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Short Term Financing (PowerPoint)

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					Short Term
 Financing




             1
         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 and inventory
  as collateral for short-term loans.

                                           2
       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
                                                     3
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.
                                              4
    Types of short-term loans:
• Promissory note
  – A legal IOU that spells out the terms of
    the loan 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
    equipment manufacturers
                                              5
    Types of short-term loans:
• Line of Credit (Overdraft Facility)
   – The borrowing limit that a bank sets for a
     firm after 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
     change over time
   – Usually covers peak demand times,
     growth spurts, etc.                      6
                 Trade Credit
• Trade credit is the act of obtaining funds by
  delaying payment to suppliers, who typically grant
  30 days to pay.
• The cost of trade credit may be some interest
  charge that the supplier charges on the unpaid
  balance.
• More often, it is in the form of a lost discount that
  would be 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.
                                                      7
  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. = Cost (interest + fees)
         Effective
       Interest Rate   Amount you get to use

Example: You borrow €10,000 from a bank, at a stated
rate 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%
                                                     8
      Variations in Loan Terms
• Sometimes lenders require that a minimum
  amount, called a compensating balance be
  kept in your bank account. It is taken from
  the amount you want to borrow.
• If your compensating balance requirement is
  €500, then the amount you can use is
  reduced by that amount.
• Effective Rate (APR) for a €10,000 simple
  interest 10% loan with a €1,000
  compensating balance = €1,000/(€10,000-
  €1,000) = .1111 = 11.11%. (1.11% more)    9
    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 the
        invoice 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.
                                             10
 Calculating Annual % Rate (APR)
• $ 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       360
Say you have a loan fee of $5.00, then
  APR = $15 + $5 x 1/90 = 2.0% x 4 = 8.0%
             1,000    360

                                               11
     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’t
  take the discount, you pay $100.
• Therefore, you (buyer) are paying $2 for the privilege
  of borrowing $98 for the additional 50 days. (Note: the
  first 10 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)
                                                      12
Accounts Receivable as Collateral
• A pledge is a promise that the borrowing firm will
  pay the lender any payments received from the
  accounts receivable collateral in the event of
  default.
• Since accounts receivable fluctuate over time, the
  lender may require certain safeguards to ensure
  that the value of the collateral does not go below
  the balance of the loan.
• So, normally a bank will only loan you 70 -75% of
  the receivable amount
• Accounts receivable can also be sold outright.
  This is known as Factoring or Forfeiting.
                                                   13
Cost of Borrowing against Receivables
• Average monthly sales = $100,000
• 60 day terms, so average AR balance = $200,000
• Bank loans 70% of AR = $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

                                                 14
           Inventory as Collateral
• A major problem with inventory financing is valuing the
  inventory.
• For this reason, lenders will generally make a loan in
  the amount of only a fraction of the value of the
  inventory. The fraction will differ depending on the
  type of inventory.
• If inventory is long lived, i.e. lumber, they (lender or a
  customer) may loan you up to 75% of the resale value.
• If inventory is perishable, i.e., lettuce, you won’t get
  much 
• Floor Plan Financing is available to High Cost Items
  such as Motor Vehicles.                                15

				
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posted:4/17/2012
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