Sources of Short Term Financing

Short-term
Financing
Prepared by: John Glenn Reoja, CPA
SHORT-TERM FINANCING
It refers to financing needs for a period of time that is within a
year.
Nominal rate vs Effective rate
Interest rate is the general term used for financing cost from
borrowed funds. Nominal rate is the basis of cash payments on
borrowings, while effective rate is the basis of determining the
interest expense on borrowings.
Simple vs Compounded effective interest
Simple effective interest assumes that the borrower had to
borrow money only ones in a given year. In contrast, the
borrower had to borrow money every time the obligation
matures.
A. Spontaneous Source of Financing/ Trade Credit
Financing that arises from the normal course of business. Trade credit is a
major source of financing for small firms.
Assuming annual credit purchases of P720,000 with terms of
2/10, n/30. The company does not take the discount and pays
in 30 days. Compute for total accounts payable (breakdown
the accounts payable into (1) free trade credit and (2) non-free
trade credit)
Analysis:
Daily credit purchase P720,000 /360 days = P 2,000
Total Accounts payable is P 2,000 x 30 days = P 60,000
(1)Free trade credit P 2,000 x 10 days = P 20,000
(2)Non-free trade credit P 2,000 x 20 days=P 40,000
Assuming annual credit purchases of P720,000 with
terms of 2/10, n/30. The company does not take the
discount and pays in 30 days. Compute for total accounts
payable (breakdown the accounts payable into (1) free
trade credit and (2) non-free trade credit)
Effective Interest
EIR = 2% x 365
100% - 2% 30-10
= 37.24%
B. Commercial Bank Loan Financing
The major type of loan made by banks to businesses is the short-
term, self-liquidating loan. These loans are intended merely to carry
the firm through seasonal peaks in financing needs that are due
primarily to buildups of inventory and accounts receivable.
Illustration:
Principal P 100,000
Nominal rate 12%
Period 120 days
Compensating balance 8%
1. Compute for the effective interest assuming
a. Discounted and with compensating balance requirement
4,000 x 360 days = 13.63%

100,000 – 4,000 – 8,000 120 days
OR
4% x 360 days = 13.63%
100% - 4% -8% 120 days
Illustration:
Principal P 100,000
Nominal rate 12%
Period 120 days
b. Discounted but no compensating balance requirement
4,000 x 360 days = 12%

100,000 – 4,000 120 days
OR
4% x 360 days = 12%
100% - 4% 120 days
Illustration:
Principal P 100,000
Nominal rate 12%
Period 120 days
c. Simple interest with compensating balance requirement
4,000 x 360 days = 13.04%

100,000 – 8,000 120 days
OR
4% x 360 days = 13.04%
100% - 8% 120 days
Illustration:
Principal P 100,000
Nominal rate 12%
Period 120 days
d. Simple interest with no compensating balance requirement
4,000 x 360 days = 12%

100,000 120 days
OR
4% x 360 days = 12%
100% 120 days
C. Cost of Installment Loan
Illustration:
Principal P100,000
Nominal rate 12%
Term Installment loan
Compute for the effective interest assuming the following installment

payments
1. Monthly
2. Quarterly
3. Semiannual
4. Annual
5. Re-compute monthly payments assume a 2-year loan
6. Re-compute the effective interest assuming the loan requires
compensating balance of 8% of Principal.
Illustration:
Principal P100,000
Nominal rate 12%

payments
1. Monthly
EIR = 2 x 12 x P 12,000
(1+12) x P100,000
= 22.15%
Illustration:
Principal P100,000
Nominal rate 12%

payments
2. Quarterly
EIR = 2 x 4 x P 12,000
(1+4) x P100,000
= 19.20%
Illustration:
Principal P100,000
Nominal rate 12%

payments
3. Semiannual
EIR = 2 x 2 x P 12,000
(1+2) x P100,000
= 16.00 %
Illustration:
Principal P100,000
Nominal rate 12%

payments
4. Annual
EIR = 2 x 1 x P 12,000
(1+1) x P100,000
= 12.00 %
Illustration:
Principal P100,000
Nominal rate 12%

payments
5. Re-compute monthly payments assume a 2-year loan
EIR = 2 x 24 x P 12,000
(1+24) x P100,000
= 23.04 %
Illustration:
Principal P100,000
Nominal rate 12%

payments
6. Re-compute the effective interest assuming the loan requires
compensating balance of 8% of Principal.
EIR = 2 x 12 x P 12,000
(1+12) x (P100,000-8,000)
= 24.08%
Revolving Credit Agreement vs Credit Line
Revolving credit and a line of credit are financing

arrangements made between a lending
institution and a business or an individual.
Illustration:
China Oil arranged a P10,000,000 revolving credit agreement

with a group of small banks. The firm paid an annual
commitment fee of one-half of one percent of the unused
balance of the loan commitment. On the used portion of the
loan, China Oil paid 10.5% annual, simple interest basis.
China Oil borrowed P6,000,000 immediately after the
agreement was signed an repaid the loan at the end of one year.
a. Compute for the total financing cost of the loan agreement

for one year.
b. Compute for the effective rate of the loan agreement.
Illustration:
a. Compute for the total financing cost of the loan agreement
for one year.
Financing cost
Unused credit line = P 4,000,000 x 0.5% = P 20,000
Borrowed amount= P 6,000,000 x10.5%=P630,000
Total Financing cost P650,000
Illustration:
b. Compute for the effective rate of loan agreement
EIR = P 650,000 / P 6,000,000

= 10.83%
C. Cost of Commercial Paper
Illustration:
Face value P1,000
Issue price P 920
Term 120 days
1. Compute for the effective interest.

2. Recompute the effective interest assuming
a. Flotation cost of P10 is required
b. Paper carries 6% nominal rate
c. Flotation cost of P10 is required and contains 6%
nominal rate.
Illustration:
Face value P1,000
Issue price P 920
Term 120 days
1. Compute for the effective interest.

EIR = P80 x 360 days
P920 120 days
= 26.09%
Illustration:
Face value P1,000
Issue price P 920
Term 120 days
2. Recompute the effective interest assuming:

a. Flotation cost of P10 is required
EIR = P80+P10 x 360 days
P920-P10 120 days
= 29.67%
Illustration:
Face value P1,000
Issue price P 920
Term 120 days

b. Paper carries 6% nominal rate
EIR = P80+20 x 360 days
P920 120 days
= 32.61%
Illustration:
Face value P1,000
Issue price P 920
Term 120 days
c. Flotation cost of P10 is required and contains 6%
nominal rate.
EIR = P80+10+20 x 360 days
P920-10 120 days
= 39.56%
SECURED SOURCES OF FINANCING
A. Receivable Financing
Two commonly used means of obtaining short-term financing with accounts
receivable are pledging accounts receivable and factoring accounts receivable.
Actually, only a pledge of accounts receivable creates a secured short-term loan.
Illustration
IKAW AT A CO. assigned P700,000 of accounts receivable to First Bank
under a non-notification arrangement. First bank advances 80% less a 2%
service charge. IKAW AT A Co. signed a 120-day promissory note that
provides for interest of 12% on the unpaid loan balance.
1. Compute for the amount of Loan
2. Compute for the effective rate
1. Compute for the amount of Loan
Accounts receivable pledged P700,000
Multiply: Percentage advance 80%

by First Bank
Total (Amount of Loan) 560,000
Less: Bank Service Charge 11,200

(2% x 560,000)
Cash Received by IKAW AT A P 548,800

CO.
EIR = Net Interest x 360

Net Proceeds 120
EIR = (12% x P560,000 x 120/360) + P11,200 x 360

P 548,000 120
EIR= 18.37%
B. Inventory Financing
Inventory financing is credit obtained by businesses to pay upfront for products that
will not be sold immediately. The loan is collateralized by the inventory.
Illustration:
The Air Supply Company is considering obtaining a loan from a sales
finance company secured by inventories under a field warehousing
arrangement. Air Supply Company would be permitted to borrow up to
P500,000 under such an arrangement at an annual interest rate of 10%.
The additional cost of maintaining a field warehouse is P15,000 per year.
Air Supply Company borrowed P400,000 during the year.
1. Compute for the financing cost of the loan
1. Compute for the financing cost of the loan

Financing cost = ?
Interest on borrowed funds
(P 400,000 x 10 %) 40,000
Cost of field warehouse 15,000
Total Financing cost 55,000
EIR = P 55,000
P 400,000
= 13.75%

Sources of Short Term Financing

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Short-term

4,000 x 360 days = 13.63%

4,000 x 360 days = 12%

4,000 x 360 days = 13.04%

4,000 x 360 days = 12%

Compute for the effective interest assuming the following installment

Compute for the effective interest assuming the following installment

Compute for the effective interest assuming the following installment

Compute for the effective interest assuming the following installment

Compute for the effective interest assuming the following installment

Compute for the effective interest assuming the following installment

Compute for the effective interest assuming the following installment

Revolving credit and a line of credit are financing

China Oil arranged a P10,000,000 revolving credit agreement

a. Compute for the total financing cost of the loan agreement

EIR = P 650,000 / P 6,000,000

1. Compute for the effective interest.

1. Compute for the effective interest.

2. Recompute the effective interest assuming:

2. Recompute the effective interest assuming:

Multiply: Percentage advance 80%

Less: Bank Service Charge 11,200

Cash Received by IKAW AT A P 548,800

EIR = Net Interest x 360

EIR = (12% x P560,000 x 120/360) + P11,200 x 360

1. Compute for the financing cost of the loan

2. Compute for the effective rate

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