Short-term/Medium-term FinancingFinancial Management Group 1: o Jenice Joy Sumawayo Jovelyn Ferrero Michael Agencia

University of the Philippines - Manila

Outline

1. Liability Structure of a Company 2. Trade Credit Financing 3. Accrual Accounts as Spontaneous

Financing 4. Unsecured Short-Term Loans 5. Secured Lending Arrangements 6. Intermediate-Term Debt 7. Protective Covenants and Loan

Agreements

Liability Structure of a Company:Permanent and Temporary Financing

Each asset would be offset with a financing instrument of the same approximate maturity. A firm incurs short-term debt to finance short-term or seasonal variations in current assets; it uses long-term debt or equity to finance the permanent component of current assets.

Hedging Financing Policy

o If current assets fluctuate in the manner shown in the figure, only the temporary fluctuations shown at the top of the figure would be financed with temporary debt.

o To finance short-term requirements with long-term debt would necessitate the payment of interest for the use of funds during times when they were notneeded.

o A hedging approach to financing suggests that apart from current installments on long-term debt, a firm would show no current borrowings at the seasonal troughs.

o Short-term borrowings would be paid off with surplus cash.

oAs the firm moved into a period of seasonal funds needs, it would borrow on a short-term basis, again paying off the borrowings as surplus cash was generated. In this way, financing would be employed only when it was needed. o In a growth situation, permanent financing would be increased in keeping with underlying increases in permanent funds requirements.

Maturity of Debt

What margin of safety should be built into the maturity schedule to allow

for adverse fluctuations in cash flows?

This depends on the trade-off between risk and profitability.

Maturity: the RISKs involved In general, the shorter the maturity schedule of a

firm's debt obligations, the greater the risk that it will be unable to meet principal and interest payments. On the other hand, the longer the maturity schedule, the less risky the financing of the firm, all other things the same.

The major risk in this regard is the possible inability to refinance short-term debt at its maturity.

There is also the uncertainty associated with interest costs on the rollover of short-term borrowings, which can either dampen or accentuate fluctuations in the firm's operating income.

Maturity: the RISKs involved

Short-term Long-term• The company bears the risk that the lender may not renew the loan at maturity.

• If there is a financial institution crisis, and the borrower must search for a new lender.

• Committing funds to a long-term asset and borrowing short carries the risk that the firm may not be able to renew its borrowings.

• If the company should fall on hard times, creditors may regard renewal as too risky and may demand immediate payment. • Will cause the firm to either retrench or go into bankruptcy

• Uncertainty associated with interestCosts

• The risk of nonrenewal can be reducedby financing the plant on a long-term basis.

• The expected cash flows being sufficientto retire the debt in an orderly manner.

• When the firm finances with long-term debt, it knows precisely what its interest costs will be over the time period it needs the funds.

Suppose a company borrows on a short-term basis to build a new plant. Theshort-term cash flows from the plant are not sufficient in the short run to pay offthe loan.

Maturity: The COSTs Trade-off

The longer the maturity schedule of a firm‘s debt, the more costly the financing is likely to be.

In periods of high interest rates, the rate on short-term corporate borrowings may exceed that on long-term borrowings; but over an extended period of time, the firm typically pays more for long-term borrowings.

Trade Credit Financing

Trade credit is a form of short-term financing common to almost all businesses.

Trade credit is the largest source of short-term funds for business firms collectively.

Most buyers are not required to pay for goods on delivery but are allowed a short deferment period before payment is due.

Trade Credit Financing:Terms of SaleCOD and

CBDNet Period Datings

The seller will be stuck with the shipping costs

A seller might ask for cash before delivery (CBD) to avoid all risk

Under either COD or CBD terms, the seller does not extend credit.

Net Period - No cash discount When credit is extended, the seller specifies theperiod of time allowed for payment.

Net Period with Cash DiscountIn addition to extending credit, the seller mayoffer a cash discount if the bill is paid during the early part of the net period.

Ex: N30, N15, N60, N120

Use to encourage customers to place their orders before a heavy selling period

Trade Credit Financing:Trade Credit as a Means of Financing

Stretching Accounts Payable the cost of the cash discount forgone and the possible deterioration in

credit rating.

Stretching Accounts Payable (supplier) Suppliers are in business to sell goods,

and trade credit may increase sales. A supplier may be willing to go along

with stretching payables, particularly if the risk of bad-debt loss is negligible.

If the funds requirements of the firm are seasonal, suppliers may not view the stretching of payables in an unfavorable light during periods of peak requirements, provided that the firm is current in the trade during the rest of the year.

Trade Credit Financing:

Advantages of Trade Credit

Ready availability Trade credit is a more flexible means

of financing. The advantages of using trade credit

must be weighed against the cost.

Trade Credit Financing:

Who bears the cost?

The burden may fall on the supplier, on the buyer, or on both parties.

The supplier of a product or service for which demand is elastic may be reluctant to increase prices and may end up absorbing most of the cost of trade credit.

Under other circumstances, the supplier is able to pass the cost on to the buyer. The buyer should determine who is bearing the cost of trade credit.

Accrual Accounts as Spontaneous Financing

Accrual accounts represent a spontaneous source of financing

The most common accrual accounts are for wages and taxes.

The expense is incurred or accrued but not paid

Usually a date is specified indicating when the accrual must be paid.

Represents costless financing or an interest-free source of financing.

Accrual Accounts as Spontaneous Financing:

Built-in Financing Wages, Taxes

Accrued Wages and Pay Period Changes

Suppose a company had a weekly payroll of $400,000 with an average amount accrued of $200,000. If the company were to increase its pay period from 1 to 2 weeks, the payroll at the end of the period would be $800,000. The average amount of accrued wages would now be $400,000 ($800,000 divided by 2). Therefore, the company increases its interest-free financing by $200,000.

The longer the pay period, the greater the amount of accrued wage financing

Sources of Financing• Unsecured short-term loans- are self-

liquidating as assets purchased with the proceeds generate sufficient cash flows to pay off the loan.

• Secured lending- lenders require security which could be the cash-flow ability of the firm or the collateral value of the security.

• Intermediate-term debt- is self-liquidating, similar to short-term financing however it can satisfy more permanent funds requirements and can serve as an interim substitute for long-term financing.

Unsecured Short-Term Loans• Line of credit- an agreement between a bank and its

customer, specifying the amount of unsecured credit the bank will lend at one time.

• Revolving Credit Agreement- a legal commitment by a bank to extend credit up to a maximum amount. The bank must extend credit whenever the borrower wishes to borrow, provided that the maximum amount is not yet reached.

• Transaction Loans- loans intended for only one purpose. A contractor may borrow from a bank in order to complete a job then pay the bank when it receives payment.

Question: what is the difference between line of credit and revolving credit?

Interest rates

IR for most business loans are determined through personal negotiations, unlike impersonal money market instruments.

Prime rate- set by large money market banks, tends to be uniform throughout the country.

IR- could be higher or lower than prime rates depending on the creditworthiness, cost of servicing a loan, etc.

%

Computing Interest Rate

• Collect basis- interest is paid at the maturity of the note.

• Discount basis- interest is deducted from the initial loan.

On a $10,000 loan at 8% interest for 1 year, effective rate of interest will be:

Collect basis$800/$10,000=8.00% Discount basis$800/$9,200= 8.70%

%

Secured Lending

Receivable loan- security to the loan is the accounts receivable which are one of the most liquid assets of the firm.

Inventory loan- security to the loan is the inventory. Floating lien- borrower pledges inventories

without specifying the inventories involved. Chattel mortgage- inventories are identified

specifically by serial number or other means.

Secured Lending

– Trust receipt loan- borrower holds in trust for the lender the inventory and the proceeds from its sale; also known as floor planning.

– Terminal warehouse receipt loan- borrower secures terminal warehouse receipt loan by storing inventory in a warehousing company.

– Field warehouse receipt loan- permits loans to be made against inventory that is located on the borrower’s premises.

Question: What is the difference between the first 3 and the last 2 methods?

Intermediate-Term debt

Term loan- business loan with a final maturity of more than 1 year, repayable according to a specific schedule.

Equipment financing- the equipment is pledged to secure a loan.

Medium-term notes (MTNs)- sold to investors through an investment bank; may be offered continually.

Protective Covenants and Loan Agreementso Allow the lender to control the situation if any are breached.o Provisions for protection contained in a loan agreement.o Usually stated under the Credit Agreements drafted by the lender and as conformed by the borrower with proper legal confirmation.

Important Protective Covenants of the loan may be classified as follows:

1. General provisions used in most loan agreements, which are variable to fit the situation.

2. Routine provisions used in most agreements, which usually are not variable &

3. Specific provision that are used according to the situation.

1. General Provision

1. Working Capital: - The Working Capital requirement is the

most commonly used & most comprehensive provision in a loan agreement.

- Its purpose is to preserve the company’s current position and ability to pay the loan.

- Based on the company’s present working capital & projected working capital, allowing for seasonal fluctiations.

2. Dividends/ Share Repurchase: - Its major restriction’s purpose is to

limit the cash going outside the business w/c preserves company’s liquidity position.

- It is usually based on a certain percentage of the net profit on a cumulative basis after a certain base date. It can also be based on a fixed amount restricted to dividends or repurchase stock.

1. General Provision

3. Capital Expenditure: - Capital Expenditure may be limited

to a fixed amount per year or probably more commonly, either to depreciation thereof.

- A tool that lender uses to ensure the maintenance of the borrower’s current position.

1. General Provision

4. Other Debt: - The limitation on other indebtedness is

the last provision. - Frequently prohibit the borrower to

incur any another long term debt. - Ensures the lender that there will be no

other claim on the borrower’s assets.

1. General Provision

2. Routine Provisions

Includes routine usually invariable provisions found in most loan agreements.

Examples of this provision may be as follows:1. The borrower must furnish the lender of the formers

financial statements & adequate insurance.2. The borrower must not sell significant portion of its

assets.3. A negative pledge clause provision (prohibits the

borrower to mortgage/pledge any of its asset)4. The borrower must not sell or discount its receivables.5. The borrower is prohibited to enter into leasing of its

property except for a certain amount.

3. Special Provisions

In a special loan agreement, the bank uses special provision to achieve a desired total protection of its loan.

A loan may contain a definite understanding regarding the use of the loan proceeds so as to avoid fund diversion.

May require an endorsement of Major stockholders Life insurance to the bank.

Aggregate executive salaries and bonuses are sometimes limited in the loan agreement to prevent excessive compensation of executives which might reduce profits.

THANK YOU!!!