SHORT-TERM FINANCING
Financial Management II
2002/2003
Sergio Diez
Petr Mestančík
Rosalia Flamarique
Jari Axen
INTRODUCTION ............................................................................................. 3
Current Assets Financing Policies .............................................................................. 3
Conservative Approach .............................................................................................. 3
Maturity Matching or “Self-Liquidating” Approach ................................................. 4
Advantages of Short-Term Financing........................................................................ 5
Speed .......................................................................................................................... 5
Flexibility ................................................................................................................... 6
Costs........................................................................................................................... 6
Disadvantages of Short-Term Financing ................................................................... 6
Risk ............................................................................................................................ 6
MAIN SOURCES OF SHORT-TERM FINANCING ......................................... 6
Accruals ........................................................................................................................ 7
Accounts Payable ......................................................................................................... 7
Bank Loans ................................................................................................................. 12
Secured Loans .......................................................................................................... 12
Unsecured Loans ...................................................................................................... 14
The Cost of Bank Loans .......................................................................................... 16
Commercial Papers .................................................................................................... 21
Corporate Bond Market ........................................................................................... 22
Other Sources of Short-Term Financing ................................................................. 23
Factoring .................................................................................................................. 23
Pledging Accounts Receivable ................................................................................ 26
Inventory Financing ................................................................................................. 27
CONCLUSION ............................................................................................... 27
SOURCES ..................................................................................................... 28
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Introduction
Some companies use current liabilities as a major source of financing for current
assets, while others rely more heavily on long-term debt and equity. Since the
different sources of financing have got different proc and cons, the aim of this paper is
to analyze possible current assets financing policies with emphasis on short-term
sources of financing. The short-term credit is defined as any liability originally
scheduled for payments within one year. The four main sources of short-term
financing are accruals, accounts payable, bank loans and commercial papers.
In order to determine company’s current assets financing policy, we divide current
assets into two main categories - temporary and permanent current assets. There are
some periods in which the enterprises accumulate more assets than in others. In the
periods in which the economy is strong, all the businesses must build up current
assets. These assets are called temporary current assets. Other types of assets that the
company has are the permanent current assets, which are the current assets that the
companies maintain also in the periods when the economy slacks off. Considering the
proportion between short-term and long-term financing, we can find three different
manners of current asset financing policy.
Current Assets Financing Policies
Conservative Approach
Here we can see the first financing policy. In this model all the permanent capital is
being used to finance all permanent assets requirements and also part of the seasonal
needs. In this model the firm uses a small amount of short- term debt. It is because
the enterprise meets a part of the seasonal needs by storing liquidity in the form of
marketable securities. It is a very safe, conservative current asset financing policy.
-3-
Figure 1
Conservative Financing Policy
Marketable Securities
Short-Term Requirements
$
Permanent Level of Current Assets
Long-Term Debt + Equity
+ Spontaneous Current Liabilities
Fixed Assets
Time Period
Maturity Matching or “Self-Liquidating” Approach
In this model the enterprises try to match assets and liabilities maturities. Here the
maturity structure of its assets and liabilities match exactly. But in the real life we
cannot see exactly this model. Firms use short-term and long-term sources of
financing, but not with an exact maturity matching because:

There is uncertainty about the lives of assets, so it is impossible to
match exactly the assets and liabilities maturities.

Some common equity must be used; common equity has no maturity.
Figure 2
$
Maturity Matching Financing Policy
Temporary Current Assets
Short-Term Financing
Requirements
Permanent Current Assets
Long-Term Debt + Equity
+ Spontaneous Current
Fixed Assets
Liabilities
Time Period
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Aggressive Approach
In this approach, a part of permanent current assets and the temporary current assets
are financed by short-term sources. Here we can find different degrees of
aggressiveness depending on what proportion of permanent current assets and/or fixed
assets is financed by short-term financing instruments (more aggressive approach, the
lower the dashed line). In this non-conservative position, the firm would be very
much subject to dangers from rising interest rates as well as to loan renewal problems,
but some firms prefer this position because short-term debt is often cheaper than longterm
debt.
Figure 3
$
Aggressive Financing Policy
Temporary Current Assets
Short-Term, Nonspontaneous
Debt Financing
Permanent Current Assets
Lon-Term Debt + Equity
+ Spontaneous Current
Fixed Assets
Liabilities
Time Period
Advantages of Short-Term Financing
Speed
It is faster and easier to obtain a short-term loan than a long-term loan. Lenders will
make a deeper financial examination before they approve a long-term loan than in a
case of short-term loan. Long-term loans have to be concreted in a considerable detail,
because a lot can happen during the life of a 10 to 20 year loan.
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Flexibility
If the needs for funds are not periodic, investor might prefer short-term financing by
three reasons. Firstly, flotation costs are smaller for short-term debt than for long-term
debt. Secondly, if the firm decides to repay the long-term debt earlier, the long-term
loans include a prepayment provision, which makes long- term debt more expensive.
Finally long-term agreements always contain provisions, or obligations, which are
specified in the contract. These restrictions constrain the firm’s future actions.
Costs
It is usual that the interest rate, which is paid in short-term debt, is lower than in longterm debt. Hence, the yield curve is normally upward sloping.
Disadvantages of Short-Term Financing
Risk
Short-term credit is riskier than long term credit because:

Interest rate, which is charged in a long-term financing, is usually
stable over the time, while in short-term financing, the interest rate
fluctuates widely.

If a firm borrows heavily in a period of time, in which a recession is
recorded. The company might be then forced into the bankruptcy,
because it might be unable to repay the loan.
Main Sources of Short-Term Financing
The companies have got several possibilities of short-term financing. Since the
different sources of short-term financing have got different advantages and
disadvantages, in the following part, we focus on each type of short-term financing.
First, we deal with accruals, then with accounts payable and bank loans, and finally
with commercial papers and other financial instruments.
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Accruals
Accruals are kind of a debt that have been incurred or accumulated over a period of
time, but not has been paid yet. In a balance sheet of a company, we can find accrued
wages and/or accrued income taxes, which increase automatically as the company is
expanding its operations. On the one hand, this type of debt is free and the company
can use it without having to pay any explicit interest. On the other hand, the
companies have got a little control over the levels of these accounts1.
Accounts Payable
Another possibility of short-term financing represent accounts payable, which are also
called trade credit. Although accounts payable are the largest single category of shortterm financing, their role is often neglected, because some managers confuse
company’s account payables management with the vendor’s account receivable
management, and simply adopt supplier’s credit policy. In this case, the payables
system is often seen as the bill paying mechanism only. Since the bills must be paid
on time, the standardization and automation of the process of settling the bills with
keeping the track of when and to whom should the company pay, might be seemingly
the only opportunity for operating efficiency gains. This is really far from truth. Since
accounts payable can be easily controlled, they are together with inventory and
accounts receivable probably the best place to improve the company’s cash position.
This holds especially for small businesses, which are likely to have limited access to
capital, so they often rely especially on accounts payable2.
Accounts payable are spontaneous source of short-term financing; they are customary
part of doing business. They are the obligation due to trade partners, they exist,
because customers prefer to receive goods now and pay later, so the seller offers
delivery of goods or services prior to receiving cash payment. Instead of collecting
1
Since the timing of paying wages is set by economic forces and industry customs, the company can
not change it.
2
In the case that company’s level of accounts payables exceeds the level of accounts receivables, the
company is said to be receiving net trade credit, which is usually the case of small companies;
otherwise company is extending its extending net trade credit.
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money, supplier, in fact, provides a loan to the customer. The amount of loan, or
credit, provided by the vendor depends on two main factors. The level of sales, and
consequently the level of purchases is the first one, and the grace period, or the time
gap between invoice date and payment date is the second one. The size of time period
provided differs from company to company and depends on the vendor’s credit
policy. Trade terms might, for example, take form Net 30 from invoice date, which
requires payment within 30 days from invoice date; or Net 30 from shipment, which
requires payment within 30 days from the shipment date; or 1/10, Net 30. In the last
example, 1% discount is offered from the market, or the list price, if the payment is
made within 10 days from the invoice date, otherwise customer is obliged to pay the
full list price within 30 days from the invoice date. The last possibility is the most
complex and the most interesting one, because company has got several options when
to pay its bills.

First, the company might decide to take the discount and pay within 10
days.

Second, the company might pass up the discount and pay within
30days.

Third, the company might get away with late payments and pay, for
example, within 60 days;

Fourth, the company might pay its bills, for example, on 15 th day and
still take discount.
The main objective of accounts payable management is to decide the payment date.
Which option will be taken depends on two offsetting factors. On the one hand, there
are the benefits from holding on the cash; on the other hand, there are also the costs.
So the only problem is evaluation and comparison of the benefits and the costs.
Although solution might look simple, it is actually rather complex, especially in the
case of late payments, because of the presence of the indirect, subjective costs, arising
from broken relationship, late payer treatment and so on.
In order to determine the cost of trade credit in general, we assume that the company
buys from its suppliers it terms X/Y, Net Z. As was already explained, that means that
the company is offered discount of X% from the list price if it pays within Y days
from the invoice date, otherwise it has to pay the full list price within Z days. We first
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consider only two possible actions – the company can take the discount and pay in X
days, or not to take discount and pay the full list price in Y days without delaying the
payments beyond this date. We also assume payments on the last possible day of
given period, because as we will see later, there is no sense in paying earlier. Using
this trade term, trade credit can be divided into two components. Firstly, there is a free
trade credit, which contains trade credit obtained during the discount period.
Secondly, there is a costly trade credit, which is the remainder after the deduction of a
free trade credit from overall trade credit. When the company decides not to take
discount and extend its trade credit, it has to pay the full list price, or in other words,
the company must pay financial charge to its supplier for providing additional funds.
That means that the list price can be also treated as consisting of two components, the
true price list price * (1 - X)  and the financial charge list price * X . This distinction is
important not only for accounting purposes3, but also for determining the cost of trade
credit. Since the average accounts payable are determined by the level of purchases
and the time gap between invoice date and the payment date, the average company’s
accounts payable in the case of taking discount and paying on day Y are equal to
average daily purchases multiplied by the number of days in discount period,
thus (list price * (1 - X) * Q) / 360 * Y . Q in the previous term denotes yearly
purchased quantity. If the company decides not to take discounts, its average accounts
payable will be equal to ((list price * (1 - X) * Q) / 360) * Z. If the company passes up
the discount, it gains additional funds ((list price * (1 - X) * Q) / 360) * (Z  Y) . The
company is not given additional funds for free, but for the price of the lost discount,
or list price * X * Q . Hence, the nominal annual cost rate of the additional trade credit
(NAR) is
NAR 
list
price * X * Q
X
360

*
((list price * (1 - X) * Q) / 360) * (Z  Y) 1  X Z  Y
The nominal annual cost rate of trade credit can be also interpreted as the cost of
trade credit per period - expressed by the term X /(1  X ) , multiplied by the number of
periods a year, in which is additional trade credit provided - term 360 /( Z  Y) .
3
According to Generally Accepted Accounting Principles it is allowed to record gross purchases unless
the discounts take material form. If the discount is in material form, purchases must be recorded net of
discounts.
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Since the (NAR) formula does not take into account compounding, the nominal
annual cost rate of trade credit will be lower than effective annual cost rate of trade
credit (EAR). To obtain effective annual cost rate of trade credit we use the following
relationship
EAR  (1  period rate) #of compounding periods  1 .
Thus, in our case, the effective annual cost rate of trade credit is equal to
EAR  (1  X /(1  X)) 360 /(ZY )  1.
If the company is effectively borrowing money, it should pass up the discount only if
there is no other possibility of shortTable 1
term financing at a lower cost than the
Sensitivity analysis
Credit terms
1/10, Net 20
1/15, Net 20
1/10, Net 30
1/15, Net 30
1/10, Net 45
1/15, Net 45
3/10, Net 20
3/15, Net 20
3/10, Net 30
3/15, Net 30
3/10, Net 45
3/15, Net 45
5/10, Net 20
5/15, Net 20
5/10, Net 30
5/15, Net 30
5/10, Net 45
Nominal cost
36.36%
72.73%
18.18%
24.24%
10.39%
12.12%
111.34%
222.68%
55.67%
74.23%
31.81%
37.11%
189.47%
378.95%
94.74%
126.32%
54.14%
Effective cost
43.59%
106.19%
19.83%
27.28%
10.89%
12.82%
199.38%
796.26%
73.02%
107.72%
36.79%
44.12%
510.69%
3629.47%
147.12%
234.10%
67.70%
5/15, Net 45
63.16%
82.79%
cost of trade credit. As we see from the
table, the cost of trade credit, expressed
both in nominal annual cost rate and
effective annual cost rate, is highly
dependent on the discount granted as
well as on the grace period provided by
the supplier to foot the bill, and might
significantly vary. In general, when
managing
accounts
payable,
for
companies, it is too expensive to turn
down the discount and pay the full list
price. However, there are some possible actions companies can take in order to reduce
unfavorably high cost of trade credit. In short, companies might get away with late
payments, or in other worlds, stretching their accounts payable. For example,
company might buy in term 1/10, Net 20, but actually behave in term 1/10, Net 45; or
buy in term 1/10, Net 20, but in fact pay on 15th day and still take the discount. As we
see from the table, befits from such behavior are obvious. As was already mentioned,
the costs of trade credit in case of paying late are the direct, objective ones, but also
indirect, subjective ones, which are hardly measurable. The explanation of
determination of the subjective variables is beyond the scope of this presentation, but
we would like to present here at least the basic features of the model. Although the
concept of taking into account both direct and indirect cost is rather complicated, the
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basic idea is still the same – as long as the costs are lower than the benefits, the
payment should be delayed and the cash withhold in the company. Whenever the
company decides such an action, it must carefully consider possible impacts on
relationship with its supplier. Having all the cost available, we can use the following
formula to obtain number of days the company should delay its payments beyond the
date provided by the supplier
(Daily benefits
- Daily direct costs)/Dai ly indirect costs .
Further delaying payments beyond the optimal date that was obtained from the above
equation is inconvenient for the company, because it brings more costs than the
benefits.
From the previous section we know that the company should use costly trade credit
only if there is no other possibility of short term financing from other sources at a
lower price. Since the various sources of short term financing have got different
impacts on the appearance of financial statements, it this section we focus our
attention to that aspect of accounts payable. For simplicity, we assume the company
that needs to raise additional $550.000 to cover its operations. The company buys in
term 1/10, Net 30 and takes the discount. It has only one supplier and average yearly
gross purchases of $10.000.000. We consider two possibilities of financing. First,
10% interest bank loan. Second, turning down the discount and extending trade credit.
In both situations, we assume accruals and common equity accounts to be unchanged.
In the first case, the company borrows the amount needed from the bank. In the
second situation, the company passes up the discount and extends its payment term,
but it still pays its bills on time. In the first case, the average level of its accounts
payable is $275.000. In the second case, average payables are $825.000. If the
company carries on taking the discount, an interest expense is incurred, but it avoids
the discounts loss. Since in this example the cost of trade credit - discount loss is
higher that the cost of bank loan - interest expense, the company should follow the
policy of taking discount and borrowing from the bank, which results in higher net
income, thus, in higher stock price.
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Table 2
Company buys in terms
1/10, Net 30
Effects on the Financial Statements
Do not take discounts;
Take discount;
use maximum trade
Difference (1)borrow from bank
credit without delaying
(2)
(1)
payments (2)
Balance sheet
Cash and equivalents
Account receivable
Inventories
Current assets
Fixed assets
Total assets
500,000.00
1,000,000.00
2,000,000.00
3,500,000.00
2,980,000.00
6,480,000.00
500,000.00
1,000,000.00
2,000,000.00
3,500,000.00
2,980,000.00
6,480,000.00
0.00
0.00
0.00
0.00
0.00
Accounts payable
Notes payable
Accruals
Current liabilities
Common equity
Total liabilities and equity
275,000.00
550,000.00
655,000.00
1,480,000.00
5,000,000.00
6,480,000.00
825,000.00
0.00
655,000.00
1,480,000.00
5,000,000.00
6,480,000.00
-550,000.00
550,000.00
0.00
0.00
0.00
0.00
14,000,000.00
9,900,000.00
3,000,000.00
55,000.00
0.00
1,045,000.00
418,000.00
627,000.00
14,000,000.00
9,900,000.00
3,000,000.00
0.00
100,000.00
1,000,000.00
400,000.00
600,000.00
0.00
0.00
0.00
55,000.00
-100,000.00
45,000.00
18,000.00
27,000.00
Income statement
Sales
Cost - Purchases
- Labour
- Interest
- Discount loss
EBT
Taxes (40%)
Net Income
Bank Loans
Loans are for non-financial corporations the second in importance after trade credit as
a source of short-term financing. Short-term loan is a debt, for which the scheduled
repayment and the anticipated use for the money is expected to be a year or less. Bank
loans to businesses are frequently written as 90-days notes, so the loan must be repaid
or renewed at the end of 90 days. Short-term loans are often used to raise the cash for
cyclical inventory needs, accounts payable, and working capital.
Secured Loans
Secured loan is a form of debt in which specific assets have been pledged to guarantee
payment. A secured loan is a promise to pay a debt, where the promise is secured by
granting the creditor an interest in specific property of the debtor. If the debtor
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defaults on the loan, the creditor can recover the money by seizing and liquidating the
specific property used as collateral on the debt.
Collateral may be defined as property that secures a loan or other debt, so that the
property may be seized by the lender if the borrower fails to make proper payments
on the loan.
When lenders demand collateral for a secured loan, they are seeking to minimize the
risks of extending credit.
Because the value of pledged collateral is critical to a secured lender, loan conditions
and covenants, such as insurance coverage, are always required from borrower. You
can also expect a lender to minimize the risk by conservatively valuing your collateral
and by lending only a percentage of its appraised value. The maximum loan amount,
compared to the value of the collateral, is known as the loan to value ratio.
In addition, many lenders will require their claim to the collateral to be a first secured
interest, meaning that no prior or superior liens exist, or may be subsequently created,
against the collateral. By being a priority lien holder, the lender ensures his/her share
of any foreclosure proceeds before any other claimant is entitled to any money.
Properly recorded security interests in real estate or personal property are matters of
public record. Because a creditor wants to have a priority claim against the collateral,
being offered to secure the loan, the creditor will search the public records to make
sure that prior claims have not been filed against the collateral. If the collateral is real
estate, the search of public records is often done by a title insurance company. The
company prepares a "title report" that reveals any pre-existing recorded secured
interests or other title defects. If the loan is secured by personal property, the creditor
typically runs a "U.C.C. search" of the public records to reveal any pre existing
claims. The cost of a title search or a U.C.C. search is often passed on to the
prospective borrower as part of the loan closing cost.
In start up businesses, a commonly used source of collateral is the equity value in real
estate. The borrower may simply take out a new, or second, mortgage on his or her
residence. In some states, the lender can protect a security interest in real estate by
retaining title to the property until the mortgage is fully paid.
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Example:
A lender might be willing to loan only 75 percent of the value of new commercial
equipment. If the equipment was valued at $100,000, it could serve as collateral for a
loan of approximately $75,000.
Unsecured Loans
Unsecured loan is also a promise to pay a debt. Unlike a secured loan, the promise is
not supported by granting the creditor an interest in any specific property. The lender
is relying on the creditworthiness and reputation of the borrower to repay the
obligation. An example of an unsecured loan is a revolving consumer credit card.
Sometimes, working capital lines of credit are also unsecured.
If the borrower defaults on an unsecured loan, the creditor has no priority claim
against any particular property of the borrower. The creditor can try to obtain just a
money judgment against the borrower. Until a small business has an established credit
history, it cannot usually get unsecured loans because of the business's risk.
If the debtor encounters financial difficulties, an unsecured creditor is often the last in
line to collect. If a small-business debtor is forced into bankruptcy, an unsecured loan
in the bankruptcy estate will usually be "wiped out" by the bankruptcy, but no assets
typically remain to pay these low priority creditors.
Aspects that can include one loan:

Promissory note - traditional bank lending arrangement.
When a bank loan is approved,, the agreement is executed by signing a promissory
note. The note specifies the amount borrowed; the interest rate; the repayment
schedule, which can call for either a lump sum or series of installments; any collateral
that might have to be put up as security for the loan; and any other terms signed, the
bank credits the borrowers checking account with the funds, so on the borrowers
balance sheet both cash and notes payable increase.

Compensating balances
Sometimes, the banks require borrowers to maintain an average demand deposit
balance equal to 10 to 20 percent of the face amount of the loan. This makes the
money unavailable for use and increases the cost of borrowing, because the interest is
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paid on the total amount of borrowing, which includes the money the borrower can
not touch. Recent surveys indicate that compensating balances are much less common
now than 20 years ago. In fact, compensating balances are now illegal in many states.
Different Types of Unsecured Loans

Informal Line of Credit: relatively informal, nonbonding agreement
between the bank and borrowing firm that specifies the maximum
amount that can be borrowed during a time period.
Example:
M&M Beverage Company has a $300,000 line of credit that requires a compensating
balance equal to 10 percent of the loan amount. The interest rate paid on the loan is 12
percent annually. $200,000 is borrowed for a six-month period. The firm does not
currently have a deposit with the lending bank, so the compensating balance has to be
borrowed.
loan borrowed = amount wanted + (%CB* loan borrowed)
loan borrowed - (%CB * loan borrowed) = amount wanted
(1 - %CB) loan borrowed = amount wanted
loan borrowed = amount wanted/(1-%CB)
loan borrowed 200,00/0.9 = 222,222.
→ borrow = $222,222 → get 200,000, CB 10%*222,222 = 22,222
borrow $222,222 for 6-month period
interest is 12% per year
interest = 12% * 222,222 * 6 /12 = $13,333.32
Annual Percentage Rate (APR) = pay/get * 360/n = 13,333.32 * 12/6 = 13.33%
borrow $222,222 → get only $200,000
C.B. $22,222
If the loan is discounted, the loan interest will be deducted from the loan amount
when borrowed.
get only $ 222,222 - $22,222 (CB) - $13,333 (Int.) = $186,666.68
- 15 -
*APR = 13,333.32/186,666.68 * 12 /6 = 14.29%

Revolving Credit Agreement: is a formal line of credit. Bank guarantees the
availability of funds up to a maximum amount during the specified time
period. The borrower pays a commitment fee that can be explained as a
percentage interest on the non-borrowed balance of the agreement. Interest
rates are generally variable and tied to the prime rate. This revolving credit
agreement is very similar to an informal line of credit, but whit an important
difference: the bank has a legal obligation to honor a revolving credit
agreement, and it receives a commitment fee. Clean-up clause often appears in
line of credit. It requires the borrower to reduce the loan balance to zero at
least once a year.
The Cost of Bank Loans
We can say in general that the cost of bank loans varies for different types of
borrowers at any given point in time and for all borrowers over time. The borrowers
have to pay higher interest rate if they like risk and if the quantity of the loan is small
because of fixed cost involved in providing and servicing loans. The prime rate is one
of the lowest rates. If the firm has financial strength, it can borrow to this rate, and if
the firm is strong customer, sometimes it can borrow at rates below than prime rate.
Bank rates vary widely over time depending on economic conditions and Federal
Reserve policy. The terms regarding short-term bank loans are spelled out in the
promissory note. This are the principal elements contained in most promissory notes:

Interest only versus amortized
Interest only: only interest is paid during the life of the loan and the principal is paid
when the loan matures.
Amortized: Some of the principal is repaid on each payment date.

Collateral.

Loan guarantees
If the borrower is a small corporation, its banks will probably insist the larger
stockholders personally to guarantee the loan.

Nominal, or stated, interest rate
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The interest rate can be either fixed or floating.

Frequency of interest payment

Maturity
Tells when the loan must be repaid or renewed. Short-term loans may or may not have
a specified maturity.

Discount interest

Add-on basis instalment loans

Other cost elements
Some loans require compensating balances or commitment fee, this increases the cost
of the loan.

Key-person insurance
Some companies use this possibility to avoid failing to repay the loan when one of
the key individuals dies.
The Financing Cost
The financing cost is the rate that must be earned to satisfy the required rate of return
of the firm's investors. If financing cost is reduced, NPV increases, more projects end
up with NPV > 0, more wealth is created to shareholders. We will analyze the
calculation of the effective cost of different bank loans. There are two procedures for
short-term business loans: regular, simple interest and discount interest.
Regular and Simple Interest
This is the most common procedure for short-term bank loans, based on an interestonly loan. When we have to negotiate the conditions of the loan with the bank, we
have to get an agreement to when will be the interest paid. The effective interest rate
on a loan depends on frequency of interest payments, the more frequently, the higher
effective rate. We will demonstrate this with two examples, first with interest paid
annually and second with quarterly payments. For illustration, we assume a loan of
$11000, at a nominal interest rate of 13%, by 365 days a year.
First of all, we calculate the interest rate per day:
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Interest rate per day 
Nominal rate
Days per year
Interest per day = 0.13/365 = 0.000356164. If we want know the quantity we have to
pay for period, we have to apply the following formula:
Interest charge for period  Days in period  Rate per day   Amount of loan )

Interest Paid Annually
If the interest is paid annually, the borrower gets in period 0 $11000 and he has to
give back 11000 plus the interest that will be calculated
11000  1  0.13   11300
The effective cost of the loan is 13%.

Interest Paid Quarterly
If the interest is paid quarterly, and each year has 365 days, each quarter is 91 days,
but one quarter will be 92. If we want to calculate the interest we have to pay, we will
use the previous formula. Hence, we have
92   0.000356164   11000   360.437. This amount will be paid three periods.
At the end we have to pay $12430. The effective interest rate in this period is equal to:
Effective Annual Rate= (1+i/n) n –1.
Thus, we obtain (1+0.13/4) 4 -1=13.64%.
As we can see in these examples, if the interest is paid more times, the effective
annual rate increases. The effective annual rate would be higher if the bank used a
360-day year.
Discount Interest
If the agreement with the bank is discount interest loan, the bank deducts the interest
in advance. Thus, the borrower receives less than the face value of the loan.
We are going to considerate the same characteristics than in the previous case. And as
above we are going to illustrate in two examples, when the interest is paid annually
and when is paid quarterly.

Discount Interest, Paid Annually
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If the loan is $11000 and the interest rate is 13%, the interest amount will be:
11000*(0.13)=1430, this is why the borrower only can use 11000-430=$9570
With this we can calculate the effective interest rate.
We get $9570 in period 0, but after one year we have to give back $11000.
We know the present value and the future value, so the effective interest rate is
11000=9570*(1+i)1, hence 14.94 percent.
If a discount loan matures in less than a year, for example after one quarter, we have
this situation:

Discount Interest, One Quarter
If the annual interest rate for one year is 13 percent, for one quarter will be, (divided
by 4) 0.0325 The amount that we will use is: 11000*(1-0.0325)=$10642.5.
Our effective interest rate will be:
11000=10642.5*(1+i) ¼
Hence, effective interest rate is 14.13 percent
Unlike the regular interest we have explained before, in the discount interest
shortening the period of a discount loan, lowers the effective interest rate.
Installment Loans: Add-On Interest
An installment loan is a structured loan to be paid back in a specified timeframe,
available with both fixed and variable rates. Loan term can vary from a few months to
a few years. You can obtain competitive rates that reward your strong payment
history, and you have multiple payments options. Business installment loans offer
predictable monthly payments that can be incorporated into a company's budget.
They're ideal for companies that need fixed-asset financing for machinery, office
equipment or a new vehicle. We can calculate the charge of installments loans as
simple interest or add-on interest. Now we will explain the add-on interest. The addon interest means that the interest is calculated and then added to the amount received
to determinate the loans face value.
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To illustrate this, we borrow $10000 on an add-on basis at a nominal rate of 12%
percent to buy a car, with the loan to be repaid in 12 monthly installments:
Finance charges are calculated on the original loan amount: (10000)*(0.12) = 1200.
Have to be added these charges to principal: $1200+$10000 = 11200.
Since the loan is paid off in monthly installments, you have the use the full money for
the first month only, and the outstanding balance declines until, during the last month,
only 1/12 of the original loan will be outstanding. We can calculate the approximate
annual rate as follows:
Approximate annual rate
Add-on =Interest
paid/(amount received)/2
1200/(10000/2) = 24%. The monthly payment is 11200/12 = $933.3. We pay all
months 933.33$, but we receive today $10000 that will be the present value of the
annuity.
We calculate the internal monthly rate and we obtain 1.7880 percent. The effective
annual rate
Add-on
= (1+kd)n -1 = (1.01788)12-1 = 23.7%. The annual percentage rate
will be = 21.46%. APR rate = (periods per year)*(rate per period) = 12*(1.7880%) =
21.46%.
How to Choose a Bank?
Considering the fact that banks offer an increasing number of financial services at
widely varying fees, choosing one to handle your particular financial needs might
seem to be a difficult and confusing task. Although there is much to consider, it is
best to select a bank the same way you would choose any product or service—first
evaluate your needs and then compare cost. Some aspects to be considered when
choosing the bank are highlighted bellow.

Willingness to Assume Risks
Banks have different basic policies towards risk.
Some follow relatively
conservative lending practices, while others engage in creative banking practices.

Advice and Counsel
Some bank loan officers are active in providing counsel and in granting loans to firms
in their early and formative years.
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
Loyalty to Customers
Banks services might be different in the confidence with the customers. While there
are banks that in bad times can support the company if it has difficulties in liquidating
the loan, others can put pressure.

Specialization
Banks differ in the degrees of loans specialization; larger banks have separate
departments that specialize in different kinds of loans.

Maximum Loan Size
The maximum loan bank can make to any one customer is limited to 15 percent of the
banks capital accounts and this can not be appropriate for large firms to have a
borrowing relationship with small banks.

Merchant Banking
Merchant banking is generally the business of making private equity investments in
non-financial firms, in particular equity investments with a venture capital character.

Others services
There are others services you have to consider when choosing a bank. Some banks
provide cash management services, assist with electronic funds transfers, help firms
obtain foreign exchange, etc.
Commercial Papers
The three principal means employed in the funding of economic enterprises are equity
instruments, bonds, and bank lending. Over the years, much attention has been
focused in the optimal ratio of debt to equity. In contrast, the “optimal” or best
balance between bond financing and bank financing has scarcely been addressed. This
is somewhat surprising because heavy average reliance on one or the other can have
far reaching effects, especially on systemic risk, since the banking system is heavily
leveraged and subject to regulatory imperfections. Investors in corporate bonds and
related instruments appear to do a better job than bankers in deciding which
enterprises to fund and on what terms – and thus in preventing the economy from
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ending up in a crisis, while factors such as monetary policy, fiscal policy, and policies
concerning capital controls clearly have an impact on economic performance.
The only country with a well-functioning corporate bond market at this time is the
United States. As a percentage of GDP, bond market financing in other countries is a
small fraction of the U.S. number. Incidentally, countries where banks play a large
role need higher savings rates to reach the same level of benefits, because returns on
bank deposits are typically smaller than on bonds and on equities. Thus, a welldeveloped corporate bond market is associated with a substantial degree of
disintermediation as well as a well-functioning market in derivatives, in which interest
rate and currency risks, for example, are readily hedged. To qualify as well
developed, a corporate bond market must also be free from government interference
with the lending process. In addition, a smoothly operating market in government
securities would typically be present in such an environment as well.
Corporate Bond Market
Having elaborated on the shortcomings of an over-bearing banking system, it is
reasonable to ask just what it is that a well-developed corporate bond market brings to
the party. The discipline of market forces as it relates to bonds, however, has many
dimensions. A pre-condition of a genuine corporate bond market is that it must be free
from government interference. Investors must feel free to base their decisions on
economic criteria alone, such as risk and expected return. Pressure on bond investors
or prices based on industrial policy, either direct or indirect, must be absent. Probably
the single most important element of a well-functioning bond market is a financial
reporting system for companies, which are relevant, reliable, and timely. The higher
the quality of the borrower’s financial statements, the sounder the basis on which the
potential investor can make decisions. There is some evidence that the higher the
quality of a firm’s disclosure practices, the lower the effective interest cost at which
its debt can be issued. A second key ingredient of a healthy corporate bond market is
a strong community of financial analysts. The role of (buy-side) financial analysts is
to provide investors with independent and informed advice. In effect, the value of a
sound financial reporting system is multiplied by the presence of profession of
financial analysts, since their evaluation of the companies is now made easier and can
therefore result in a better product. Thus, an informative accounting system also tends
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to raise the quality of analysts’ recommendations. Groups of analysts long ago began
Table 3
Standard &
Poor's
A-1+
A-1
A-2
A-3
B
C
D
forming rating agencies, of which
Rating
the best known are Moody’s,
Moody's
P-1
P-2
P-3
NP
Explanation
Prime rating
High prime rating
Medium prime
rating
Low prime rating
Not prime rating
Approaching
insolvent
Liquidation
Insolvent
liquidation
Standard & Poor’s, and Fitch
Investors.
specialty
Their
is
to
particular
assist
bond
investors by assigning companies
and new issues a grade from a
predetermined and well-known
scale. Their reports provide a
clear,
objective
basis
for
determining the “fair” interest rate for a given bond issue. Respected rating agencies
are thus a key ingredient of a mature bond market.
When rating short-term debt, you distinguish between prime ratings and not prime
ratings, which are modified by 1, 2 and 3.
Recent years have seen the emergence of new types of corporate debt instruments, in
particular high-risk (junk) bonds and mortgage- and other asset-backed securities.
This in turn has led to a sharp increase in demand for credit analysis, since sizing up
the risks of default now becomes central in assessing the proper yields to make these
instruments attractive to investors. As a consequence, a strong corps of credit analysts
has become a central element of a well-developed corporate bond market.
Other Sources of Short-Term Financing
Factoring
At some point a growing businesses usually faces a cash flow problem. In fact,
research has shown that many growing businesses that fail do so because they owe
more in the short term than they can pay short term.
Traditionally businesses have gone to credit lines, credit cards and expensive shortterm bridge loans to get the cash they need to pay their bills. Often they will forgo tax
payments to make ends meet. If their credit lines are tapped out, they may have to go
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through a lengthy process to find new financing. If this process takes too long, the
flow may be just too negative to survive.
This seems paradoxical. How could a growing business -- that is actually profitable -go under? On closer examination it is not so ironic or surprising -- a large contract
comes in that does not pay on time or a new market open up and management ramps
up production and related costs. There are many other scenarios as well.
But there is an alternative to going under. The general term for this alternative is
factoring and accounts receivable financing. If your company has receivables or
outstanding invoices you can get advances on these receivables. A factoring -- A/R
financing company can advance you funds based on your receivables. Factoring can
bridge the gap between billing and collections, enabling a business to match cash flow
with cash needs. These companies can be finance companies, banks, factoring
companies, capital corporations, etc.
The dynamics are rather simple: you get up to about 80% of your receivables before
your account pays. In some situations your customers may pay you directly and in
other situations they pay the factoring company directly. When the balance is paid
you get that as well -- minus the financing fee. This fee usually runs from 2-4% which
does not sound like much except that the 2-4% can be the equivalent of a monthly fee.
So the rates end Sup being somewhat comparable to a credit card rate. The factoring
company does take on some degree of risk that they cover with their own insurance.
Another big advantage is that most factoring can be done within several working
days. Since factoring companies are not banks they do not have to go through a
lengthy loan approval process. Some factoring companies boast they can have money
in your hand in less than 24 hours. This can be very appealing if the proverbial wolves
are at your door. One huge advantage is that these companies can advance money to
companies with poor credit or even companies involved in bankruptcy proceedings.
Obviously the easing of cash flow pressure is the primary benefit of factoring and A/R
financing. Another benefit is that it does not require tying up assets as collateral to
guarantee the loan. In other words, your company could use factoring-- A/R financing
and still applies for traditional loans, credit lines, credit cards, etc. Since factoring is
not a true 'loan' it does not affect the balance sheet, as would a traditional loan.
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Another true advantage of factoring is that working capital can be recycled to fund
growth. Many companies use factoring to recoup cost of goods sold so they can
reinvest in expansion and meet increased market demands. In effect, through factoring
they leave about 20% of their receivables 'out' so their future collections are their
profit margins.
Approval by factoring companies is not automatic. Normally your company must
have a solid product/service, satisfied customers and credit-worthy customers. And
factoring companies will not deal with small companies. Just like banks, they have to
make profit.
Many factoring companies will allow you to apply even before you need the money.
This is very important if your company is in a cyclical or seasonal marketplace.
The best business advice is to watch your money and monitor your cash flow. If you
see your company running short of working capital, try to find a solution before your
creditors do. Factoring and A/R financing may be a very desirable option!
Example of Factoring
Your company will bill your customers in the usual way, along with sending a copy of
the invoices to the factoring company. The factoring company will then advance your
business 75% to 90% of the face amount of the invoices thus retaining 10% to 30% as
a reserve. The factoring company then takes the responsibility for collecting payment
from your customers.
Once the factoring company is paid on the invoices, they will release to your
company the reserved amount previously withheld on the invoice, minus the
appropriate financing fee for advancing the cash.
The financing fee is based not on the strength of your company but rather on the
quality of your accounts. The cost fluctuates according to the creditworthiness and
performance of your customers. The fees can range from as low as 1% to 5% of the
invoice amount normally 3 %, depending on the level of risk involved.
The funding time for your first factoring transaction is usually 5 to 7 days. Once your
account has been set up, cash can be advanced on your invoices and can be wire
transferred to your bank account anywhere in the country within 24 hours. You can
customize the program to fit your needs. There is no requirement to factor all your
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invoices, you choose when and how much is factored (depending of course on your
customers’ credit). Therefore, if you need cash to meet payroll or other expenses, you
factor the invoices necessary to cover these bills. If not, you may retain the invoices
and collect the cash as you are doing currently.
OK so what are the differences? First, you will receive between 75% and 90%
immediately. The difference is retained by the factor for his protection and fees. The
interest is charged to you based on the number of days the cash was advanced to you.
The retained amount (less the interest and factors fees) will be sent to you once your
customer makes the payment to the factor.
Here is an example:
Face amount of Client's invoice
$1000,000
Reserve Fund held for security
$ 200,000
Cash Advanced to client from Factor
$800,000
Customers Payment Received
$1000,000
Factor Reserve Fund Refund Paid to Client
$170,0004
Cash proceeds Retained by Factor
$30,000 (fee)
When you factor, you do not incur any debt, and there are no monthly payments. You
control your cash flow by determining how much to factor, and when.
When compared to the cost of maintaining receivables for 30 days or more, and the
administrative expense associated with collections, factoring is a wise alternative to
traditional financing from banks.
Pledging Accounts Receivable
The financial institution wants to protect itself and that’s why wants some pledges.
Institutions never give loan what is the full of the pledged receivables. This is not so
popular than factoring.
4
Fee is deducted from reserve.
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Inventory Financing
Blanket liens- the inventory blanket lien gives the lending institution a lien against all
the borrowers’ inventories. But borrower can sell inventories and the value of the
collateral can be used to the loan.
Trust receipts- the inventory is held in trust for the lender. The borrower manages the
goods and stock can be public warehouse or borrowers stock. All the sales have to pay
to lender that means like daily payments.
Warehouse receipts are one way to use inventory as security. This means that
company uses inventory as security and that requires public notification, physical
control of the inventory, and supervision by a custodian of the field warehousing
concern. Warehouse is independent third-party and only stock for goods. Borrower
has rights those good what is in the stock.
Conclusion
Companies have got several alternative policies they can follow in order to finance
their current assets. Current assets’ financing policies differ from company to
company and depend on the level of risk companies are willing to take. On the one
hand, there is a very safe conservative approach, in which companies use very low
amount of short-term financing; on the other hand, there is risky aggressive approach,
in which proportion between short-term and long-term financing is higher. The higher
is the proportion between short-term and long-term financing, the higher level of risk
involved. Sources of short-term financing can be divided into four main categories.
First, there are accruals, which are spontaneous source of short-term financing arising
from accrued wages and taxes. Second, there are accounts payable, which are also
spontaneous source of short-term financing, customary part of doing business.
Accounts payable are obligations due to trade partners. They are usually the largest
single category of short-term financing. Third, there are bank loans. The last main
category of short-term financing represent commercial papers, which are issued by
large corporations.
- 27 -
Sources
[1]
Brigham, Eugene F., Daves, Phillip R. – Intermediate Financial Management
[2]
http:// www.i2m.org/ftp/freepubs/1505.pdf
[3]
http://uwadmnweb.uwyo.edu/SBDC/fod/253.html
[4]
http://www.bof.fi/
[5]
http://www.vm.fi/
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