• The need for short-term financing.
• The advantages and disadvantages of short-
• 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
• 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
– 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
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 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
• 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%
Say you have a loan fee of $5.00, then
APR = $15 + $5 x 1/90 = 2.0% x 4 = 8.0%
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
• 1% fee on all receivables = 1% x $100,000 x 12
• 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
• Floor Plan Financing is available to High Cost Items
such as Motor Vehicles. 15