SHORT-TERM FINANCING
SECTION 5.0: OVERVIEW
ASSET LIQUIDITY
FINANCING PLAN
LOW LIQUIDITY HIGH LIQUIDITY
High profit Moderate profit
SHORT-TERM
High risk Moderate risk
Moderate profit Low profit
LONG-TERM
Moderate risk Low risk
SECTION 5.1: SOURCES OF SHORT-TERM FINANCING
1. Short-term loans – borrowing from banks and other financial institutions for one year or less.
2. Trade credit – borrowing from suppliers
3. Commercial paper – only available to large credit-worthy businesses
SECTION 5.2: TYPES OF SHORT-TERM LOANS
1. 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. 12%
Often requires that loan be repaid in full with interest at the end of the loan period.
Usually with a bank financial institution; occasionally with suppliers or equipment
manufacturers
2. 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 pre-approved
Usually informal agreement and may change over time
Usually covers peak demand times, growth spurts,etc.
3. 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. 3/15; n/30
Credit has a cost. That cost may be passed along to the customer as higher prices or
borne by the seller as lower profits, or some of both.
SECTION 5.3: ESTIMATION OF COST OF SHORT-TERM CREDIT
1. Calculation is easiest if the loan is for a one year period 12%
2. Effective interest rate is used to determine the cost of the credit to be able to compare differing
terms.
Effective interest rate = cost (interest amount + fees)
Amount you get to use
Example: You borrow P10,000 from a bank, at a stated rate of 10%, and must pay P1,000
interest at the end of the year. Your effective rate is the same as the stated rate:
P1,000/P10,000 = .10 = 10%
Stated/nominal/coupon
Effective/Market/Yield to maturity
Page 1 of 4
SHORT-TERM FINANCING
SECTION 5.4: VARIATIONS IN LOAN TERMS
1. A discount loan requires that interest be paid up front when the loan is given.
2. This changes the effective cost in the previous example since you only get to use:(P10,000 -
P1,000) = P9,000.
3. Effective rate (APR) = P1,000/P9,000 = .1111 = 11.11%.
4. 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.
5. If your compensating balance requirement is P500, then the amount you can use is reduced
by that amount.
6. Effective Rate (APR) for a P10,000 simple interest 10% loan with a P500 compensating
balance = P1,000/(P10,000-P500) = .1053 = 10.53%.
7. Sometimes, lenders will require both discount interest (paid in advance) and a compensating
balance.
8. If the interest is P1,000 and the compensating balance is P500, then the effective rate (APR)
becomes:
9. P1,000 / P10,000 - P1,000 - P500
10. P1,000 / P8,500 = 11.76%
SECTION 5.5: COST OF TRADE CREDIT
1. Typically receive a discount if you pay early.
2. 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.
3. The cost is in the form of the lost discount if you don’t take it.
4. CALCULATING EFFECTIVE PERCENTAGE RATE (APR)
Interest = principal x rate x time
Example: Borrow P10,000 at 8.5% for 9 months
Interest = P10,000 X .085 X 9/12 = P637.50
We can use the simple relationship: Interest = principal X rate X time:
To solve for rate, and get the APR:
APR (rate)= . Interest .
Principal X time
Principal = . Interest .
Rate X time
Time =. Interest .
Principal X rate
Example: If you pay P637.50 in interest on P10,000 principal for 9 months. What is the
APR? 637.50 637.50
10,000*9/12 7,500
5. Assume your purchase is P100 list price at 2/10 net 60.
6. If you take the discount, you pay P98. If you don’t take the discount, you pay P100.
7. Therefore, you (buyer) are paying P2 for the privilege of borrowing P98 for the additional 50
days. (Note: the first 10 days are free in this example).
8. APR (nominal cost of credit)= P2/P98 x 365/50 = 14.9% (If you pay in 60 days)
.02040816 X 7.3 = 14.9%
Page 2 of 4
SHORT-TERM FINANCING
9. or; if the firm can forego discount and pay on day 60,
a. Determine the net daily purchase = 98/365 = .27
b. Payable level, if the firm takes discounts
i. Payables = .27 (10) = 2.7
c. Payables level, if the firm takes no discounts
i. Payables = .27 (60) = 16.2
d. Credit breakdown:
i. Total trade credit = 16.2
ii. Free trade credit = (2.7)
iii. Cost of trade credit 13.5
10. What if 2/10, net 30
11. APR = P2/P98 x 365/20 = 37.25%! (If you pay in 30 days)
Activity
SECTION 5.6: COMMERCIAL PAPER
1. 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 face x DTG)/time
DTG = days to go (to maturity)
Step 2: Compute the price = Face value - Discount
Step 3: Compute Effective Annual Rate (APR): P interest you pay/ P you get to use x
time
2. Example: P1M issue of 90 days commercial paper quoted at 4% discount rate, what is the
cost of commercial paper? 4.04%
a. Or; Determine the net daily cost = 990,0000/360 = 2,750
How to get the 990,000
= 1,000,000*.04*90/360 = 10,000
= 1,000,000- 10,000
= 990,000
i. Payable level, if paid in 90 days (2,750*90) = P247,500
b. Credit breakdown:
i. Total debt P247,500
ii. Free 0
iii. Cost of commercial paper P247,500
c. In view thereof, the cost of commercial paper if pay in 90 days is 4.04% =
10,000/247,500
SECTION 5.7: BANK LOANS
1. The firm can borrow P100,000 for 1 year at an 8% nominal rate.
2. Interest may be set under one of the following scenarios:
a. Simple annual interest
i. 8,000 = (100,000*8%)
b. Discount interest
i. Amount borrowed = amount needed / (1-discount)
ii. 100,000/(1-.08) = 108,696
c. Discount interest with 10% compensating balance
i. Amount borrowed = amount needed / (1-discount-comp. bal.)
ii. 100,000/(1-.08-.1) = 121,951
iii. Interest = .08(121,951)= 9,756
iv. Effective cost = 9,756/100,000 = 9.756%
Page 3 of 4
SHORT-TERM FINANCING
d. Installment loan, add-on, 12 months
i. Interest = .08(100,000) = 8,000
ii. Face amount = 100,000 + 8,000 = 108,000
iii. Monthly payment = 108,000/12 = 9,000
iv. Approximate cost = interest/ (principal/2)
1. 8,000/50,000 = 16%
SECTION 5.8: COLLATERAL IN SHORT-TERM FINANCING
1. Pledging Accounts Receivable
Using receivables selected by the lending institutional as collateral for a loan.
2. Factoring Receivables
Receivables are sold outright to a finance company.
3. Inventory Financing
Borrowing against inventory to acquire additional funds.
Page 4 of 4
