receivable andinventory as collateral for short-term loans.



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Why Do Firms Need Short-term

Financing?Cash flow from operations may not be sufficient

to keep up with growth-related financing 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 prefer short-term financing instead of long-term sources of financing due to:

• easier availability

• usually has lower cost (remember yield curve)

• matches need for short term assets, like inventory



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Sources of Short-term Financing

Short-term loans.

• borrowing from banks and other financial

institutions for one year or less.Trade credit.

• borrowing from suppliers

Commercial paper.• only available to large credit- worthy

businesses.



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Types of short-term loans:

Promissory note

• A legal IOU that spells out the terms of theloan agreement, usually the loan amount, the

term of the loan and the interest rate.• Often requires that loan be repaid in full with

interest at the end of the loan period.

• Usually with a Bank or Financial Institution;occasionally with suppliers or equipmentmanufacturers



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Types of short-term loans:

Line of Credit

• The borrowing limit that a bank sets for a firmafter reviewing the cash budget.

• The firm can borrow up to that amount of money without asking, since it is pre-approved

• Usually informal agreement and may changeover time

• Usually covers peak demand times, growthspurts, etc.



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Trade Credit

Trade credit is the act of obtaining funds by delayingpayment to suppliers, who typically grant 30 days to pay.

The cost of trade credit may be some interest chargethat the supplier charges on the unpaid balance.

More often, it is in the form of a lost discount that wouldbe given to firms who pay earlier.

Credit has a cost. That cost may be passed along to the

customer as higher prices, (furniture sales, Office Max),or borne by the seller as lower profits, or some of both.



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Estimation of Cost of Short-Term Credit

Calculation is easiest if the loan is for a one year period:Effective Interest Rate is used to determine the cost of

the credit to be able to compare differing terms.

EffectiveInterest Rate

Cost (interest + fees)Amount you get to use

=

Example: You borrow $10,000 from a bank, at a statedrate of 10%, and must pay $1,000 interest at the end of the year. Your effective rate is the same as the stated

rate: $1,000/$10,000 = .10 = 10%



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Variations in Loan Terms

A discount loan requires that interest be paid upfront when the loan is given.

This changes the effective cost in the previousexample since you only get to use:

($10,000 - $1,000) = $9,000.

Effective rate (APR) = $1,000/$9,000 = .1111 =11.11%.



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Variations in Loan Terms

Sometimes lenders require that a minimumamount, called a compensating balance be kept inyour bank account. It is taken from the amountyou want to borrow.

If your compensating balance requirement is$500, then the amount you can use is reduced bythat amount.

Effective Rate (APR) for a $10,000 simple interest10% loan with a $500 compensating balance =

$1,000/($10,000-$500) = .1053 = 10.53%.



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Both Discount Interest and

Compensating BalanceSometimes, lenders will require both discount

interest (paid in advance) and a compensating

balance.If the interest is $1,000 and the compensating

balance is $500, then the effective rate (APR)

becomes:$1,000 / $10,000 - $1,000 - $500

$1,000 / $8,500 = 11.76%



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Cost of Short Term Credit

Cost of Trade Credit

• Typically receive a discount if you pay early.

• Stated as: 2/10, net 60

Purchaser receives a 2% discount if payment is made within 10 days of theinvoice date, otherwise payment is due

within 60 days of the invoice date.

• The cost is in the form of the lost discount if you don’t take it.



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Calculating APR (same as EIR)

$ Interest = Rate x Principle x Time

i.e. Int = 6% x $1,000 x 90/360 = $15

APR = $ Interest (cost) x 1

$ Net Borrowed Time

APR = $15 x 1 / 90 = 1.5% x 4 = 6.0%

$1,000 360Say you have a loan fee of $5.00, then

APR = $15 + $5 x 1/90 = 2.0% x 4 = 8.0%

1,000 360



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Cost of Trade Credit 2/10 net 60

Assume your purchase is $100 list price.

If you take the discount, you pay only $98. If you don’ttake the discount, you pay $100.

Therefore, you (buyer) are paying $2 for the privilege of borrowing $98 for the additional 50 days. (Note: the first10 days are free in this example).

APR = $2/$98 x 365/50 = 14.9% (If you pay in 60 days)

What if 2%/10, net 30

APR = $2/$98 x 365/20 = 37.25%! (If you pay in 30 days)



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Commercial PaperCommercial paper is quoted on a discount basis,

meaning that the interest is subtracted from the facevalue to arrive at the price. See 3 steps below for calculation:

Step 1: Compute the discount (D) from face value of thecommercial paper

• Discount (D) = (Discount rate x par x DTG)/365

• DTG = days to go (to maturity)Step 2: Compute the price = Face value - Discount

Step 3: Compute Effective Annual Rate (APR):

$ interest you pay/ $ you get to use



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Cost of Commercial Paper Example

$1 million issue of 90 day commercial paper quoted at 4%discount rate.Step 1: Calculate D = .04 x $1 mill. x 90 = $10,000

360

Step 2: Calculate price (amount you get)= $1,000,000 - $10,000

= $990,000

Step 3: Calculate effective rate (APR)= $10,000 / $990,000 = 1.010% x 4 = 4.04%



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Accounts Receivable as Collateral A pledge is a promise that the borrowing firm will pay

the lender any payments received from the accountsreceivable collateral in the event of default.

Since accounts receivable fluctuate over time, the

lender may require certain safeguards to ensure thatthe value of the collateral does not go below thebalance of the loan.

So, normally a bank will only loan you 70 -75% of thereceivable amount

Accounts receivable can also be sold outright. This is

known as factoring.



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Cost of Borrowing against Receivables

Average monthly sales = $100,00060 day terms, so average Acct Rec balance = $200,000

Bank loans 70% of Accts Rec = $140,000

Interest is 3% over prime (say 8%) = 11% x $140,000 =$15,400

1% fee on all receivables = 1% x $100,000 x 12 =

$12,000 APR = $15,400 + $12,000 x 1/1 = 19.57%!

$140,000



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Inventory as Collateral

A major problem with inventory financing is valuing theinventory.

For this reason, lenders will generally make a loan in

the amount of only a fraction of the value of theinventory. The fraction will differ depending on the typeof inventory.

If inventory is long lived, i.e. lumber, they (lender or acustomer) may loan you up to 75% of the resale value.

If inventory is perishable, i.e., lettuce, you won’t get

much



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The End

The End!

Prof D

Students

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Short Term Finances