POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
Chapter 10: Short-Term Financing
and Intermediate-Term Financing
A Written Report in Financial Management
under Prof. Leandro Fua
By: Harold B. Dela Fuente. Ferdinand Parulan, Erly Mae Descalzo,
Jeraldin Raotraot, Chester De Mayo
2013
[TYPE
THE COMPANY ADDRESS]
Short-Term Financing and Intermediate-Term Financing
Short-Term Financing
Short term financing may be used to meet seasonal and temporary fluctuations in funds, position
in fund position as well as to meet long
long term needs. For example, short term financing may be
used to provide additional working capital , finance current assets ( such as receivables and
inventory) Or provide interim financing for a long term project ( such as acquisition of plant and
equipment) until long-term financing is arranged.
When compared to long term financing, short term financing has several advantaged. It is usually
easier to arrange and less expensive and has more flexibility. The drawbacks of short term
financing are that it is subject to greater fluctuations in interest rates, refinancing is frequently
required, there is greater risk of default because the loan comes due sooner, and any delinquency
may damage the business enterprise’s cr edit rating.
The sources of short term financing include trade credit, bank loans, bankers’ acceptances,
finance business enterprise loans, commercial paper, receivable financing, and inventory
financing. One particular source may be more appropriate than another in a given circumstance;
Soma are more desirable than the others because of interest rates or collateral requirements.
You should consider the merits of the different sources of short
sho rt term financing, focusing on;

Cost

Effect on financial ratios




Effect on credit rating (Some sources of short term financing may negatively impact the
business enterprise’s credit rating such as factoring accounts receivable).
Risk (Reliability of the source of funds for future borrowing). If your business enterprise
is materially affected by outside forces, it will need more stable and reliable financing.
Restrictions, such as requiring a minimum level of working capital

Flexibility
Expected money market conditions (e.g.., future borrowing). If your business enterprise
is materially affected by outside forces, it will need more stable and reliable financing.

Inflation Rates

Business enterprise profitability and liquidity positions, both of which must be
favourable if the business enterprise is to be able to pay its near term obligations

Stability and maturity of operations

Tax rate
If the Business enterprise can predict that it will be short of cash during certain times, the
financial manager should arrange for financing ( such as a line of credit) in advance instead of
waiting for an emergency
Using Trade Credit
Trade credits (accounts payables) are balances owed by your business enterprise to suppliers. It
is a spontaneous (recurring) financing source for creditworthy companies. Since it comes for
normal operations. Trade credit is the least expensive form of financing inventory. Its benefit are
that it is readily available, since its suppliers want business; It requires no collateral; There is no
interest charge or else minimal one; It is convenient; and it is likely to be extended
e xtended if the business
enterprise gets in to financial trouble. If the business enterprise has a liquidity difficulties, It may
be able to stretch accounts payable; However, the business enterprise will be required to give up
any cash discount offered and accept a lower credit rating. The business enterprise should
prepare a report analyzing accounts payable in terms of lost discounts, aged debit balances, aged
unpaid invoices, and days to pay.
Example 10-1
The business enterprise purchases P500 worth of merchandise per day from suppliers. The terms
of purchase are net/60 and the business enterprise pays on time. The accou
accounts
nts payable is
500 per day x 60 days = 30000
The business enterprise should typically take advantage of a cash discount offered for early
payment because failing to do so results in a high opportunity cost. The cost of not taking
discount equal:
Discount loss/ Peso proceeds you have use of by not taking the discount X 360/Number of days
you have use of the money by not taking the discount
Example 10-2
The business enterprise buys P1000 in merchandise in terms 2/10 net 30. The business enterprise
fails to take the discount and pays
p ays the bill on the thirtieth day. The cost of the discount is
20/980 x 360/20 = 36.7%
The business enterprise would be better off taking the discount even if it needed to borrow the
money from the bank, since the opportunity cost is 36.7%. The interest rate
rate of a bank loan
would be far less.
Bank loans
Even though other institutions, such as savings and loan associations and credit unions, provide
banking services, most banking activities are conducted by the commercial banks. Commercial
banks allow the business enterprise to operate with minimal cash and still be confident of
planning activities even in uncertain conditions.
Commercial banks favour short term loans since they like to get their money back within one
yea. If the business enterprise is large, a group of banks may form a consortium to furnish the
desired level of capital.
The prime interest rate is a benchmark for the short term loan interest rate banks charge credit
worthy corporate borrowers. Good Companies with strong financial strength can get terms below
prime. Your business enterprise’s interest rate may be higher depending
depending upon the risk the bank
believes it is taking

Unsecured loans: Most short term unsecured loans are self liquidating. This kind of loan
is recommended if the business enterprise has an excellent credit rating. It is usually used
ito finance projects

Secured loans

Lines of credit

Revolving credit

Instalment loans
Example 10- 3
The business enterprise borrows 200,000 and is requires to keep a 12 percent compensating
balance. It also has an unused line of credit of 100,000, for which a 10% compensating balance is
required. The minimum balance that must be maintained is;
(200,000 X .12) + ( 100,000 X .10) = 24,000 + 10,000
Interest
Interest on loan may be paid either at maturity (Ordinary interest) or in advance (discounting the
loan) proceeds are reached and the effective (true)
(true) interest ra
rate
te is increased.
Example 10-4
A business enterprise borrows
bo rrows 30,000
30,00 0 at 16% interest per annum and repays the loan one year
later. The interest is 30,000 X .16 = 4,800. The effective interest rate is 16 percent
(4800/30,000).
The effective interest rate, effective annual interest rate, annual equivalent rate (AER) or
simply effective rate is the interest rate on a loan or financial product restated from the nominal
interest rate as an interest rate with annual compound
compoun d interest payable in arrears.
It is used to compare the annual interest between loans with different compounding terms (daily,
monthly, annually, or other).
Effective annual interest or yield may be calculated or applied differently depending on the
circumstances, and the definition should be studied carefully. For example, a bank may refer to
the yield on a loan portfolio after expected losses as its effective yield and include income from
other fees, meaning that the interest paid by each borrower may differ substantially from the
bank's effective yield.
Example:
*Interest = Principal x Interest Rate
eg. P100000 x 10% = P10000
*Proceeds = Principal – Interest
eg. P100000 – P10000 = P90000
*Effective Interest Rate = Interest / Proceeds
eg. P10000 / P90000 = 11.11%
^A compensating balance will increase the effective interest rate from 10% to 11.11%.
*Effective Interest Rate (with compensating balances) =
Interest Rate x Principal
(1 – Percentage of Compensating Balance) x Principal
*Effective Interest Rate (with discount) =
Interest Rate x Principal
[(1 – Percentage of Compensating Balance) x Principal] – Interest
*Effective Interest Rate (with line of credit) =
Interest Rate (on loan) x Principal
Principal – Compensating Balance
^On an installment loan,
*Effective Interest Rate =
Interest
Average Loan Balance
^Average Loan Balance can be obtained by adding the beginning balance and ending balance
then divided by 2.
Example:
The enterprise borrows P100000 and will repay it in three monthly installments of P25OOO,
P25000 and P50000. The interest rate is 12%.
Amount of borrowing equals:
Installment loan P100000
Less: Interest on first installment (P25000 x 12%)(3000)
BalanceP97000
We now compute the effective interest cost on the installment loan as follows:
0 = -P97000 + [P25000
[P250 00 / (1 + cost)] + [P25000 / (1 + cost)2] + [P50000 / (1 + cost)3]
= 1.37% on monthly basis
= 1.37% x 12 = 16.44% on annual basis
^This shows that the effective annual interest rate on the installment loan is 16.44%.
DEALING WITH A BANKER
Investment Banker- an individual who works in a financial institution that is in the business
primarily of raising capital for companies, governments and other entities, or who works in a
large bank's division that is involved with these activities. Investment bankers may also provide
other services to their clients such as mergers and acquisition advice, or advice on specific
transactions, such as a spin-off or reorganization. In smaller organizations that do not have a
specific investment banking arm, corporate finance staff may fulfill the duties of investment
bankers.
Banks are eager to lend money to meet self-liquidating, cyclical business needs. A short term
bank loan is an expensive way
wa y to obtain fund to satisfy working capital requirements during the
business cycle. But the financial officer must be able to explain what the business enterprise’s
needs are in an intelligent manner.
COMMERCIAL FINANCE LOANS
Commercial Loan- a debt-based funding arrangement that a business can set up with a financial
institution. The proceeds of commercial loans may be used to fund large capital expenditures
and/or operations that a business may otherwise be unable to afford.
When credit is unavailable from a bank, the business enterprise may have to go to a commercial
finance business enterprise, which typically charges higher interest rate than the bank and
requires collateral. Typically, the value of the collateral is greater than the balance of the loan
and may consist of accounts receivable, inventories and plant assets. Commercial finance
companies also finance the installment purchases of industrial equipment. A portion of their
financing is sometimes obtained through commercial bank borrowing at wholesale rates.
COMMERCIAL PAPER
Commercial paper- An unsecured, short-term debt instrument issued by a corporation, typically
for the financing of accounts
accoun ts receivable, inventories and meeting short-term liabilities. Maturities
on commercial paper rarely range any longer than 270 days. The debt is usually issued at a
discount, reflecting prevailing market interest rates
Commercial paper is sold at a discount, with the interest immediately deducted from the face of
the note by the creditor, however the business enterprise pays the full face value. Commercial
paper may be issued through a dealer or directly placed to an institutional investor is an entity het
buys large volumes of securities, such as banks and insurance companies.
The benefits of commercial paper are that
th at no security is required; the interest rate is typically less
than that required by banks or finance companies, and the commercial paper dealer often offers
financial advice. The drawbacks are that commercial paper can be issued only by large,
financially sound companies and that commercial paper dealings are impersonal. Commercial
paper is usually backed by a bank letter of credit.
Example:
The business enterprise issues P500000 of commercial paper every two months at a 13% rate.
There is a P1000 placement cost each time. The percentage cost of the commercial paper is:
Interest (P500000 x 13%)
Placement Cost (P1000 x 6)
Cost
P71000
P65000
6000
Percentage Cost of Commercial Paper = P71000
P500000
= 14.2%
USING RECEIVABLES AS FINANCING
In accounts receivable financing, the accounts receivable serve as security for the loan as well as
the source of repayment.
Financing backed by accounts receivable generally takes place when:
*Receivables are at least P25000. –Sales are at least P250000.
*Individual receivables are at least P100.
*Receivables apply to selling merchandise rather than rendering services.
*Customers are financially strong.
*Sales return is low.
*The buyerreceives title to the goods at shipment.
Receivable financing has several advantages. It eliminates the need to issue bonds or
share capital to obtain a recurring cash flow. Its drawback is the high administrative costs of
monitoring many small amounts.
Accounts receivable may be financed under either a factoring agreement or an
assignment/pledging agreement.
Factoring is an outright sale of receivables, since the transfer of these receivables is
without recourse. The factor company (finance company) assumes the risk of collection and
generally handles the billing and collection function. As in any sale of assets, a gain or loss is
recognized for the difference between the proceeds received and the net carrying amount of
receivables factored.
If the factor retains a portion of the purchase price to cover probable sales discounts, returns and
allowanced, such as amount is charged to a “Receivable from Factor” account. This is also
known as factor holdback. Subsequent discounts, returns and allowances are credited to this
account. Final settlement of the factor’s holdback is made after the factored receivables have
been fully collected.
Assignment of accounts receivable is a more formal borrowing arrangement in which specific
receivables are identified and used as security for a loan. This is also known as specific
arrangement of accounts receivable.
The borrower pledges the specifically described receivables to a lender and signs a promissory
note payable. The assignor retains the credit risks and continues collection efforts. In most cases,
customers are not notified of the assignment and they make pa
payments
yments directly to the assignor and
the assignor remits the collection to the assignee.
Example 10-16
A factor will purchase the business enterprise’s P120,000 per month accounts receivable. The
factor will advance up to 80 percent of the receivables for an annual charge of 14 percent and a
1.5 percent fee on receivables purchased. Find the cost of this factoring arrangement.
a rrangement.
Solution:
Factor Fee[0.015 x (120,000 x 12)]
Cost of borrowing [ 0.14 x (120000x0.8)]
Total Cost
P 21600
13440
P 35040
Example 10-17
A factor charges a 3 percent fee per month. The factor lends the business enterprise up to 75
percent of receivables purchased for an additional 1 percent per month. Credit Sales are
P400,000 per month. As a result of the factoring arrangement, the business enterprise saves
P6,500 per month in credit costs and a bad debt expense of 2 percent on credit sales.
ABC Bank has offered an arrangement to lend the business enterprise up to 75 percent of the
receivable. The bank will charge 2 percent per month plus interest plus a 4 percent processing
charge on receivable lending.
The collection period is 30 days. If the business enterprise borrows the maximum per month,
should it stay with the factor or switch to ABC Bank?
Ba nk?
Solution:
Cost of factor:
Purchased receivables (0.03 x 400,000)
P 12000
Lending Fee (0.01 x 0.75 x P400,000)
Total Cost
3000
P 15,000
Cost of bank financing:
Interest (0.02 x .75x 400,000)
Processing charge(0.04 x P300,000)
P 6,000
12,000
Additional cost of not using the factor:
Credit costs
6,500
Bad debts (0.02 x P400,000)
8,000
Total Cost
P 32,500
Example 10-18
A business enterprise needs P 250,000 and is weighing the alternatives of arranging a bank loan
or going to a factor. The bank loan terms are 18 percent interest, discounted, with a
compensating balance of 20 percent. The factor will change a 4 percent commission on invoices
purchased monthly; the interest rate on the purchased invoices is 12 percent, deducted in
advance. By using a factor, the business enterprise will save P 1,000 monthly credit department
costs, and avoid uncollectible accounts estimated at 3 estimated at 3 percent of the factored
accounts. Which is the better alternative for the business enterprise?
The bank loan which will net the business enterprise its desired P 250,000 is:
Proceeds
P 250,000
=
(100% - proceeds deducted)
100% - (18% + 20%)
P 250,000
=
1.0 – 0.38
P 250,000
=
0.62
=
P 403, 226
The effective interest rate of the bank loan is:
Interest rate
Effective interest rate
=
.18
=
=
Proceeds, %
.29 or 29%
.62
We must briefly switch to the factor arrangement in order to determine the P8,929 below as a
bank cost.
The amount of accounts receivable that should be to net the firm P 250,000 is
P250,000
P 250,000
=
=
1.0-.12- .04
P 297, 619
0.84
The total annual cost of the bank arrangement is:
Interest ( P250,000 x 0.29)
P 72,500
Additional cost of not using a factor:
Credit costs ( P1,000 x 12)
12,000
Uncollectible accounts ( P297,619 x 0.03)
Total cost
8,929
P93,429
The effective interest rate of factoring accounts receivable is
Interest rate
Effective interest rate
=
0.12
=
=
14.3%
Proceeds, %
0.84
The total annual cost of the factoring alternative is:
Interest (P250,000 x 0.143)
P 35,750
Factoring (P297,619 x 0.04)
11,905
Total cost
P 47,655
* Factoring should be used since it will cost almost half as much as the b
bank
ank loan.
* Reserve on accounts receivable is the amount retained by the factor against problem
receivables, which reduces the proceeds received by the business enterprise.
* Average accounts receivable is the balance held for the period and is the basis for the factor’s
commission at the time the receivables are purchased by
b y the factor.
Example 10-19
A business enterprise is considering a factoring arrangement.
arrangement . The business enterprise’s sale are
P2,700,000, accounts receivable turnover is 9 times, and a 17 percent reserve on accounts
receivable is required. The factor’s commission charge on average accounts receivable payable
at the point of receivable purchase is 2.0 percent. The factor’s interest charge is 16 percent of
receivables after subtracting the commission charge and reserve. The interest charge reduces the
advance. The annual effective cost under the factoring arrangement is computed as follows:
Credit sales
Average accounts receivable
=
P2,700,000
=
Turnover
=
300,000
9
The business enterprise will receive the following amount by
b y factoring its accounts receivable:
Average accounts receivable
(Less): Reserve (P300,000 x 0.17)
P 300,000
(51,000)
Commission (P300,000 x 0.02)
Net prior to interest
(Less): Interest (P243,000 x 16%/9)
Proceeds received
The annual cost of the factoring arrangement is:
(6,000)
P243,000
(4,320)
P238,680
Commission
P 6,000
Interest
4,320
Cost each 40 days (360/9)
P10,320
Turnover
x
Total annual cost
P92,880
9
The annual effective cost under the factoring arrangement based on the amount received is:
Annual cost
P 92,880
=
Average amount received
=
38.9%
P 238,680
Inventories for Financing
Financing inventory, which typically takes place when the business enterprise has completely
used its borrowing capacity on receivables, requires the existence of marketable, nonperishable,
and standardized goods that have quick turnover and that are not subject to rapid obsolescence.
Good collateral inventory can be easily sold. However, you should consider the price stability on
merchandise and the costs of selling it when deciding
d eciding on a course o
off action.
The cash advance for financed inventory is high when there is marketable inventory. In general,
the financing of raw materials and finished goods is about 75 percent of their value; the interest
rate is approximately 3 to 5 points
po ints over the prime interest rate.
The drawbacks of inventory financing include the high interest rate and the restrictions it
places on inventory.
Types of Inventory Financing:

Floating lien
o

The creditor’s security lies in the aggregate inventory rather than in its
components. Even though the business enterprise sells and restocks, the lender’s
security interest continues.
Warehouse receipt
o
The lender receives an interest in the inventory stored at a public warehouse; the
fixed cost of this arrangement is high. There may be a field warehouse
arrangement in which the warehouse sets up a secured area directly at a business
enterprise’s location; the business enterprise has access to the goods but must
continually account for them.

Trust receipt loan
o
The creditor has title to the goods but releases them to the business enterprise to
sell on the creditor’s behalf; as the goods are sold, the business enterprise remits
the funds to the lender. The drawback of the trust receipt management is that a
trust receipt must be given for specific items.
A collateral certificate guaranteeing the existence of pledged inventory may be issued by a third
party to the lender. The advantage of a collateral certificate is its flexibility; merchandise need
not to be segregated or possessed by the lender.
Example 10-20
A business enterprise wants to finance P500,000 of inventory. Funds are required for three
months. A warehouse receipt loan may be taken at 16 percent with a 90 percent advance against
the inventory’s value.
The warehousing cost is P4,000 for the three-month period. The cost of financing the inventory
is:
Interest [0.16 x 0.90 x P500,000 x (3/12)]
Warehousing cost
Total cost
P18,000
4,000
P22,000
10.3 INTERMEDIATE-TERM FINANCING: TERM LOANS AND LEASING
A term loan is a monetary loan that is repaid in regular payments over a set period of time. Term
loans usually last between one and ten years, but may last as long as 30 years in some cases. A
term loan usually involves an unfixed interest rate that will add additional balance to be
b e repaid.
Intermediate-term loans are loans with a maturity of more than one year but less than five years.
They are appropriate when short-term unsecured loans are not, such as when a business is
acquired, new plant assets are purchased, or
o r long-term is retired.
Ordinary intermediate-term loans are payable in periodic equal installments except for the last
payment, which may be higher (a balloon payment). The schedule of loan payments should be
based on the business enterprise’s cash flows position to satisfy the debt. The periodic payments
in a term loan is equal to the amount of loan divided b
by
y the present value factor.
Restrictions may be placed on the business enterprise by the lender in an intermediateterm loan agreement in order to protect the lender’s interest. Typical restrictions are:
1. Working capital requirements and cash dividend limitations, such as requiring a
minimum amount of working capital or limiting dividend payment to no more than 20
percent of net income.
2. Routine (uniform) provisions employed universally in most agreements, such as the
payment of taxes and the maintenance of proper insurance to assure maximum lender
protection.
3. Specific provisions tailored to a particular situation, such as limiting future loans and
requiring adequate life insurance for executives.
Advantages of intermediate-term financing
1. Flexibility: the borrower can get loan as his/her need.
2. Low cost: cost is less than long-term financing.
3. Convenience in repayment: the borrower can repay the loan as installment or at a time.
4. Renewable: if the borrower fails to repay installment, the loan repayment period can be
expand.
5. Maintaining secrecy
6. Goodwill for the borrower
7. Rapid financing: collecting loan from capital market by selling share or debenture is
time consuming. So business collect intermediate-term credit in a short time.
8. Control
9. Only source for small business
10. Get ownership of asset without capital
11. Tax advantage
Disadvantages of intermediate-term financing
1. It is comparatively high cost than short-term financing.
2. Inconvenience of installment payment if inflow of cash is decreasing.
3. If borrower fails to repay installment, the lender collect money by selling borrower’s
collateral security.
4. It is not easy to get loan for financially weak, small and new business. Because banks,
financial institutions give more afford to borrower’s financially solvency when
considering loan.
5. Sometimes lenders impose some restrictions over the borrower which limits the
borrower’s power.
6. The borrower is required to keep a portion of loan as compensating balance.
Lease is an agreement whereby the owner of an asset conveys to another in return for a
payment or series of payments
pa yments the right to use the asset for an agreed
a greed period of time. The owner
of the property is called the lessor, while the party which receives the right for the use of
property is called the lessee.
Types of Leases:
1. Operating (service) lease- type of lease that includes both financing and maintenance
services. A lease is classified as an operating lease if it does not transfer substantially all
the risks and rewards incidental to ownership. A leased therefore, that is not considered a
finance lease is an operating lease.
2. Financial (capital) lease- type of lease usually does not provide for maintenance services.
A lease is classified as a financial lease if it transfers substantially all the risks and
rewards incidental to ownership of an asset. Title may or may not eventually be
transferred to the lessee.
3. Sale and leaseback-this transaction involves the sale of the leasing back of the same asset
to the seller. Thus, the buyer becomes the lessor, and the seller becomes the lessee. A
sale-leaseback transaction indicates that the original owner (seller) sells the asset to
obtain cash requirements I operation. However, it also needs the asset in its operation,
such that immediately after sale, the asset is leased from the buyer.
bu yer.
4. Leveraged lease- a third party serves as the lender. The lessor borrows a significant
portion of the purchase price to buy the asset and provides the balance of the purchase
price as his equity investment. The property
p roperty is the leased to the lessee. As ssecurity
ecurity for the
loan, the lessor grants the long-term lender a mortgage on the asset and assigns the lease
contract to the lender.
Advantages of Leasing:
1. No immediate cash outlay is required.
2. It is a satisfactory way to meet temporary equipment needs and provides flexibility in
operations.
3. Usually there is a purchase option that allows the business enterprise to obtain the
property at a bargain price at the expiration of the lease. This allows the flexibility to
make a purchase decision based on the value of the property at the termination date.
4. The lessor’s expert service is available.
available.
5. Leasing typically imposes fewer financing restrictions than are imposed by lenders.
6. The business enterprise’s obligation for future rental payment need not be reported on the
statement of financial position if the lease is considered an operating lease. However,
capital leases must be stated in financial statements.
7. Leasing allows the business enterprise, in effect, to depreciate land, which is not allowed
if land is purchased.
8. Lessors may claim a maximum of three years’ lease payments in the event of bankruptcy
b ankruptcy
or reorganization, whereas creditors have a claim for the total amount of the unpaid
financing.
9. Leasing eliminates equipment disposal.
10. Leasing is a great way to minimize the impact on your clients' capital budgets, since
month-to-month payments usually come out of their cash budget.
bud get.
Leasing may be more attractive than buying when a business cannot use all of the tax deductions
and tax credits associated with purchasing the assets.
The lease-purchase option decision is one commonly confronting firms considering the
acquisition of new assets. It is a hybrid capital budgeting decision that forces a business
enterprise to compare the leasing and purchasing alternatives.