Chapter Five
Financial Management-II
CHAPTER FIVE
5. SHORT TERM FINANCING
5.1. Short-Term Sources of Finance (Accruals, Bank Credit, and Inventory
Financing)
Short term financing refers to the various external financing sources incurred by the firm that are
payable within one year. They appear as current liabilities on a firm’s balance sheet. Some of the
sources of short term financing include accruals, Trade Credit, Bank Credit, and Inventory
Financing.
1. Accruals
Accrual is one of spontaneous sources of short-term financing for an organization. Accruals are
liabilities for which services are received but payments have yet to be made. The most common
items accrued by a firm are wages and taxes. For both accounts, the expense is incurred, or
accrued, but not yet paid. Like accounts payable, accrued expenses tend to rise and fall with the
level of the firm’s operations. For example, as sales increase, labor costs usually increase and
with them, accrued wages also increase. And as profits increase, accrued taxes increase.
In a sense, accruals represent costless financing. Services are rendered for wages, but employees
are not paid and do not expect to be paid until the end of the pay period. Similarly, taxes are not
paid and do not expected to be paid until their due date. Thus, accruals represent an interest –free
source of financing.
2. Bank Credit (loan)
Bank Credit or Loans: Banks are a major source of unsecured short-term loans to businesses.
Short-term unsecured bank loans are typically regarded as “ self-liquidating “ in that the assets
purchased with the proceeds of the loan from the bank generate sufficient cash flows to pay off
the unsecured loan. Self-Liquidating loans are intended merely to carry the firm through seasonal
peaks in financing needs that are attributable primarily to buildups of accounts receivable and
inventory. It is expected that as receivables and inventories are converted into cash, the funds
needed to retire these loans will be generated automatically. In other words, the investment in
which the borrowed money is put provides the mechanism through which the loan is repaid
(hence the term self liquidating).
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A.M. | CPU College/2019
Chapter Five
Financial Management-II
3. Inventory Financing
Inventory is, generally, second to accounts receivable in desirability as short-term loan collateral.
When judging whether a firm’s inventory would be suitable collateral for a loan, the primary
considerations of the lender are the type, physical characteristics, and marketability.
There are three types of inventory financing arrangements. These are floating inventory liens,
trust receipt inventory loans and warehouse receipt loans.
Floating Inventory Liens: A lender may be willing to secure a loan under a floating inventory
lien, which is a claim on borrower’s inventory in general for a secured loan. This arrangement is
most attractive when the firm has a stable level of inventory that consists of a diversified group
of relatively inexpensive merchandise. Because it is difficult for a lender to verify the presence
of the inventory, the lender will generally advance / provide/ a loan less than 50 percent of the
book value of the average inventory. The borrower retains title and possession of inventories,
thus making it difficult for the lender to monitor the collateral.
Trust Receipt Inventory Loans: A trust receipt inventory loan is often made against relatively
expensive inventories that can be identified by serial number. This arrangement allows the
borrower to retain possession of inventory and to sell the inventory used as collateral. Unlike the
floating liens, however, all the items that make up the collateral are listed in the trust agreement
and identified by their serial numbers. The lender has a lien, or claim, on a specific inventory
items listed in the trust receipt. The borrower is free to sell the merchandise but is trusted to
remit the amount lent against each item along with accrued interest to the lender immediately
after the sale. Although the lender doesn’t have direct control over the collateral, the borrower
can be audited to see if the borrower has sold any of the collateral without remitting the proceeds
as specified in the loan agreement. In short, trust receipt inventory lien, is an agreement under
which the lender advances 80 to 100 percent of the cost of the borrower’s relatively expensive
inventory items in exchange for the borrower’s promise to immediately repay the loan, with
accrued interest, on the sale of each item.
Warehouse Receipt Loans: A warehouse receipt loan is an arrangement whereby the lender
receives control of the pledged inventory collateral, which is stored, or warehoused, by a
designated warehousing company on the lender's behalf. After selecting acceptable collateral, the
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A.M. | CPU College/2019
Chapter Five
Financial Management-II
lender hires a warehousing company to act as its agent and take possession of the inventory. The
warehousing company places a guard over the inventory. Only on written approval of the lender
can any portion of the secured inventory be released to borrower for sale.
The actual lending agreement specifically states the requirements for the release of inventory. As
in the case of other secured loans, the lender accepts only collateral that is believed to be readily
marketable and advances only a portion, generally, 75 to 90 percent-of the collateral's value. The
specific costs of warehouse receipt loans are, generally, higher than those of any other secured
lending arrangements due to the need to hire and pay a third party {the warehousing company) to
guard and supervise the collateral.
4. Accounts Payable (Trade Credit)
Firms generally make purchases from other firms on credit, recording the debt as an account
payable. Accounts payable, or trade credit, is the largest single operating current liability,
representing about 40% of the current liabilities for an average nonfinancial corporation. The
percentage is somewhat larger for smaller firms: Because small companies often have difficulty
obtaining financing from other sources, they rely especially heavily on trade credit.
Trade credit is a spontaneous source of financing in the sense that it arises from ordinary
business transactions.
5. Commercial Paper
Commercial paper is a type of unsecured promissory note issued by large, strong firms and sold
primarily to other business firms, to insurance companies, to pension funds, to money market
mutual funds, and to banks.
The use of commercial paper is restricted to a comparatively small number of very large
concerns that are exceptionally good credit risks.
Advantages of Short-Term Financing
First, a short-term loan can be obtained much faster than long-term credit. Lenders will insist on
a more thorough financial examination before extending long-term credit, and the loan
agreement will have to be spelled out in considerable detail because a lot can happen during the
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Chapter Five
Financial Management-II
life of a 10- to 20-year loan. Therefore, if funds are needed in a hurry, the firm should look to the
short-term markets.
Second, if its needs for funds are seasonal or cyclical, then a firm may not want to commit itself
to long-term debt. There are three reasons for this:
(1) Flotation costs are higher for long-term debt than for short-term credit.
(2) Although long-term debt can be repaid early (provided the loan agreement includes a
prepayment provision), prepayment penalties can be expensive. Accordingly, if a firm thinks its
need for funds will diminish in the near future, it should choose short-term debt.
(3) Long-term loan agreements always contain provisions, or covenants, that constrain the firm’s
future actions. Short-term credit agreements are generally less restrictive.
The third advantage is that, because the yield curve is normally upward sloping, interest rates are
generally lower on short-term debt. Thus, under normal conditions, interest costs at the time the
funds are obtained will be lower if the firm borrows on a short-term rather than a long-term
basis.
Disadvantages of Short-Term Debt
Even though short-term rates are often lower than long-term rates, using short-term credit is
riskier for two reasons:
(1) If a firm borrows on a long-term basis then its interest costs will be relatively stable over
time, but if it uses short-term credit then its interest expense will fluctuate widely, at times going
quite high. Many firms that had borrowed heavily on a short-term basis simply could not meet
their rising interest costs; as a result, bankruptcies hit record levels during that period.
(2) If a firm borrows heavily on a short-term basis, a temporary recession may render it unable to
repay this debt. If the borrower is in a weak financial position then the lender may not extend the
loan, which could force the firm into bankruptcy.
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