Sources of Short-Term Financing
(Chapter 8)
(Chapter 6 – pages 151 – 155)
Short-Term Vs. Long-Term Financing
Approaches to Financing Policy
Trade Credit
Simple Interest
Discount Interest
Compensating Balance
Add-On Interest
Commercial Paper
Use of Collateral
Short-Term Vs. Long-Term Financing
Short-term financing tends to be riskier than longterm financing:
Uncertainty concerning future rates.
May not be able to renew.
Use of short-term financing, however, may lead to
higher returns:
Most frequently, short-term rates are lower than
long-term rates (i.e., the term structure is
normally upward sloping)
Flexibility: When financing is not required, shortterm debt can be paid off.
Approaches to Financing Policy
Maturity Matching Approach
A general rule of thumb is to use shortterm financing for temporary asset needs,
and long-term financing for permanent
asset requirements.
Aggressive Approach
Use more short-term financing.
Conservative Approach
Use less short-term financing
Maturity Matching
(A Moderate Financing Approach)
Millions of Dollars
16
14
Temporary Current Assets
Short-Term Financing
12
10
8
Permanent
Current Assets
6
Long-Term Financing
4
2
Time Period
21
18
15
12
6
3
0
9
Fixed Assets
0
Aggressive Financing
(Higher Risk - Higher Expected Return)
Millions of Dollars
16
14
Temporary Current Assets
Short-Term Financing
12
10
8
Permanent
Current Assets
6
Long-Term Financing
4
2
Fixed Assets
Time Period
21
18
15
12
9
6
3
0
0
Conservative Financing
(Lower Risk - Lower Expected Return)
Millions of Dollars
16
14
Marketable Securities
Short-Term Financing
Permanent
Current Assets
Long-Term Financing
12
10
8
6
4
2
Fixed Assets
Time Period
21
18
15
12
9
6
3
0
0
Trade Credit
A very large source of short-term credit
Example of terms: 2/10, net 60
Free Trade Credit: Credit received during the
discount period. Always use (i.e., Do not pay
early).
Costly Trade Credit: Loss of discount if you do
not pay within the discount period. Compare
the % cost with the cost of funds from other
sources.
Trade Credit (Continued)
Disc %
360



% cost  


 100% - Disc %  Total Credit Period - Disc Period 
 (Interest Rate Per Period)(Nu mber of Interest Periods)
 2  360 
=  
  .1469  14.69%
 98  60 - 10 
Note: The above is only an approximation due to the
compounding effects:
Interest rate period = 2/98 = .0204
Number of interest periods = 360/(60 - 10) = 7.2
Effective Annual Rate = (1.0204)7.2 - 1 = .1565 =
15.65%
Simple Interest Bank Loans
A single payment of principal and interest on the
maturity date of the loan.
One-year loan:
Interest
Effective Annual Rate 
Principal
Less than one-year loan: (Approximation)
 Interest 

360


Effective Annual Rate  
 Principal  Days Loan is Outstandin g 
 (Interest Per Period)(Nu mber of Interest Periods)
Discount Interest
A single payment is made on the maturity date of
loan. The interest charge, however, is paid in
advance.
One-year loan:
Interest
Effective Annual Rate 
Principal - Interest
Less than one-year loan: (Approximation)



Interest
360


Effective Annual Rate  
 Principal - Interest  Days Loan is Outstandin g 
 (Interest Rate Per Period)(Nu mber of Interest Periods)
Compensating Balance
One year loan:
Interest
Principal - CB
CB  compensati ng balance
Effective Annual Rate 
Less than one year loan: (Approximation)
 Interest


360


Effective Annual Rate  
 Principal - CB  Days Loan is Outstandin g 
 (Interest Rate Per Period)(Nu mber of Interest Periods)
Note: If a firm normally carries excess balances with
the bank, an adjustment must be made.
Add-On Interest
(Installment Loans)
Approximation:
Interest
Approximat e Annual Rate 
(Principal )/2
Note: If a more precise annual rate is desired, use
the approach discussed in the text.
Commercial Paper
Unsecured promissory notes issued to the public by
large corporations
Major Advantage to Issuer
Interest rate is typically below the prime rate.
Disadvantage to Issuer
Banks provide a certain degree of loyalty,
commitment, and flexibility to their customers
(willing to help customers who have “temporary”
problems). Dealers in commercial paper are much
more impersonal.
Direct Paper (Finance Paper) – Issued by finance
companies (e.g., GE Credit) directly to institutional
investors.
Dealer Paper – Sold by companies through a dealer
network.
Uses of Collateral in Short-Term Financing
Pledging Accounts Receivable
Using receivables selected by the lending
institutional as collateral for a loan.
Factoring Receivables
Receivables are sold outright to a finance
company.
Inventory Financing
Borrowing against inventory to acquire additional
funds.
Note: Accounts receivable and inventory financing
can be quite expensive.