SHORT TERM

FINANCING
 SHORT TERM FINANCING
■ Short term financing is defined as debt originally
scheduled for repayment within 1 year.
■ Before using short term financing, the firm must
assess the factors associated with short term
financing:-

1. The effective cost of credit

2. The availability of credit and the amount needed and for
the period of time when financing is required
3. The influence of the use of the particular credit source of
the cost compared to the availability of other sources.
 Types of Short Term Financing
1. Spontaneous financing
■ An internal financing
■ Arise from ordinary business transaction.
■ There is no loan agreement or negotiation
needed.
■ They are in the form of Trade Credit ( Account
Payable) and Accruals (wages and salaries due to
be paid)
 Spontaneous Financing
a) Trade Credit ( Account Payable )
■ It is obtained automatically (spontaneously) when
company purchase goods on credit from its suppliers

Cost of Credit
■ Usually the credit term offered with trade credit involved a cash
discount for early payment. They are major items in the credit
term
■ E.g. a / b net c
2 / 10 net 30

a = 2 🡪 is the cash discount

b = 10 🡪 is the discount period
c = 30 🡪 is the credit period
 Cost of Trade Credit
■ Interpretation
■ 2 percent cash discount is allowed if the bill is paid
by the 10th day. If the discount is not taken. Full
amount of the bill is due by the 30th.

■ There are 2 options to take when a credit is

offered:
■ Take Discount
■ Foregoing the Trade Discount
 Example
Example:
■ If a buyer purchase RM2,000.00
worth of merchandise
■ Being offered a trade credit term of
2 /10 net 30
 Cost of Trade Credit
I. Taking the Cash Discount

Worth of good RM2,000

Less: Cash discount = 0.02 X RM2 K RM 40
Payment to be made by the 10th day RM1,960

■ Thus, taking cash discount there will be no cost

involved but savings of RM40 is obtained.
 Cost of Trade Credit
2. Foregoing the Trade Discount
■ Referring to the same example. If the buyer chooses not
to take ( foregoing ) the cash discount he is able to use
RM2,000 for another 20 days.
■ The cost of foregoing the cash discount is interpreted as
the implied rate of interest paid in order to delay payment
of an account payable for an additional number of days
which can be calculated as follows:-

■ Cost of Foregoing Cash Discount

= a X 360
100 – a c-b
 Cost of Trade Credit
■ From the same example : with credit term 2/10 net 30

= 2 X 360
100 – 2 30 – 10

= 2 X 360
98 20

= 0.36734 🡺 36.73%
 Cost of Trade Credit
■ The cost of foregoing trade is LOWER if the length of credit
period is extended. 🡪 2 /10 net 90

Cost of foregoing cash discount

= 2 X 360
100 – 2 90 – 10

= 2 X 360
98 80

= 0.091836 🡺 9.18%
■ Thus, the buyer CAN REDUCE COST BY
PAYING LATE (i.e instead of paying on 30th
day, he pays on the 90th) , the cost is 9.18%
instead of 36.73%. This is known as
STRETCHING the ACCOUNT PAYABLE

■ If buyer does that:-

1. It shows bad reputation
2. Buyer may destroy the ability of getting credit
from the same supplier.
 Spontaneous Financing
b) Accruals
■ Accrual represent a “ free source of credit” since
no interest is charged for services rendered
before paying for it. Accruals are wages, taxes
etc
 Types of Short Term Financing
2. Non Spontaneous Financing
■ This type of financing can be obtained from
banks in the form of unsecured ( without
collateral ) short term loans

a) Line of credit / overdraft

b) Revolving credit agreement
c) Transaction loan
 Line of Credit / Overdraft (OD)

■ It is an informal arrangement between bank

and its client specifying the maximum amount
of unsecured credit the bank will permit the
firm to owe at any time
■ Normally, the authorized or maximum limit of
OD is fixed and a formal arrangement is
signed
 Line of Credit / Overdraft
■ Example:
■ If a line of credit of RM500K is given this means that the
firm can make use up to the maximum of RM500K as an
overdraft
■ It provide a temporary financing to bridge the gap between
cash inflow and cash outflow.
■ Bank will charge interest 🡪 based on personal negotiation
between the borrower and the bank
■ The rate charged depend on the creditworthiness
relationship with the bank
■ Interest in loan can be paid on Collect Basis or on Discount
Basis
(Refer to the method of Computing Effective Interest
Rate )
 Revolving Credit Agreement

■ Same as line of credit. EXCEPT THAT BANK

MAKES A FORMAL AND LEGAL BINDING
COMMITMENT TO GIVE CREDIT up to the
amount stated.

■ The bank must make the credit available regardless of

the tightness of money

■ Interest will be charged on loan

 Revolving Credit Agreement

■ Commitment fee has to be paid for the

privilege of having fund available on demand

■ Commitment fee is charged based on

UNUSED PORTION of the Revolving Credit
 Transaction Loan
■ The loan acquired by the borrower is used to
finance a contract that has been agreed upon
with the large and reliable company for
undergoing the company’s project.

■ The loan has to be settled as soon as payment

is received from the company under the agreed
contract.

■ Customer is required to maintain a

compensating balance.
 Other Types of Short Term
Financing
■ The loan that does not arise from daily business
transaction or loan from banks
 Commercial Paper
■ Commercial paper (CP) is a short term
promissory notes that is generally SOLD by
large corporation on DISCOUNT BASIS to
institutional investors (insurance co. pension
fund, banks ) and other corporation.

■ It is an alternative for companies to raise fund

 Commercial paper cont
■ Raising fund through CP may be preferred
due to the following factors:-
1. Interest rate charged is LOWER THAN THE
RATE ON BANK LOANS
2. The issuing firms are not required to maintain
any compensating balance on their outstanding
amount
3. A CP is widely recognized 🡪 so it can tap source
of financing from banks outside its own area,
across the country.
Short Term Bank Loans
The Cost of Short Term Bank Loans
■ Short term loan have cost. The costs are expressed in terms of interest rate.

Nominal Interest Rate

■ It is the stated interest rate the bank charged its customers. It is not an
actual or true rate.

Prime Rate
■ It is the rate that the bank charges its most creditworthy borrowers
(because of the size and financial strength)
■ It is normally the lowest rate the bank charges
■ The prime rate is usually equal to or slightly higher than base rate.

Effective Interest Rate

■ This is the actual rate incurred by the borrower after conditions have been
imposed by the lender to the borrower The conditions are:-
 Condition of Effective Interest Rate
1. Collect Basis ( Simple Interest )
■ This is one of the ways effective cost is
calculated.
■ Under this condition, the interest rate is paid at
maturity.

2. Discounted Basis ( Discounted Interest)

■ Under this condition, bank deducts interest in
advance.
■ This will reduce the net proceeds from the loan
and increase the effective cost of the loan
 Condition of Effective Interest Rate

3. Compensating Balance ( CB)

■ Compensating Balance is the non interest
earning minimum cash balance required to be
maintained in an account of the borrower.
■ This provide the bank as a safety measure
should the loan default and for the services
provided. The balance to be maintained is 10%
- 20% of the loan.
■ With CB, is raises the Effective Cost of the loan
because the firm is unable to use the funds
retained and loan amount received is lesser.
 Method of Calculating Effective Cost of Short Term Financing

A. Loan with no compensating balance

Interest Payment = Interest Rate X Loan X ( n / 360 )

On Collect Basis

Effective Interest Rate (EIR) = Interest Payment X 360

Loan n

On Discount Basis

Effective Interest Rate (EIR) = Interest Payment X 360

(Loan – Interest) n

Where; n = number of days loan outstanding

Note: Time period can be in months, or a year, besides in days, if in month 12 / n,

if in year convert days into 360 / 360
Example 1.

Syarikat Sitang needs RM100,000 for 180 days. The stated

interest rate is 10% per annum. What is the effective interest
cost on the loan?
Interest payment = 10% X RM100,000 X (180 / 360)
= RM5,000

On Collect Basis

Effective Cost = (RM5,000 / 100,000) X (360 / 180)

= 0.1 🡺 10%.

On Discount Basis

Effective Cost = RM5,000 X 360

RM100,000 – RM5,000 180

= 10.53%
Example 2
Ah Lee Jaya Enterprise is going to borrow RM3,000 for one year at 12% interest.
What is the effective rate of interest

a) if loan is on collect basis

b) if loan is on discount basis

Interest payment = 12% X RM3,000 X 1 year ( 360 / 360 )

= RM360

On Collect Basis:

Effective Cost = (RM360 / RM3,000) X (360 / 360)

= 12%

On Discount Basis:

Effective Cost = RM360 X 360

RM3,000 – RM360 360

= 0.1364 🡺 13.64%
Example 3
Suppose you borrow RM10,000 for one year at 11% interest. If loan is on
DISCOUNT BASIS, calculate the EIR on the loan

Interest payment = 11% X RM10,000 X 1

= RM1,100

Effective Cost = RM1,100 X 360

RM10,000 – RM1,100 360

= 0.1236 🡺 12.36%
Method of Calculating Effective Cost of Short Term Financing

B. Loan with Compensating Balance Requirement

On Collect Basis

Effective Cost = Interest Payment X 360

( Loan – CB) n

On Discounted Basis

Effective Cost = Interest Payment X 360

(Loan – Int. – CB) n
Example 4
Suppose you borrow RM20,000 at 14% interest rate per annum paid at
maturity and the compensating balance requirement is 10%. What is the
effective cost of the loan?

Interest payment = 14% X RM20,000 X 1 = RM2,800

Compensating Balance = 10% X RM20,000 = RM2,000

On Collect Basis:

Effective Cost = 2,800 / (20,000 – 2,000) X (360 / 360)

= 0.1555 🡺 15.56%

On Discount Basis:

Effective Cost = 2800 / (20,000 – 2,000 – 2,800) X (360/360)

= 0.1842 🡺 18.42%
Method of Calculating Effective Cost of Short Term Financing

C. Loan with compensating Balance and Borrower maintain

Account Balance equal to and more than compensating
balance ; (A/C > CB)

On Collect Basis

EIR = Interest Pay X 360

Loan – 0 n
Example :
Colby Company has taken a loan of RM75,000. The stated annual interest rate is
10%. Compensating balance is 15% of the initial face value amount. The company
currently has RM20,000 in checking account and plan to maintain the balance.
What is the effective rate on loan?

Interest payment = 10% X RM75,000 X 1 = RM7500

CB = 15% X RM75,000 = RM11,250
A/C Balance = RM20,000 i.e > CB

EIR = 7,500 / (75,000 – 0) X (360/360)

= 10%

On Discount Basis

EIR = Interest Payment X360

Loan – Interest – 0 360
Method of Calculating Effective Cost of Short Term Financing

D. Loan with compensating Balance and Borrower maintain

Account Balance less than compensating balance ;
(A/C < CB)

On Collect Basis

EIR = Interest Payment X 360

Loan – (CB-A/C Bal) n

On Discount

EIR = Interest Payment X 360

Loan – Int – (CB – A/C Bal) n
Example
A discounted loan with 11% interest and another 10% requirement for a
compensating balance. The account balance in the bank is RM120,000. Total
amount of money needed is RM2,000,000 for 3 months. Calculate EIR.

Interest payment = 11% X 2,000,000 X 3/12 = RM55,000

CB = 10% X 2,000,000 = RM200,000
A/C Balance = RM120,000 i.e < CB

EIR = 55,000 / ( 2,000,000 – 55,000 – (200,000 – 120,000) X (12/3)

= 11.79%
Method of Calculating Effective Cost of Short Term Financing

E. EIR on Commercial Paper

■ Key point to estimate cost of commercial paper are:
■ Interest is on DISCOUNT BASIS
■ A FEE is charged if a dealer is used to place the issue.
If no dealer, other cost may also incurred e.g. flotation
cost

EIR = Interest Payment + Fee X 360

Loan – Interest - Fee n
Example
In May 1996, Motorolla Corporation plan a commercial paper issue of
RM30 million. The firm has never used commercial paper before but has
decided to go through a dealer to handle the process. The commercial paper
will carry a 270 day maturity and will require interest based upon a rate of
11% per annum. In addition, the firm will have to pay fees totaling
RM200,000 for going through the dealer. What is the effective cost of the
commercial paper issued by Motorolla Corporation?

Interest payment = 30,000,000 X 11% X 270/ 360 = RM2,475,000

EIR = Int + Fee X 360

Loan – Int. - Fees n

EIR = 2,475,000 + 200,000 X 360

30,000,000 – 2,475,000 – 200,000 270

= 0.131 🡺 13.1%
Method of Calculating Effective Cost of Short Term Financing

F. EIR on Revolving Credit Agreement

■ The EIR of revolving credit agreement is calculated
based on collect basis

EIR = Interest Payment + Commitment Fees X 360

Loan – Compensating Balance n
Example
Suppose Binariang Corporation has a revolving
credit agreement with the bank. It can borrow up to
RM2,000,000 at 12% interest but is required to
maintain a 10% compensating balance on any funds
borrowed under the agreement. In addition, it must
pay 0.5% commitment fee on the unused portion of
the formal line. What is the effective cost of taking
such loan, if the firm utilizes RM800,000 for the
entire year.
Interest payment = 12% X 800,000 X 1 = RM96,000
Compensating Balance = 10% X 800,000 = RM80,000
Commitment Fee (CF) = ( 2,000,000 – 800,000 ) X 0.005 =
RM6,000

Effective Cost = 96,000 + 6,000 X 360

800,000 – 80,000 360

= 102,000 X 360
720,000 360

= 14.17%
 EXERCISES
■ Dec 2016 FIN420 - Q3(b)
■ Jan 2018 FIN420 - Q3(b)
■ Jun 2018 FIN430 - Q3(B)
■ Dec 2018 FIN430 - Q3(a)