Chapter 15
Short-Term Financing
Learning Objectives
 The need for short-term financing.
 The advantages and disadvantages of short-term
financing.
 Three types of short-term financing.
 Computation of the cost of trade credit, commercial
paper, and bank loans.
 How to use accounts receivable and inventory as
collateral for short-term loans.
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Why Do Firms Need Shortterm Financing?
 Cash flow from operations may not be sufficient to
keep up with growth-related financing needs.
 Firms may prefer to borrow now for their inventory
or other short term asset needs rather than wait
until they have saved enough.
 Firms prefer short-term financing instead of longterm sources of financing due to:
 easier availability
 usually has lower cost (remember yield curve)
 matches need for short term assets, like inventory
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Sources of Short-term
Financing
 Short-term loans.
 borrowing from banks and other financial
institutions for one year or less.
 Trade credit.
 borrowing from suppliers
 Commercial paper.
 only available to large credit- worthy
businesses.
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Types of short-term loans:
 Promissory note
 A legal IOU that spells out the terms of the
loan agreement, usually the loan amount,
the term of the loan and the interest rate.
 Often requires that loan be repaid in full with
interest at the end of the loan period.
 Usually with a Bank or Financial Institution;
occasionally with suppliers or equipment
manufacturers
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Types of short-term loans:
 Line of Credit
 The borrowing limit that a bank sets for a
firm after reviewing the cash budget.
 The firm can borrow up to that amount of
money without asking, since it is preapproved
 Usually informal agreement and may
change over time
 Usually covers peak demand times, growth
spurts,
etc.
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Trade Credit
 Trade credit is the act of obtaining funds by delaying
payment to suppliers, who typically grant 30 days to pay.
 The cost of trade credit may be some interest charge
that the supplier charges on the unpaid balance.
 More often, it is in the form of a lost discount that would
be given to firms who pay earlier.
 Credit has a cost. That cost may be passed along to the
customer as higher prices, (furniture sales, Office Max),
or borne by the seller as lower profits, or some of both.
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Estimation of Cost of Short-Term Credit
 Calculation is easiest if the loan is for a one year
period:
 Effective Interest Rate is used to determine the cost
of the credit to be able to compare differing terms.
Effective
= Cost (interest + fees)
Interest Rate Amount you get to use
Example: You borrow $10,000 from a bank, at a
stated rate of 10%, and must pay $1,000 interest at
the end of the year. Your effective rate is the same
as the stated rate: $1,000/$10,000 = .10 = 10% 8
Variations in Loan Terms
 A discount loan requires that interest be
paid up front when the loan is given.
 This changes the effective cost in the
previous example since you only get to
use:
($10,000 - $1,000) = $9,000.
 Effective rate (APR) = $1,000/$9,000 =
.1111 = 11.11%.
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Variations in Loan Terms
 Sometimes lenders require that a minimum
amount, called a compensating balance be
kept in your bank account. It is taken from
the amount you want to borrow.
 If your compensating balance requirement is
$500, then the amount you can use is reduced
by that amount.
 Effective Rate (APR) for a $10,000 simple
interest 10% loan with a $500 compensating
balance = $1,000/($10,000-$500) = .1053 =
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10.53%.
Both Discount Interest and
Compensating Balance
 Sometimes, lenders will require both
discount interest (paid in advance) and
a compensating balance.
 If the interest is $1,000 and the
compensating balance is $500, then the
effective rate (APR) becomes:
 $1,000 / $10,000 - $1,000 - $500
 $1,000 / $8,500 = 11.76%
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Cost of Short Term Credit
 Cost of Trade Credit
 Typically receive a discount if you pay
early.
 Stated as: 2/10, net 60
Purchaser receives a 2% discount if
payment is made within 10 days of the
invoice date, otherwise payment is due
within 60 days of the invoice date.
 The cost is in the form of the lost discount
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if you don’t take it.
Calculating APR (same as EIR)
 $ Interest = Rate x Principle x Time
 i.e. Int = 6% x $1,000 x 90/360 = $15
 APR = $ Interest (cost) x
1
$ Net Borrowed Time
APR = $15
x 1 / 90
= 1.5% x 4 = 6.0%
$1,000
360
Say you have a loan fee of $5.00, then
APR = $15 + $5 x 1/90
= 2.0% x 4 = 8.0%
1,000
360
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Cost of Trade Credit 2/10 net 60
 Assume your purchase is $100 list price.
 If you take the discount, you pay only $98. If you don’t
take the discount, you pay $100.
 Therefore, you (buyer) are paying $2 for the privilege of
borrowing $98 for the additional 50 days. (Note: the first
10 days are free in this example).
 APR = $2/$98 x 365/50 = 14.9% (If you pay in 60 days)
 What if 2%/10, net 30
 APR = $2/$98 x 365/20 = 37.25%! (If you pay in 30
days)
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Commercial Paper
 Commercial paper is quoted on a discount basis, meaning
that the interest is subtracted from the face value to
arrive at the price. See 3 steps below for calculation:
 Step 1: Compute the discount (D) from face value of the
commercial paper
 Discount (D) = (Discount rate x par x DTG)/365
 DTG = days to go (to maturity)
 Step 2: Compute the price = Face value - Discount
 Step 3: Compute Effective Annual Rate (APR):
$ interest you pay/ $ you get to use
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Cost of Commercial Paper
Example
 $1 million issue of 90 day commercial paper quoted at 4%
discount rate.
Step 1: Calculate D = .04 x $1 mill. x 90
= $10,000
360

Step 2: Calculate price (amount you get)

Step 3: Calculate effective rate (APR)
= $1,000,000 - $10,000
= $990,000
= $10,000 / $990,000 = 1.010% x 4 = 4.04%
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Accounts Receivable as Collateral
 A pledge is a promise that the borrowing firm will pay the
lender any payments received from the accounts
receivable collateral in the event of default.
 Since accounts receivable fluctuate over time, the lender
may require certain safeguards to ensure that the value of
the collateral does not go below the balance of the loan.
 So, normally a bank will only loan you 70 -75% of the
receivable amount
 Accounts receivable can also be sold outright. This is
known as factoring.
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Cost of Borrowing against Receivables
Average monthly sales = $100,000
60 day terms, so average Acct Rec balance = $200,000
Bank loans 70% of Accts Rec = $140,000
Interest is 3% over prime (say 8%) = 11% x $140,000 =
$15,400
 1% fee on all receivables = 1% x $100,000 x 12 = $12,000
 APR = $15,400 + $12,000 x 1/1 = 19.57%!
$140,000




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Inventory as Collateral
 A major problem with inventory financing is valuing the
inventory.
 For this reason, lenders will generally make a loan in the
amount of only a fraction of the value of the inventory. The
fraction will differ depending on the type of inventory.
 If inventory is long lived, i.e. lumber, they (lender or a
customer) may loan you up to 75% of the resale value.
 If inventory is perishable, i.e., lettuce, you won’t get much
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