SOURCES OF SHORT-

TERM FINANCING
What is short-term financing?
Short term financing is business financing that
you obtain usually for a term of one year or less.
Who is the largest
provider of short-
term credit?
The largest provider of short-term credit is the
manufacturer or seller of goods and services.

40% Accounts Payable/

Trade Credit
Payment Period

•Trade credit is usually extended for 30 to

60 days.
•Many firms attempt to “stretch the
payment period” to receive additional
short-term financing.
Cash Discount Policy
A cash discount allows a reduction in price if payment is made
within a specified time period.

Ex.
A 2/10, net 30 cash discount – means we can deduct 2
percent if we remit our funds 10 days after billing, but failing
this, we must pay the full amount by the 30th day.
• On a $100 billing, we could pay $98 up to the 10th day or $100 at the
end of 30 days. If we fail to take the cash discount, we will get to use
$98 for 20 more days at a $2 fee. The cost is a high 36.72%.

Standard formula for this example:

Cost of failing to take a cash discount is equal to:

Discount percent______ x _________360_________

100 percent – Discount percent Final due date – Discount period
 Discount percent x 360
100 percent – Discount percent Final due date – Discount period
= 2% x 360 = 2.04% x 18 = 36.72%
100%-2% (30 - 10)

Cash discount terms may vary. For example, on a 2/10, net 90 basis, it
would cost us only 9.18 percent not to take the discount and to pay the
full amount after 90 days.

= 2% x 360 = 2.04% x 4.5 = 9.18%

100%-2% (90 - 10)
Net- Credit Position
Accounts Payable Source of Fund
Accounts Receivable Use of Fund

Net Trade Credit

POSITIVE Accounts Receivable > Accounts Payable

NEGATIVE Accounts Receivable < Accounts Payable

Example:
Average daily sales $5000 and collects in 30 days
A/R balance = $150,000

Average daily purchases $4000 and a 25-day average payment period

A/P balance = $100,000

$50,000 more in credit is extended than received.

Example:
Average daily sales $5000 and collects in 30 days
A/R balance = $150,000

Average daily purchases $4000 and a 40-day average payment period

A/P balance = $160,000

A/R now exceeds A/R by $10,000.

Larger firms tend to be net providers of trade
credit (relatively high receivables), with smaller
firms in the user position (relatively high
payables).
Bank Credit
• The typical banker prefers a self-liquidating loan in which the use of
funds will ensure a built-in or automatic repayment scheme.
• 2/3 of bank loans are short-term in nature
• Major changes occurring in banking today are centered on the
concept of “full-service banking.”
• The modern banker’s function is much broader than merely accepting
deposits, making loans, and processing checks. A banking institution
may be providing trust and investment services, a credit card
operation, real estate lending, data processing.
Prime Rate
• Prime Rate is the rate a bank charges its most creditworthy
customers, and it usually increases as a customer’s credit risk gets
higher.
• At certain slack periods/ because of international competition, banks
may actually charge top customers less than the published prime
rate.
Compensating Balance
- a minimum average account balance that must be maintained in a
bank account, used to offset the cost incurred by a bank to set up a
business loan.

interest rates : compensating balance

• Example
If you borrow P100,000, paying 8% interest on the full amount with a 20%
compensating balance requirement, you will be paying P8000 for the use of
P80,000 in funds, or an effective rate of 10%.

The amount that must be borrowed to end up with the desired sum of money is
simply figured by:

Amount to be borrowed = Amount needed

(1-c)

where:
c = compensating balance (expressed as decimal)
If you borrow P100,000, paying 8% interest on the full amount with a 20%
compensating balance requirement, you will be paying P8000 for the use of
P80,000 in funds, or an effective rate of 10%.

Amount to be borrowed = P100,000

(1 - 0.2)
= P125,000
To check:
P125,000 Loan
- 25,000 20% Compensating bal. requirement
P100,000 Available funds
Compensating Balance
• The purpose of this balance is to reduce the lending
cost for the lender;
providing some surety that the lender will be repaid.
Maturity Provisions
• Bank loans have been traditionally short-term in nature.
• In the last decade there has been a movement to the use of the term
loan, in which credit is extended for one to seven years. The loan is
usually repaid in monthly or quarterly instalments over its life rather
than in one single, payment.
• Bankers are hesitant to fix a single interest rate to a term loan.
• The more common practice is to allow the interest rate to change
with market conditions.
Cost of Commercial Bank Financing
• The effective interest rate on a loan is based on the loan amount, the
dollar interest paid, the length of the loan, and the method of
repayment.

• A P60 interest on a P1000 loan for one year would carry a 6% interest
rate, but what if the same loan were for 120 days?
• Effective rate = Interest x Days in the year (360)
Principal Days loan is outstanding
= P60 x 360 = 6% x 3 = 18%
P1000 120
• If the bank uses a discounted loan, and deducts interest in advance,
the effective rate of interest increases.
• For example, a P1000 one-year loan with P60 of interest deducted in
advance represents the payment of interest on only P940, or an
effective rate of 6.38%.

• Effective rate on
discounted loan = Interest x Days in the year (360)
Principal-Interest Days loan is outstanding
= P60 x 360 = P60 = 6.38%
P1000 - 60 360 940
Interest Costs with Compensating Balances
Effective rate with = Interest
compensating balances (1 – c)
= 6%
(1 – 0.2)
= 7.5%
Interest Costs with Compensating Balances
• Effective rate with = Interest x Days in the year (360)
compensating balances Principal – CB Days loan is outstanding
= 60 x 360 x P60
P1000 – P200 360 P800
= 7.5%
Rate on Installment Loans
• Installment loan calls for a series of equal payments over the life of
the loan.
• Assume that you borrow P1000 on a 12-month installment basis, with
regular monthly payments to apply to interest and principal, and the
interest requirement is P60.
• Effective rate with = 2 x Annual no. of payments x Interest
compensating balances (Total no. of payments + 1) x Principal
= 2 x 12 x P60 = P1440
13 x P1000 13,000
= 11.08%
Annual Percentage Rate
• Congress passed the Truth in Lending Act in 1968.
• This act required that the actual annual percentage rate (APR) be
given to the borrower.
• The APR is really a measure of the effective rate we have presented.
The Credit Crunch Phenomenon
• In 1969-70, 1973-74, and 1979-81, the economy went
through periods of extreme credit shortage in the
banking sector and in other financial markets.
Financing through Commercial Paper
• Commercial Paper – represents a short-term,
unsecured promissory note issued to the public in
minimum units of $25,000.
Financing through Commercial Paper
Advantages of Commercial Paper:
• May be issued at below the prime interest rate.
• No compensating balance balance requirements are
associated with its issuance
Financing through Commercial Paper
Limitations on Issuance of Commercial Paper:
• Although the funds provided through the issuance of
commercial paper are cheaper than bank loans, they
are also less predictable.
• While a firm may pay a higher rate for a bank loan, it
is also buying a degree of loyalty and commitment
that is unavailable in the commercial paper market.
Foreign Borrowing
• An increasing source of funds for US firms has been overseas
banks.
• Eurodollar loan is a loan denominated in dollars and made
by a foreign bank holding dollar deposits. Such loans are
usually short-term to intermediate term in maturity.
Use of Collateral in Short-Term Financing
• Almost any firm would prefer to borrow on an unsecured
(no-collateral) basis, but if the borrower’s credit rating is too
low or its need for funds is too great, the lending institution
will require that certain assets be pledged.
• A secured credit arrangement might help the borrower
obtain funds that would otherwise be unavailable.
ACCOUNTS RECEIVABLE FINANCING
Pledging Accounts Receivable
• The lender will have full recourse against the borrower if any
of the accounts go bad.

• The interest is computed against the loan balance

outstanding, a figure that may change quite frequently, as
indicated in the table.
Pledging Accounts Receivable
Month 1 Month 2 Month 3 Month 4
Total Accounts P11,000 P15,100 P19,400 P16,300
Receivable
Acceptable
accounts 10,000 14,000 18,000 15,000
receivable (to
finance company)
Loan balance 8,000 11,200 14,400 12,000
(80%)
Interest 12%
annual – 1% per 80 112 144 120
month
Factoring Receivables
• When we factor receivables, they are sold outright to the finance
company.
• Our customers may be instructed to remit the proceeds directly to
the purchaser of the account
• The factoring firm generally does not have recourse against the seller
of the receivables
• When the factoring firm accepts an account, it may forward funds
immediately to the seller, in anticipation of receiving payment 30 days
later as part of the normal billing process.
INVENTORY FINANCING
Inventory Financing
Stages of Production
Raw Materials and Finished Goods are likely to provide the best
collateral, while goods in process may qualify for only a small
percentage loan.
Nature of Lender Control
The methods for controlling pledged inventory go from
the simple to the complex, providing ever greater assurances
to the lender but progressively higher administrative costs.
Typical arrangements are as follows:
Nature of Lender Control
• Blanket Inventory Liens
The simplest method is for the lender to have a general claim
against the inventory of the borrower through blanket inventory liens.
Specific items are not identified or tagged, and there is no physical
control.
Nature of Lender Control
• Trust Receipts
A Trust Receipt is an instrument acknowledging that the
borrower holds the inventory and proceeds from sales in trust for the
lender. Each item is carefully marked and specified by a serial number.
When sold, the proceeds are transferred to the lender and the trust
receipt is cancelled.
Nature of Lender Control
• Trust Receipts
-Also known as Floor Planning
- Provides tighter control than does the blanket inventory lien
- does not give the lender direct physical control over inventory-
only a better and more legally enforceable system of tracing the
goods.
Nature of Lender Control
• Warehousing
-Under this arrangement, goods are physically indentified,
segregated, and stored under the direction of an independent
warehousing company.
-The firm issues a warehouse receipt to the lender, and goods
can be moved only with the lender’s approval.
IT’S TIME FOR A
QUIZ

1. Business financing that you obtain usually

for a term of one year or less
QUIZ

2. Allows a reduction in price if payment is

made within a specified time period.
QUIZ

3. a minimum average account balance that must be

maintained in a bank account, used to offset the cost
incurred by a bank to set up a business loan.
QUIZ

4. During this phenomenon, the economy went

through periods of extreme credit shortage in the
banking sector and in other financial markets.
QUIZ

5. The type of Accounts Receivable Financing wherein

they are sold outright to the finance company.
QUIZ

6. The type of Accounts Receivable Financing wherein

the lender will have full recourse against the
borrower.
QUIZ

7-8. _________and _________are likely to provide

the best collateral, while goods in process may qualify
for only a small percentage loan.

Good Luck!
Mwa.
QUIZ

9. True or False. Larger firms tend to be net providers of

trade credit (relatively high receivables), with smaller firms
in the user position (relatively high payables).
QUIZ

10. True or False. The largest provider of short-term

credit is the retailer or buyer of goods and services.
QUIZ

11. Represents a short-term, unsecured promissory

note issued to the public in minimum units of
$25,000.
QUIZ

12. Net trade credit is ______ when Accounts

Receivable > Accounts Payable.
QUIZ

13. True or False. One of the advantages of

commercial paper is that they may be issued at below
the prime interest rate.
QUIZ

14.
Amount to be borrowed = Amount needed
(1-c)

where:
c = compensating balance (expressed as ___?___)
QUIZ

15. True or False. Trust receipts is also known as

Floor planning.
ANSWERS
1. Business financing that you obtain usually for a term
of one year or less

ANSWER:
Short-term financing
ANSWERS
2. Allows a reduction in price if payment is made within
a specified time period.

ANSWER:
Cash Discount
ANSWERS
3. A minimum average account balance that must be
maintained in a bank account, used to offset the cost
incurred by a bank to set up a business loan.

ANSWER:
Compensating Balance
ANSWERS
4. During this phenomenon, the economy went
through periods of extreme credit shortage in the
banking sector and in other financial markets.

ANSWER:
Credit Crunch Phenomenon
ANSWERS
5. The type of Accounts Receivable Financing wherein
they are sold outright to the finance company.

ANSWER:
Factoring Accounts Receivable
ANSWERS
6. The type of Accounts Receivable Financing wherein
the lender will have full recourse against the borrower.

ANSWER:
Pledging Accounts Receivable
ANSWERS
7-8. _________and _________are likely to provide the
best collateral, while goods in process may qualify for
only a small percentage loan.

ANSWER:
Raw Materials; Finished Goods
ANSWERS
9. True or False. Larger firms tend to be net providers
of trade credit (relatively high receivables), with
smaller firms in the user position (relatively high
payables).

ANSWER:
True
ANSWERS
10. True or False. The largest provider of short-term
credit is the retailer or buyer of goods and services.

ANSWER:
False (manufacturer or seller)
ANSWERS
11. Represents a short-term, unsecured promissory
note issued to the public in minimum units of $25,000.

ANSWER:
Commercial Paper
ANSWERS
12. Net trade credit is ______ when Accounts
Receivable > Accounts Payable.

ANSWER:
Positive
ANSWERS
13. True or False. One of the advantages of commercial
paper is that they may be issued at below the prime
interest rate.

ANSWER:
True.
ANSWERS
14.
Amount to be borrowed = Amount needed
(1-c)

where:
c = compensating balance (expressed as ___?___)

ANSWER:
decimal
ANSWERS
15. True or False. Trust receipts is also known as Floor
planning.

ANSWER:
True.
Summary of Answers:
1. Short-term financing 10. False (manufacturer or seller)
2. Cash discount 11. Commercial Paper
3. Compensating balance 12. Positive
4. Credit Crunch Phenomenon 13. True
5. Factoring Accounts Receivable 14. decimal
6. Pledging Accounts Receivable 15. True
7-8. Raw Materials; Finished Goods
9. True