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Short Term Financing (PowerPoint)


  • pg 1
									Short Term

         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.

       Why Do Firms Need Short-term
• 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
Sources of Short-term Financing
 • Short-term loans.
   – borrowing from banks and other
     financial institutions for one year or
 • Trade credit.
   – borrowing from suppliers
 • Commercial paper.
   – only available to large credit- worthy
    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
  – Usually with a Bank or Financial
    Institution; occasionally with suppliers or
    equipment manufacturers
    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-
   – 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
• 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.
  Estimation of Cost of Short-Term
• 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)
       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%
      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
  – 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.
 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

     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
• What if 2%/10, net 30
• APR = $2/$98 x 365/20 = 37.25%! (If you pay in 30
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
• 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.
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%!

           Inventory as Collateral
• A major problem with inventory financing is valuing the
• 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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