chapter 05 st financing 1ce lecture 050930

Sources of Short-Term Financing

2006 by Nelson, a division of Thomson Canada Limited

*Chapter 5 Outline (1)Sources of Short-term Financing Spontaneous FinancingTrade CreditThe Prompt Payment DiscountAbuses of Trade CreditBank Operating LoansShort Term Bank Credit Line of Credit or Revolving Credit AgreementInterest Rates on LoansAnnual Interest RateCleanup Requirements



*Chapter 5 Outline (2)Short-Term Credit Secured by Current AssetsReceivables FinancingPledging Accounts ReceivableFactoring Accounts ReceivableInventory FinancingTypes of Inventory FinancingMoney Market InstrumentsCommercial PaperBankers AcceptancesSecuritization of Receivables



*Sources of Short-term FinancingSpontaneous financingAccounts payable and accrualsBank operating loansRevolving credit agreement, line of creditSecured loans for accounts receivable and inventoryMoney market instrumentsCommercial paperBankers acceptancesSecuritization of receivables



*Spontaneous FinancingAccrualsFor example, money you owe employees for work they have performed but not yet been paid Tend to be very short-termAccounts payable (AKA: trade credit)Money you owe suppliers for goods you bought on creditAttractive source of financing No security requiredInterest-freeCredit Terms: Terms of trade specify when you are to repay the debt



*Trade CreditSeller lends buyer purchase price from time of shipment to time of paymentNo security and no interestSeller may offer cash discount for early paymentCost of forgoing a cash discount:



*The Prompt Payment Discount



*Abuses of Trade CreditAbuses of Trade Credit TermsTrade credit is now expected in many businessesCompanies offer it because they have to

Stretching payablesa common abuse of trade creditPaying payables beyond the due date (AKA: leaning on the trade)Slow paying companies receive poor credit ratings in credit reports issued by credit agencies



*Bank Operating LoansRepresent primary source of short-term loans for most companiesProvide financing for working capital and expensesAdvanced against value of receivables and inventoryRepaid from collections on receivablesMay be arranged for specific transactions or as revolving credit agreement or line of credit



*Line of Credit or Revolving Credit Agreement

Line of creditNon-binding agreement to borrow up to predetermined limit at any time Revolving creditLegally commits the bankUsually securedRequires commitment fee on unborrowed funds



*Interest Rates on LoansInterest Rates on LoansPrime rate is rate that bank charges its largest and most creditworthy corporate customers. Interest rates on operating loans are usually based on banks prime rate plus a risk premium



*Interest Rates on LoansLoan rates will depend upon such factors as:How intense is competition among lenders for loan business?How large is the loan?Does borrower have good credit history?Does borrower have adequate and reliable cash flow?Does borrower have adequate security?Is loan guaranteed under a government program?What is term of the loan?What is debt-to-equity ratio?



*Annual Interest Rate where: r = Annual rate I = Interest paid (dollars) P = Principal d = Number of days loan is outstanding



*

Example 5.1: Revolving Credit Agreement

Q: The Arcturus Company has a $10 million revolving credit agreement with its bank at prime plus 2.5%. Prior to June, the company had borrowed $4 million that was outstanding for the entire month. On June 15, it took borrowed $2 million. Prime is 9.5% and the banks commitment fee is 0.25% annually. What bank charges will Arcturus incur for the month of June?



*Example 5.1: Revolving Credit Agreement



*Clean Up Requirements Theoretically a firm can constantly roll-over its short-term debtBorrow on a new note to pay off an old noteRisky for both firm and bank

Banks require that borrowers clean up short-term loans once a yearRemain out of short-term debt for certain time period



*Short-Term Credit Secured by Current Assets

Debt is secured by the current assets being financed ( accounts receivable and inventory)

Common in seasonal businesses such as retail



*Receivables FinancingReceivables Financing: Lenders may extend credit backed by the value of accounts receivableReceivables may make excellent collateral:Fairly liquidEasy to recover in event of defaultCollectibility of accounts is key issueCommon arrangementsPledgingFirm retains titleFactoringFirm sells A/R



*Pledging Accounts ReceivableBorrower uses A/R as collateral for a loanAccounts Receivable still belong to borrower, which still collects the accountsBorrower promises to use collected accounts to pay off loan Lender can provideGeneral line of credit tied to all receivablesSpecific line of credit tied to individual accounts receivableLender generally charges interest at rates over prime, plus an administrative fee.



*Example 5.2: Pledging Accounts Receivable



* Example 5.2: Pledging Accounts Receivable



*Factoring Accounts Receivable

Firm sells Accounts Receivable to lender (at a severe discount) and lending firm (factor) takes control of the accountsAccounts receivable are now paid directly to factorFactor usually reviews accounts and only accepts accounts it deems creditworthy



*Factoring Accounts Receivable

Factors offer wide range of servicesPerform credit checks on potential customersAdvance cash on accounts it accepts or remit cash after collectionCollect cash from customersAssume bad-debt risk when customers dont pay



*Inventory FinancingUse firms inventory as collateral for a short-term loan

Popular but subject to number of problemsLenders arent usually equipped to sell inventorySpecialized inventories and perishable goods are difficult to market



*Types of Inventory FinancingBlanket lienslender has a lien (claim) against all inventories of borrowerBorrower remains in physical control of inventory

Trust receipt (chattel mortgage agreement)collateralized inventory is identified by serial number and cant be sold without lenders permission Borrower remains in physical control of inventory

Warehousingcollateralized inventory is removed from borrowers premises and placed in a warehouse (borrowers access controlled by third party)When inventory is sold, lender is informed to expect money from borrower soon



*Money Market Instruments

Larger corporations may sell short-term debt instruments in the money marketAnother method to borrow to meet temporary cash needsInstruments include commercial paper, bankers acceptances and securitization of receivables



*Commercial PaperNotes issued by large, financially-strong firms and sold to investorsUnsecured (usually)Buyers are usually other corporations and financial institutions Maturity is less than 270 daysConsidered very safe investment, therefore pays a relatively low interest rate (sold at a discount)No flexibility in repayment terms



*Commercial Paper Annual Interest Rate on Discounted Money Market Security

where M = Maturity (face) value of the security P = Discounted price (net proceeds on issue) d = Number of days to maturity r = Annual interest rate



*Bankers Acceptancesbankers acceptancecreated when a bank adds guarantee of payment to the promissory note or draft of the issuer (corporate borrower) Issuer receives money from bank. Bank then sells the bankers acceptance in the money market to an investor. At maturity, bank repays face value to the investor and the issuer repays bankTraded on a discount basis to yield interest rate slightly lower than that of commercial paperUsual terms are 30, 60, and 90 days.



*Securitization of ReceivablesSale of receivables by large firms in public offerings arranged by securities dealers The issuing firm thus receives immediate cash for future cash flows Financing is raised at a relatively low cost, often lower than prime or commercial paper rate, because the issue is asset-backed.


chapter 05 st financing 1ce lecture 050930

Documents

shortterm credit

credit reports

credit agencies

poor credit ratings

terms of trade

trade creditseller

trade creditmoney

time revolving creditlegally