Chapter 5

SHORT-TERM
FINANCING
 Short-Term Financing

• Spontaneous Financing
• Negotiated Financing
• Factoring Accounts
Receivable
• Composition of Short-Term
Financing
Spontaneous Financing

Types of spontaneous
financing
– Accounts Payable (Trade Credit
from Suppliers)

– Accrued Expenses
 Spontaneous Financing
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.
 Spontaneous Financing
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.
 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.
 Terms of the Sale
 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.
 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!
 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 =
% discount X 365 days
(100% - % discount) (payment date - discount period)
 Cost to Forgo a Discount
What is the approximate annual cost to
forgo the cash discount of “2/10, net 30,”
and pay at the end of the credit period?

Approximate annual interest cost =

2% 365 days
X
(100% - 2%) (30 days - 10 days)

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

 Cost to Forgo a Discount
The approximate interest cost over a
variety of payment decisions for
“2/10, net ____.”

Payment Date* Annual rate of interest

11 744.9%
20 74.5 %
30 37.2 %
60 14.9 %
90 9.3 %
* days from invoice date
 S-t-r-e-t-c-h-i-n-g Account
Payables
Postponing payment beyond the end of the
net (credit) 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
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
 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.
 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.
 Spontaneous Financing

Types of negotiated financing

• Money Market Credit
– Commercial Paper
– Bankers’ Acceptances
• Unsecured Loans
– Line of Credit
– 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 dealer and 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 Loans
 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.
 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.
 Secured
(or Asset-Based) 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
 Accounts-Receivable-Backed
Loans
 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.
 Accounts-Receivable-Backed
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.
 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
 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.
 Types of
Inventory-Backed Loans
 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.
 Types of
Inventory-Backed Loans

 FieldWarehouse 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.
 Composition of
Short-Term Financing
The best mix of short-term
financing depends on:
• Cost of the financing method
• Availability of funds
• Timing
• Flexibility
• Degree to which the assets are
encumbered