Chapte
5
Slides Developed by:
Terry Fegarty
Seneca College
Sources of Short-Term
Financing
Chapter 5 – Outline (1)
• Sources of Short-term Financing
• Spontaneous Financing
 Trade Credit
 The Prompt Payment Discount
 Abuses of Trade Credit
• Bank Operating Loans
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Short Term Bank Credit
Line of Credit or Revolving Credit Agreement
Interest Rates on Loans
Annual Interest Rate
Cleanup Requirements
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Chapter 5 – Outline (2)
• Short-Term Credit Secured by Current Assets
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Receivables Financing
Pledging Accounts Receivable
Factoring Accounts Receivable
Inventory Financing
Types of Inventory Financing
• Money Market Instruments
 Commercial Paper
 Bankers’ Acceptances
 Securitization of Receivables
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Sources of Short-term Financing
• Spontaneous financing
 Accounts payable and accruals
• Bank operating loans
 Revolving credit agreement, line of credit
• Secured loans for accounts receivable and
inventory
• Money market instruments
 Commercial paper
 Bankers’ acceptances
 Securitization of receivables
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Spontaneous Financing
• Accruals
 For example, money you owe employees for work
they have performed but not yet been paid
• Tend to be very short-term
• Accounts payable (AKA: trade credit)
 Money you owe suppliers for goods you bought on
credit
 Attractive source of financing
• No security required
• Interest-free
 Credit Terms: Terms of trade specify when you are
to repay the debt
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Trade Credit
• Seller lends buyer purchase price from
time of shipment to time of payment
• No security and no interest
• Seller may offer cash discount for early
payment
• Cost of forgoing a cash discount:
% discount
365
APR =
×
100% - % discount Final payment date - Last discount date
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The Prompt Payment Discount
Q: Vendor offers a discount of 2% if payment is made within ten
days. If the discount is not taken, full payment is due in 30 days.
What is the annual cost of not accepting the 2% discount?
Example
A:
% discount
365
=
×
100% - % discount Final payment date - Last discount date
2
365
=
×
100 - 2 30 - 10
= 37.24%
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Abuses of Trade Credit
• Abuses of Trade Credit Terms
 Trade credit is now expected in many
businesses
• Companies offer it because they have to
 Stretching payables—a common abuse of
trade credit
• Paying payables beyond the due date (AKA:
leaning on the trade)
• Slow paying companies receive poor credit ratings
in credit reports issued by credit agencies
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Bank Operating Loans
• Represent primary source of short-term loans
for most companies
• Provide financing for working capital and
expenses
• Advanced against value of receivables and
inventory
• Repaid from collections on receivables
• May be arranged for specific transactions or as
revolving credit agreement or line of credit
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Line of Credit or Revolving Credit
Agreement
• Line of credit
 Non-binding agreement to borrow up to
predetermined limit at any time
• Revolving credit
 Legally commits the bank
 Usually secured
 Requires commitment fee on unborrowed
funds
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Interest Rates on Loans
• Interest Rates on Loans
 Prime rate is rate that bank charges its largest and
most creditworthy corporate customers.
 Interest rates on operating loans are usually based
on bank’s prime rate plus a risk premium
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Interest Rates on Loans
• Loan rates will depend upon such factors as:
 How intense is competition among lenders for loan
business?
 How large is the loan?
 Does borrower have good credit history?
 Does borrower have adequate and reliable cash
flow?
 Does borrower have adequate security?
 Is loan guaranteed under a government program?
 What is term of the loan?
 What is debt-to-equity ratio?
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Annual Interest Rate
I 365
r= ×
P d
where: r = Annual rate
I = Interest paid (dollars)
P = Principal
d = Number of days loan is outstanding
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Example
Example 5.1:
Revolving Credit
Agreement
Q: The Arcturus Company has a $10 million revolving credit agreement
with its bank at prime plus 2.5%. Prior to June, the company had
borrowed $4 million that was outstanding for the entire month. On
June 15, it took borrowed $2 million. Prime is 9.5% and the bank’s
commitment fee is 0.25% annually.
What bank charges will Arcturus incur for the month of June?
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Example 5.1:
Example
A:
Revolving Credit
Agreement
Arcturus will have to pay both interest on the money borrowed
and a commitment fee on the unused balance of the revolving
agreement.
 Monthly interest rate: (Prime + 2.5%)  12 = 1%
 Monthly commitment fee: 0.25%  12 = 0.0208%
 $4 million was outstanding for the entire month of June
and $2 million was outstanding for 15 days of June, so the
total dollar interest charges are:
 $4,000,000

15 

 0.01 +  $2,000,000 
 $50,000
30 

The commitment fee must be paid on an average of
$5,000,000 that was unused during June, or:
• $5,000,000  .000208 = $1,040
• Total bank charges = $51,040
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Clean Up Requirements
• Theoretically a firm can constantly rollover its short-term debt
 Borrow on a new note to pay off an old note
• Risky for both firm and bank
• Banks require that borrowers clean up
short-term loans once a year
 Remain out of short-term debt for certain
time period
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Short-Term Credit Secured by
Current Assets
• Debt is secured by the current assets
being financed ( accounts receivable and
inventory)
• Common in seasonal businesses such as
retail
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Receivables Financing
• Receivables Financing:
 Lenders may extend credit backed by the
value of accounts receivable
 Receivables may make excellent collateral:
• Fairly liquid
• Easy to recover in event of default
• Collectibility of accounts is key issue
 Common arrangements
• Pledging–Firm retains title
• Factoring–Firm sells A/R
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Pledging Accounts Receivable
 Borrower uses A/R as collateral for a loan
 Accounts Receivable still belong to borrower,
which still collects the accounts
 Borrower promises to use collected accounts
to pay off loan
 Lender can provide
• General line of credit tied to all receivables
• Specific line of credit tied to individual accounts
receivable
 Lender generally charges interest at rates
over prime, plus an administrative fee.
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Example
Example 5.2:
Pledging Accounts
Receivable
Q: The Kilraine Quilt Company has an average receivables balance
of $100,000 which turns over once every 43 days. It generally
pledges all of its receivables to the Cooperative Finance
Company, which advances 75% of the total at 4% over prime
plus a 1.5% administrative fee.
If prime is 5%, what total financing rate is Kilraine effectively
paying for its receivables financing?
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Example
Example 5.2:
Pledging Accounts
Receivable
A: Average Receivables balance: $100,000
Average loan outstanding: 75% x $100,000 = $75,000
Interest rate: 5% + 4% = 9%
Receivables pledged in year: $100,000 x 365 / 50 = $730,000
Administrative fee: 1.5% x $730,000 = $10,950
% of the average loan balance:$10,950 / $75,000 = 14.6%
Annual financing cost: 9% + 14.6% = 23.6%
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Factoring Accounts Receivable
• Firm sells Accounts Receivable to lender
(at a severe discount) and lending firm
(factor) takes control of the accounts
 Accounts receivable are now paid directly to
factor
 Factor usually reviews accounts and only
accepts accounts it deems creditworthy
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Factoring Accounts Receivable
• Factors offer wide range of services
 Perform credit checks on potential customers
 Advance cash on accounts it accepts or remit
cash after collection
 Collect cash from customers
 Assume bad-debt risk when customers don’t
pay
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Inventory Financing
• Use firm’s inventory as collateral for a
short-term loan
• Popular but subject to number of
problems
 Lenders aren’t usually equipped to sell
inventory
 Specialized inventories and perishable goods
are difficult to market
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Types of Inventory Financing
• Blanket liens—lender has a lien (claim) against all
inventories of borrower
• Borrower remains in physical control of inventory
• Trust receipt (chattel mortgage agreement)—
collateralized inventory is identified by serial number
and can’t be sold without lender’s permission
• Borrower remains in physical control of inventory
• Warehousing—collateralized inventory is removed
from borrower’s premises and placed in a warehouse
(borrower’s access controlled by third party)
• When inventory is sold, lender is informed to expect money
from borrower soon
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Money Market Instruments
• Larger corporations may sell short-term
debt instruments in the money market
• Another method to borrow to meet
temporary cash needs
• Instruments include commercial paper,
bankers’ acceptances and
securitization of receivables
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Commercial Paper
• Notes issued by large, financially-strong
firms and sold to investors
 Unsecured (usually)
 Buyers are usually other corporations and
financial institutions
 Maturity is less than 270 days
 Considered very safe investment, therefore
pays a relatively low interest rate (sold at a
discount)
 No flexibility in repayment terms
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Commercial Paper
• Annual Interest Rate on Discounted
Money Market Security
(M-P)
r=
P

365
d
where M = Maturity (face) value of the security
P = Discounted price (net proceeds on issue)
d = Number of days to maturity
r = Annual interest rate
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Bankers’ Acceptances
 bankers’ acceptance—created when a bank adds
guarantee of payment to the promissory note or
draft of the issuer (corporate borrower)
 Issuer receives money from bank. Bank then sells
the bankers’ acceptance in the money market to an
investor.
 At maturity, bank repays face value to the investor
and the issuer repays bank
 Traded on a discount basis to yield interest rate
slightly lower than that of commercial paper
 Usual terms are 30, 60, and 90 days.
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Securitization of Receivables
• Sale of receivables by large firms in
public offerings arranged by securities
dealers
• The issuing firm thus receives immediate
cash for future cash flows
• Financing is raised at a relatively low
cost, often lower than prime or
commercial paper rate, because the issue
is asset-backed.
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