Topic 8

1
Chapter 10: Short Term Finance
working capital

Reference: Beal, Goyen & Shamsuddin, 2008

2
Working capital
Working capital is the amount of funds
invested in current assets.
Current assets are the assets the firm expects
to be able to convert into cash in the normal
course of business during the next twelve
months.
Current assets comprise cash, debtors and
inventory.
Net working capital is the excess of current
assets over current liabilities.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital

Current liabilities are debts that will be paid in

the next twelve months or accruals for which
the accounting entries will be shortly reversed
or written out of the books.
Liabilities include trade creditors and short-
term debt among others.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital
In managing the level of working capital, and
indeed net working capital, the firm is
concerned with three things:
the need to maintain liquidity
the need to earn the required rate of return
on the assets
the cost and risk of short-term funding.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital - the need to
maintain liquidity

Liquidity is a measure of the ease of

conversion of an asset into cash.
Firms are said to have liquidity when they have
sufficient cash to pay their bills on time.
Businesses really run on trust and short term
credit and businesses want to be paid by their
debtors or they themselves may be in danger
of failure.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital - the need to maintain
liquidity
To maintain liquidity firms may pursue one of
three strategies:
keep a tight rein on cash and use cash budgeting
extensively and accurately to ensure enough
cash is available at all times.
maintain a better safe than sorry policy of
keeping an overestimate of the cash needed on
hand at all times
use a bank overdraft as a cushion to provide cash
when needed at times when cash is short.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital -the need to maintain
liquidity
The first policy requires the most time and
effort.
The second and third policies normally cost
more.
The second in terms of opportunity costs, for
example if a firm habitually overestimated its
cash needs and kept $100 000 too much in its
current account which earned 0.25% per
annum when it could have earned 4.25% in a
term deposit then the cost of the policy is
$4000 [100 000 x (4.25%-0.25%)]
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital - the need to
maintain liquidity
The third in terms of real cash costs. The cost
of this policy is the account establishment and
maintenance fees, plus interest on the amount
borrowed in any period.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital - the need to earn the
required rate of return
The required rate of return that investors need
in order for them to maintain their investment
in the firm applies not only to long-term capital
investment but also to working capital.
Investors do not differentiate between the two.
As a result, it is important that a firms working
capital is managed efficiently.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital - the cost and risk of
short-term funding
The third aspect which firms must manage is
the cost and risk of current liabilities.
Funds may be raised through either short- or
long-term debt.
The more the firm relies on short-term debt,
the more likely its liquidity will be decreased.
This is because (i) short-term debt must be
repaid more often and (ii) the cost of funds may
be more volatile through this funding method
which may impact on the firms liquidity.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital
On the other hand, short-term debt normally
costs less in interest charges than long-term
debt.
Under normal circumstances in the debt
markets, interest yields show a rising trend over
the short to medium term with a flattening as
the time to maturity approaches and exceeds.
This is known as the normal yield curve.
The normal yield curve shows investors expect
future short-term interest rates to be higher than
current rates over the medium term.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital

Thus a 90 day fund from the market might cost

5%, a 180 day fund 5.2%, one year funds 6%, 3
year funds 7% and 10 year funds 9.5%.
The reason for the increase in yields is the
expectation by investors that short term funds
in the future will attract higher interest rates.
However other expectations are possible, such
as a inverse yield curve .

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Working capital
Managing working capital

An inverse yield curve shows short-term

interest rates are expected to fall over the
medium term.
Thus, in normal circumstances, a firm raising
short-term funds can expect to pay less for the
money than it would if it raised long-term
funds.
As seen, current liabilities tend to be less
expensive than long term liabilities but
increase the risk of illiquidity.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
An appropriate level of net working capital
The principle of self-liquidating debt (or
hedging principle) provides loose guidance to
the maintenance of an appropriate level of net
working capital.
Self-liquidating debt occurs when debt-
funded investments generate cash inflows that
are received when the debt payments are due.
The hedging principle is based on the idea of
matching the maturity of the source of funding
with its use.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
An appropriate level of net working capital
Example a retail toy store preparing for
Christmas trading period will order extra stock
in October for delivery in early November. The
invoices will be payable by 7 December but the
store may not be able to recoup all the funds by
then. To be on the safe side the store could
arrange for a 30 day funding repayable on 6
January, which will also cost say 5% per annun or
0.41% for the 30 days.
There is an additional cost of doing business, but
it ensures the firm is able to pay its bills on time
and maintain a good reputation.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
An appropriate level of net working capital

In order to make the hedging principle more

useful, it is constructive to think in terms of
permanent, temporary and spontaneous
sources of funding.
Permanent funding comprises funding with
maturities greater than one year and includes
long-term debt, leases and ordinary shares.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
An appropriate level of net working capital

Temporary funding comprises the short-term

formal sources of finance such as commercial
bills and bank loans.
The spontaneous sources of funding are
those that arise in an unplanned way in the
ordinary course of business. Examples include
trade creditors, wages, superannuation
contribution, interest and taxes.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
An appropriate level of net working capital

The principles for using the permanent,

temporary and spontaneous classifications to
advantage are:
permanent assets should be financed with
permanent and spontaneous sources of
funding
temporary assets should be financed with
temporary sources of funding.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
An appropriate level of net working capital

However, getting the funding recipe wrong can

lead to ultimate business failure.
It is important to note that the hedging
principle does not give any guidance as to the
level of net working capital that provides the
optimal return. Such an assessment involves
several cost-benefit analysis.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term
finance

The most common sources of informal short

term finance for businesses are
Accrued wages, superannuation and taxes
Trade credit

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term finance

Accrued wages, superannuation and taxes

Example: consider an institution with a $4

million fortnightly wage bill.
On average this institution effectively owes its
employees $2 million all the time. This $2
million funding is provided free of charge.
In addition the superannuation funds collected
from the employees is again paid to the
agencies once a month. This source of funding
is also free.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term
finance
Accrued wages, superannuation and taxes

Similarly tax is collected but usually paid to the

agencies on a quarterly basis. This source of
funding is also free.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term finance
Trade credit
Such credit arises during the normal course of
business and it usually is extended without
formal agreements and is normally unsecured.
Trade credit is most likely to be offered on a net
30 days or even net 7 days basis.
This means that the full amount of the invoice
must be paid within 30 days or seven days,
respectively.
Sometimes, firms offer discounts for early
payment.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term finance
Trade credit
Thus, an invoice may be marked 2/10, net 30,
which means a 2% discount will be granted if the
bill is paid within 10 days, but no discount will be
available if the bill is paid within 30 days.
Even though a 2% discount is attractive for the
period for which it is granted, many firms dont
try to gear up their accounts payable
departments to take advantage of these offers.
They prefer to keep to the standard billing cycle,
as it is easier to manage.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term
finance
Trade credit

Neglecting to earn the discount can be costly in

terms of the effective annual rate foregone as
the following equation shows:

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term
finance
Trade credit
Example: suppose Countrywide Ltd receives an
account for $100 marked 2/10, net 30. Calculate
the cost of forgoing the cash discount.

= 2/( 98 * 20/365)
= 37.24%

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of informal short-term
finance
Trade credit

The discount is lost if Countrywide uses the suppliers

money for another 20 days (the 30 days less the 10
days discount period).
By not taking the discount and using the suppliers
funds for another 20 days, the customer has made use
of the funds with an annual charge of 37.24%.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term
finance

The most common sources of formal short-

term finance for businesses are:
Bank overdrafts
Commercial bills, promissory notes and
commercial paper
Factoring or debtor/invoice/trade finance
Stock/inventory loans or floor-plan finance.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term
finance
Bank overdrafts
An overdraft is a permitted over-drawing of
funds beyond the credit balance in the account.
Overdrafts are useful for businesses, because
firms are able to carry on their normal activities
without being forced to track their cash with
100% accuracy every day, so long as they are not
operating near their overdraft limits.
Overdrafts provide a cushion of liquidity beyond
that provided by the firms own balance of cash.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term
finance
Bank overdrafts

The interest rate charged on overdrafts

normally lies towards the middle of the range
of common interest rates at any time.

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term
finance
Commercial bills, promissory notes and
commercial paper
There are normally three parties to the issue of
a bank-accepted commercial bill (BAB): (i) the
borrower; (ii) the discounter and; (iii) the
acceptor.
BABs are often standardised in maturity to 90
and 180 days to facilitate marketability
although other periods, normally about 30, 60
or 120 days, are available.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term finance
Commercial bills, promissory notes and
commercial paper
Promissory notes (PNs) are similar to BABs, but
they are not endorsed by an acceptor.
As there is no other party involved in
guaranteeing the repayment, the raising of
finance by means of PNs tends to be restricted to
larger firms that have good reputations and
excellent credit ratings.
PNs for large amounts transacted by major
borrowers and lenders are often called
commercial paper.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term
finance
Factoring or debtor/invoice/trade finance
With pledging a general line of receivables, the
borrower offers its debtors in total as security
for a loan.
As the lender has no control over the quality of
the debts and there may be some potentially
bad debts included, normally the loan does not
exceed a loan-to-value ratio (LVR) of 70-75%.
Thus a firm with $200 000 in receivables may
be able to access a loan of $150 000.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term finance

Factoring or debtor/invoice/trade finance

Invoice discounting involves the pledging of
specific invoices.
Because the quality of the invoices based on
the perceived creditworthiness of each
customer can be ascertained, the loan-to-value
ratio is often as high as 85%.
With pledging of a general line of receivables
and invoice discounting, customers know
nothing of the financial arrangements that are
being made on the basis that they will pay their
bills on time.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term
finance
Factoring or debtor/invoice/trade finance
Factoring involves businesses selling their
invoices at a discount for cash to another party
that takes over the right to collect the amounts
owing.
Essentially the factor (lender) discounts the
invoices and hands over the cash. It then
collects the amounts owing by the borrowing
firms customers through its specialised debt
collection process.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term finance

Factoring or debtor/invoice/trade finance

Factoring and discounting businesses normally
require client firms using their services to:
sell goods on normal credit terms
have efficient debtors ledgers and credit
assessment systems
have a spread of debtors so that no one
debtor is responsible for a large part of the
outstanding debt
have a projected minimum annual turnover
of $200 000.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term
finance
Stock/inventory loans or floor-plan finance
Stock can be used to secure short-term finance.
The quality of stock as security depends on its
nature. Quality, age, perishability and
marketability all impact on the usefulness of
stock as security for a loan.
Floor-plan finance or inventory finance
provided to car and whitegoods dealers to buy
stock to place on showroom floors; secured by
the stock itself.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term finance
Stock/inventory loans or floor-plan finance

There are two types of floor-plan lenders

captives and independents.
Captive floor-plan lenders are often affiliates or
subsidiaries of manufacturers that were
established to offer financing to their retail
dealer networks and thus facilitate sales for the
manufacturers.
The independent financiers lend to dealers in
many different industries.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term finance
Stock/inventory loans or floor-plan finance

Floor-plan lenders generally write, service and

monitor loans to dealers.
The lending arrangements with floor-plan
finance involve three parties the lender, the
manufacturer and the borrower (the retail
dealer).

Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
Sources and costs of formal short-term finance

Stock/inventory loans or floor-plan finance

After the initial contracts outlining each partys
responsibilities are in place, the dealer places an
order with the manufacturer who then contacts
the lender to see if the dealers credit for that
amount is good.
If so, the order is filled, the dealer gets the stock
and the lender receives the invoice to pay.
Until the stock is sold, the dealer pays interest
monthly to the lender and has an obligation to
repay principal as soon as the stock is sold.
Beal D., Goyen M. and Shamsuddin A. (2008). Introducing Corporate Finance,2nd ed., chapter 10, Australia: Wiley.
42