Chapter 8

Sources of Short-Term Financing

Chapter 8 - Outline
y Sources of Short-Term Financing y Trade Credit y Net Credit Position y Bank Credit Terminology y Types of Bank Loans y Corporate and Foreign Borrowing Terminology y Accounts Receivable Financing

Sources of Short-Term Financing

There are various sources of short-term funds available to a firm:
Trade Credit from Suppliers Bank Loans Corporate Promissory Notes Foreign Borrowing Loans Against Receivables and Inventory

Trade Credit
y The largest source of short-term financing for a firm. Approximately 40

percent of short-term financing is in the form of accounts payable or trade credit

y Accounts payable y Is a Spontaneous source of funds y Grows as the business expands y Contracts when business declines

y Extending the payment period to an unacceptable period results in:

y Alienate suppliers y Diminished ratings with credit bureaus

y It is usually a 30-60 day grace period before a bill is due y A cash discount is often given if payment is made within a specified time

Ex., 2/10 net 30 means a 2% discount is given if paid in 10 days; if not, the full amount is due in 30 days

Net-Credit Position
y Determined by examining the difference between accounts

receivable and accounts payable

y Positive if accounts receivable is greater than accounts payable

and vice versa y Larger firms tend to be net providers of trade credit (relatively high receivables) y Smaller firms in the relatively user position (relatively high payables)

Cash Discount Policy

y Allows reduction in price if payment is made within a

specified time period

y Example: A 2/10, net 30 cash discount means: y Reduction of 2% if funds are remitted 10 days after billing y Failure to do so means full payment of amount by the 30th day

y Cost of NOT taking a discount:

Bank Credit Terminology

Prime Rate:
the interest rate charged to a banks best customers acts as a benchmark for calculating other interest rates

Compensating Balance:
when a bank requires a minimum average account balance for business customers in order to qualify for a loan can be thought of as a form of collateral

Effective Interest Rate:

the actual interest rate or true cost of a loan also known as the annual percentage rate (APR)

Types of Bank Loans

Discounted Loan:
when a bank deducts the interest on the loan in advance and lends the balance

Installment Loan:
calls for a series of equal payments over the life of the loan ex., most car loans and home mortgages

Compensating Balance Loan:

when a compensating balance is required as part of the loan

Effective Rates for Different Types of Bank Loans

Effective Rate = Interest / $ Received x 360 / Days loan is outstanding Or % / 1 x 360 / Days loan is outstanding

For Discounted Loan subtract Interest from Principal (or int. % from 1) when computing denominator. For Compensating Balance Loan:
Subtract Compensating Balance from Principal (or % CB from 1) when computing denominator.
If discounted loan with compensating balance, then subtract interest plus compensating balance (or % and

CB%).

For Installment Loan, the approximation for annualizing is: 2 x Annual # of payments / Total number of payments + 1 (instead of x 360 / days loan is outstanding note that all annualizing shown ignores compounding of interest)

Corporate and Foreign Borrowing Terminology

Commercial Paper:
a short-term unsecured promissory note issued to the public in minimum units of $25,000 total amount of commercial paper outstanding has increased greatly in recent years

Eurodollar:
a U.S. dollar held or deposited in a foreign bank loans from foreign banks denominated in American dollars are called Eurodollar loans

Advantages of Commercial Paper

y May be issued at below the prime interest rate y No associated compensating balance requirements y Associated prestige for the firm to float their paper in an elite

market

Disadvantages of Commercial Paper

y y y y

Many lenders have become risk-averse post a multitude of bankruptcies Firms with downgraded credit rating do not have access to this market The funds generation associated with this is less predictable Lacks the degree of commitment and loyalty associated with bank loans

Accounts Receivable Financing

y A/R financing includes 2 choices:

pledging accounts receivable as collateral for a loan OR an outright sale (also called factoring) of receivables to a bank or finance company
y Tends to be a relatively expensive source of financing

The Credit Crunch Phenomenon

y The Federal Reserve tightens the growth in the money

supply to combat inflation the affect:

y Decrease in funds to be lent and an increase in interest rates y Increase in demand for funds to carry inflation-laden inventory and

receivables y Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns

y Credit conditions can change dramatically and suddenly

due to:
y Unexpected defaults y Economic recessions y Changes in monetary policy y Other economic setbacks