HANDOUTS ON FUNDAMENTALS OF (b.

1) implicit/hidden costs Suppliers of

FINANCIAL MANAGEMENT 1 (For Classroom trade credit incur the costs of operating a
Discussion) credit department and financing
(Ms. Carmelita U. de Guzman, CPA, MGM)
accounts receivables. They pass these
Chapter 11: Short-term Financing
costs on to the buyers in the price of the
(Reference: Van Horne and John M.
product or service.
Wachowicz, Fundamentals of Financial
(b.2) opportunity costs/missed cash
Management, 13th edition)
discount Trade credit does not have
(refer to the powerpoint presentation of .. ) explicit cost if there is no discount
offered or if the buyer pays the invoice
Chapter 20: Short-term Sources of
during the discount period. However, if
Financing Current Assets
the terms of sale include a discount and
(Reference: Cabrera, Ma. Elenita
the discount is not taken, an opportunity
Balatbat, Financial Management
cost is incurred because the buyer
(Principles and Applications, vol. 1) 2015
forgoes an opportunity to pay less for the
edition)
purchases.
c) cost of bank loans Interest on
1. Short-term financing refers to debt
bank loans are calculated in five ways:
originally scheduled for repayment within
(c.1) simple interest : In a single
one year. It is used to finance all or part
interest loan, the borrower receives the
of the firms working capital
face value of the loan and repays the
requirements and sometimes to meet
principal and interest at maturity date.
permanent financing needs.
(c.2) discount interest: In a discount
2. Two basic problems encountered in
interest loan, the bank deducts the
managing the firms use of short-term
interest in advance or discounts the loan.
financing:
(c.3) add-on interest : Add-on interest
a) determining the level of short-term
is interest that is calculated and added to
financing the firm should use, and
funds received to determine the face
b) selecting the source of short-term
amount of an installment loan.
financing.
(c.4) simple interest with compensating
3. Factors in selecting a source of short-
balance : Compensating balance is he
term funds
minimum account balance that a lending
a) effective cost of credit
bank requires the borrower to maintain.
b) availability of credit in the amount
Its effect is to raise the effective rate on
needed and for the period of time when
a loan because the ne withdrawable
financing is required
amount is reduced.
c) influence of the use of a particular
(c.5) discount interest with compensating
credit source on the cost and availability
balance:
of other sources of financing, and
d) cost of commercial paper
d) any additional covenants of the loans
5. Sources of short-term funds
that are unique to the sources mentioned
a) Unsecured credit includes all those
previously
sources that have as their security only
4. Estimating cost of short-term credit
the lenders faith in the ability of the
a) accruals current liabilities for
borrower to repay the funds when due.
services received but for which complete
Unsecured short-term financing is an
payments have not been made as of the
obligation without specific assets
reporting date. These include wages,
pledged as collateral. The major sources
taxes, rent and interest payable. Accruals
of unsecured short-term credit are
are interest-free sources of financing and
accruals, trade credit, bank loans,
do not involve either implicit or explicit
commercial papers, business firms and
costs.
individuals.
b) cost of trade credit Credit
b) Secured loans involve the pledge of
received during the discount period is
specific assets as collateral in the event
sometimes called free trade credit. The
the borrower defaults in payment of
view that trade credit is free may be
principal or interest. Accounts
misleading as there are costs associated
receivable and inventory are the most
with trade credit, although these are not
common sources of collateral for short-
as obvious as interest charges.
term financing.

1
(b.1) Spontaneous source of short-term
financing sources that arise
automatically from ordinary business
transaction. They do not require special
effort or negotiation on the part of the
finance officer.
Spontaneously generated funds will
be provided by accounts payable and
accruals. As sales increase, so will the
purchase of raw materials that will lead
to higher levels of accounts payable.
Similarly, a higher level of operations
will require more labor while higher sales
will result in a higher taxable income.
Therefore, the spontaneous liability
accounts payable will follow the
movement of sales.
a) ACCRUALS: As the firms sales
increase, so does its labor expense,
value-added taxes, income taxes, etc.
Since most businesses pay their
employees only periodically (weekly,
biweekly or monthly), they accrue a
wages payable account that is, in
essence, a loan from the firms
employees. Income taxes are likewise
paid quarterly, VAT, withholding taxes,
electricity and other expenses are paid
on a deferred basis. The longer the
period of time that the firm holds these
payments, the greater the amount of
financing they provide. These sources of
financing arise spontaneously with the
firms sales. These accrued expense
items provide the firm with automatic or
spontaneous sources of financing.
b) TRADE CREDIT (Accounts
Payable): provides one of the most
flexible sources of spontaneous financing
because it arises from ordinary business
transactions. Lengthening the credit
period as well as increasing the firms
purchases, generate additional financing.
The major advantage of trade credit lies
in its rather quick availability. However,
the relatively high cost of trade credit
makes it a less desirable source of short-
term financing when compared to other
alternatives.
(b.2) Nonspontaneous negotiated or
short-term financing sources that
require special effort or negotiation. The
major sources of negotiated short-term
credit are bank loans, commercial paper
and accounts receivable/ inventory loan.
a) Short-term bank loans vary in type,
availability, and cost. The most common
type is the commercial bank loan that is
2
for a specific purpose, short-term and
self-liquidating.
b) Line of credit If a firm does not wish
to borrow until the working capital is
actually required, it may arrange a credit
arrangement with a large commercial
bank. Such arrangement often take
either of the two forms:
(1) Informal arrangement a bank
agrees to lend up to a specified
maximum amount of funds during a
designated period.
(2) Revolving credit arrangement a
legal commitment by the bank to extend
credit up to some maximum amount for a
few months or several years. This is a
formal line of credit often used by large
firms who pay an annual commitment fee
of about of 1% on the unused balance
to compensate the banks for making the
commitment.
c) Commercial paper an unsecured
short-term (six months or less)
promissory note sold in the money
market by highly credit-worthy firms. Big
firms use commercial paper to finance
their working capital because it is much
less expensive than the costs of trade
credit.
d) Pledging or assignment of accounts
receivable
1) Accounts receivables are
considered by many lenders to be prime
collateral for a secured loan. Under
pledging arrangement, the borrower
simply pledges or assigns accounts
receivable as security for a loan obtained
from either a commercial bank or a
finance company. The amount of the
loan is stated at a percent of the face
value of the receivables pledged.
2) If all the accounts receivable
are pledged as collateral for the loan and
the lender has no control over the quality
of the accounts receivable being
pledged, the loanable value is set at a
relative low percent generally ranging
downward from a maximum of around 75
percent.
3) However, of the lender could
select and assess the creditworthiness of
each individual account being pledged,
the loan value might reach as high as
85% or 90% of the face value.
4) One primary advantage of
pledging of accounts receivable as a
source of short-term financing is its
flexibility.
 5) Cost of Financing: A
disadvantage associated with this
method of financing is its relatively high
cost owing to the interest rate charged
on loans which is 2% to 5% higher than
the banks prime rate and processing or
handling fee of about 1% to 2% on
pledged accounts.
e) Factoring accounts receivable
involves the outright sale of the firms
accounts receivable to the finance
company.
f) Inventory Financing A firm may
borrow against inventory to acquire
funds. The extent to which inventory
financing may be employed is based on
the marketability of the pledged goods,
their associated price stability, and the
perishability of the product.
Some of the typical arrangements
by which inventory can be used to secure
short-term financing are:
1) Blanket inventory lien This gives the
lender a general lien or claim against the
inventory of the borrower. The borrowing
firm maintains full control of the
inventories and continues to sell and
replace them as it sees fit.
2) Trust receipts/chattel mortgage
agreement A trust receipt is an
instrument acknowledging that the
borrower holds the inventory and
proceeds from sales in trust for the
lender.
3) Warehousing Goods are physically
identified, segregated and stored under
the direction of an independent
warehousing company. The warehousing
firm issues a warehouse receipt for the
merchandise which carries title to the
goods represented therein.