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Short Term Short Term FinancingFinancing

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Learning ObjectivesLearning ObjectivesThe need for short-term financing.The advantages and disadvantages of

short-term financing.Types of short-term financing.Computation of the cost of trade credit,

commercial paper, and bank loans.How to use accounts receivable and

inventory as collateral for short-term loans.

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Why Do Firms Need Why Do Firms Need Short-term Financing?Short-term Financing?

Cash flow from operations may not be sufficient to keep up with growth-related financing needs.

Firms may prefer to borrow now for their inventory or other short term asset needs rather than wait until they have saved enough.

Firms prefer short-term financing instead of long-term sources of financing due to:• easier availability

• usually has lower cost (remember yield curve)

• matches need for short term assets, like inventory

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Sources of Short-term Sources of Short-term FinancingFinancing

Short-term Loans.

• borrowing from banks and other financial institutions for one year or less.

Trade Credit.

• borrowing from suppliersCommercial Paper.

• only available to large credit- worthy businesses.

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Types of short-term Types of short-term loans:loans: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.

• Often requires that loan be repaid in full with interest at the end of the loan period.

• Usually with a Bank or Financial Institution; occasionally with suppliers or equipment manufacturers

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Types of short-term Types of short-term loans:loans:

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.

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Trade CreditTrade CreditTrade 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.Credit has a cost. That cost may be passed along to the

customer as higher prices, (furniture sales, Office Max), or borne by the seller as lower profits, or some of both.

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Estimation of Cost of Short-Term Estimation of Cost of Short-Term CreditCreditCalculation is easiest if the loan is for a one year

period:Effective Interest Rate is used to determine the cost of

the credit to be able to compare differing terms. Effective Interest Rate

Cost (interest + fees) Amount you get to use

=

Example:Example: You borrow $10,000 from a bank, at a stated rate of 10%, and must pay $1,000 interest at the end of the year. Your effective rate is the same as the stated rate: $1,000/$10,000 = .10 = 10%

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Variations in Loan TermsVariations in Loan TermsA discount loan requires that interest be paid up

front when the loan is given.This changes the effective cost in the previous

example since you only get to use:

($10,000 - $1,000) = $9,000.Effective rate (APR) = $1,000/$9,000 = .1111 =

11.11%.

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Variations in Loan Variations in Loan TermsTerms

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.

If your compensating balance requirement is $500, then the amount you can use is reduced by that amount.

Effective Rate (APR) for a $10,000 simple interest 10% loan with a $500 compensating balance = $1,000/($10,000-$500) = .1053 = 10.53%.

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Both Discount Interest Both Discount Interest and Compensating Balanceand Compensating BalanceSometimes, lenders will require both discount

interest (paid in advance) and a compensating balance.

If the interest is $1,000 and the compensating balance is $500, then the effective rate (APR) becomes:

$1,000 / $10,000 - $1,000 - $500$1,000 / $8,500 = 11.76%

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Cost of Short Term Cost of Short Term CreditCreditCost of Trade Credit

• Typically receive a discount if you pay early.

• Stated as: 2/10, net 60Purchaser 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.

• The cost is in the form of the lost discount if you don’t take it.

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Calculating APR Calculating APR (same as (same as EIR)EIR)$ Interest = Rate x Principle x Timei.e. Int = 6% x $1,000 x 90/360 = $15APR = $ Interest (cost) x 1

$ Net Borrowed Time

APR = $15 x 1 / 90 = 1.5% x 4 = 6.0%

$1,000 360

Say you have a loan fee of $5.00, then

APR = $15 + $5 x 1/90 = 2.0% x 4 = 8.0%

1,000 360

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Cost of Trade Credit 2/10 net Cost of Trade Credit 2/10 net 6060

Assume your purchase is $100 list price.If you take the discount, you pay only $98. If you don’t

take the discount, you pay $100.Therefore, you (buyer) are paying $2 for the privilege of

borrowing $98 for the additional 50 days. (Note: the first 10 days are free in this example).

APR = $2/$98 x 365/50 = 14.9% (If you pay in 60 days)What if 2%/10, net 30APR = $2/$98 x 365/20 = 37.25%! (If you pay in 30 days)

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Commercial PaperCommercial PaperCommercial 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 par x DTG)/365

• DTG = days to go (to maturity)Step 2: Compute the price = Face value - DiscountStep 3: Compute Effective Annual Rate (APR):

$ interest you pay/ $ you get to use

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Cost of Commercial Paper Cost of Commercial Paper ExampleExample$1 million issue of 90 day commercial paper quoted at 4%

discount rate.Step 1:Step 1: Calculate D = .04 x $1 mill. x 90 = $10,000

360

Step 2:Step 2: Calculate price (amount you get) = $1,000,000 - $10,000 = $990,000

Step 3:Step 3: Calculate effective rate (APR) = $10,000 / $990,000 = 1.010% x 4 = 4.04%

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Accounts Receivable as Accounts Receivable as CollateralCollateralA pledge is a promise that the borrowing firm will pay

the lender any payments received from the accounts receivable collateral in the event of default.

Since accounts receivable fluctuate over time, the lender may require certain safeguards to ensure that the value of the collateral does not go below the balance of the loan.

So, normally a bank will only loan you 70 -75% of the receivable amount

Accounts receivable can also be sold outright. This is known as factoring.

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Cost of Borrowing against ReceivablesCost of Borrowing against ReceivablesAverage monthly sales = $100,00060 day terms, so average Acct Rec balance = $200,000 Bank loans 70% of Accts Rec = $140,000Interest is 3% over prime (say 8%) = 11% x $140,000 =

$15,4001% fee on all receivables = 1% x $100,000 x 12 =

$12,000APR = $15,400 + $12,000 x 1/1 = 19.57%!

$140,000

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Inventory as CollateralInventory as CollateralA major problem with inventory financing is valuing the

inventory. For this reason, lenders will generally make a loan in

the amount of only a fraction of the value of the inventory. The fraction will differ depending on the type of inventory.

If inventory is long lived, i.e. lumber, they (lender or a customer) may loan you up to 75% of the resale value.

If inventory is perishable, i.e., lettuce, you won’t get much

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DIFFERENT FINANCING DIFFERENT FINANCING

OPTIONSOPTIONS

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QUESTIONS TO ASK WHEN QUESTIONS TO ASK WHEN LOOKING FOR FINANCINGLOOKING FOR FINANCING

WHAT AMOUNT DO I NEED?HOW DO I RAISE THE FUND? IS IT

THROUGH EQUITY OR DEBT?WHAT INFORMATION DO I NEED TO

PROVIDE THE LENDER/INVESTORWHAT ARE THE REPAYMENT TERMS?

DO I HAVE TO PAY INTEREST? IF SO, WILL IT VARY OVER TIME OR FIXED?

HOW LONG WILL IT TAKE TO ACQUIRE THE FUNDS?

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QUESTIONS LENDERS WILL QUESTIONS LENDERS WILL ASK BEFORE TAKING ASK BEFORE TAKING DECISIONDECISION

INFORMATION TO DERTERMINE HOW THE BUSINESS IS MANAGED

THE SIZE OF THE LOAN AS COMPARED TO HOW MUCH YOU HAVE

COMPANY’S ABILITY TO LIQUIDATE ITS CURRENT ASSETS

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FINANCING METHODSFINANCING METHODS

SHORT TERM FINANCINGLONG TERM FINANCING

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SHORT TERM LOANSSHORT TERM LOANS

Use for seasonal build-ups of inventory and receivables, as well as to take advantage of supplier discounts or pay lump-sum expenses, such as taxes or insurance.

Repayment is usually in a lump sum with interest at maturity

Short-term loans are generally made on a secured (or collateralized) basis and are for a term of a year or less.

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CREDIT LINESCREDIT LINESThe lender, usually a bank, supplies a business with

funds intended to fill temporary shortages in cash that are brought about by timing differences between cash outlays and collections.

They are typically used to finance inventories, accounts receivable or for project or contract related work.

A track record is often needed before approving a credit line and collateral may be required.

Banks will generally require maintenance of certain balances of funds in your commercial bank account.

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ASSET - BASED ASSET - BASED FINANCINGFINANCING

A lender accepts as collateral the assets of a company in exchange for a loan.

The loan is used as a source of funds for working capital needs.

Most asset based loans are financed against accounts receivable since they self-liquidate in a short period of time by themselves

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FACTORINGFACTORINGSimilar to accounts receivable financing with one

notable exception. Factors actually buy your receivables and rely on

their own credit and collection expertise. Essentially, your customers

become their customers. Payments are made directly to the factor by your

buyer.Factoring is generally used by firms unable to

obtain bank financing. As a result, the cost of factoring is usually higher than other forms of short-term financing.

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TERM LOANSTERM LOANSUse to finance your permanent working capital,

purchase of new equipment, construction of buildings, business expansion, refinance existing debt and business acquisitions.

Term loans are repaid from the long-term earnings of the business.

Therefore, projected profitability and cash flow from operations are two key factors lenders consider when making term loans.

Generally, interest rates on long- term loans are higher than for short-term loans.

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LEASINGLEASINGThis has become a significant source of

intermediate-term financing for small companies in recent years.

Any type of fixed asset may be financed through a leasing arrangement.

Leasing can be accomplished through a leasing company, commercial bank, the equipment owner or a commercial finance company.

Leasing offers a great deal of flexibility as it can be used to finance even small amounts.

The leasing company will be particularly interested in the cash flow of your company.

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VENTURE CAPITALVENTURE CAPITALOne problem many new businesses face is raising

sufficient capital. A business in its primary phase will also face a

difficult challenge getting a bank loan. Venture capital firms offer capital in exchange

for equity in a company. This type of financing is ideal for new

businesses since venture capital firms focus mainly on the future prospects of a company when banks use past performance as a primary criteria.

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LETTER OF CREDITLETTER OF CREDITA letter of credit is a guarantee from a

bank that a specific obligation will be honored by the bank if the borrower fails to pay.

Letters of credit can be useful when dealing with new vendors who may not be assured of a company's credit worthiness.

The bank would then offer a letter of credit as an assurance to the vendor of payment. Although no funds are paid by the bank.

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ANGEL INVESTINGANGEL INVESTINGAngel investor or Business angel is an

affluent individual who provides capital for a start – up business usually in exchange for convertible debt or ownership equity

A small but increasing number of angel investors are organizing themselves into angel networks or angel groups to share research and pool their investment capital.

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PRIVATE EQUITY FUNDS

A fund that invests in companies and/or entire business units with the intention of obtaining a controlling interest (usually by becoming a majority shareholder, sometimes by becoming the largest plurality shareholder) so as to be in the position of restructuring the target company's reserve capital, management, and organizational infrastructure.

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