2. Specific Objectives
At the end of the chapter, the learners should be able to:
Explain the advantages and disadvantages of short-term funds
for a firm.
Describe the different suppliers of short-term funds.
Explain the advantages of intermediate-term funds.
Describe the different suppliers of intermediate-term funds.
Define loan agreement.
Explain long-term financing and discuss the different sources
and uses of long- term funds.
Discuss the different types of stocks and how they are classified
in the market.
Explain corporate bonds as a source of long-term financing.
Discuss the 5Cs of credit.
3. Categories
Category 1 Category 2 Category 3
Firms make money by selling
their products and services
for a price which is higher
than what it would to
produce those products to
deliver the service to
customers. Firms make
money when they earn
profits from business
transactions. Ideally, the bulk
of a firm’s funds should come
from this category.
Firms can borrow money.
One disadvantages of
borrowing money is the
interest charges that the firm
has to pay over time. A firm
with a good
reputation in terms of ability
to pay its financial
obligations will naturally
have better access to loans
with better (lower) interest
rates.
Firms can also seek funds
from investors. Corporation
sells stocks. Partnerships
and sole proprietorships
are funded by their owners
in the form of additional
capital. Here, interest
charges are avoided.
However, profits have to be
shared between owners.
Dividends are paid in the
case of corporations.
5. Short Term Loans provide the following advantages to the firm:
Short-term loans are easier to obtain.
Financial institutions charge less interest on short-term loans.
There is flexibility in terms of options.
One of the factors that affects the level of risk on loans is the term or
length of the payment period. Short-term loans are not as risky as long-term
loans. If a firm has a good relationship with banks and financing institutions,
securing short-term loan is usually easy. The firm may even be given an
unsecured loan.
Financial institutions charge less interest on short-term loans. Firms do not
spend much on dept servicing (interest charges) of short- term loans.
Because of the relatively low risk, the return required by bank and financing
companies is lower compared to what they would require on riskier loans.
There are many types of short-term loans offered by different financial
institutions. Depending on the need of the firm, there are several options
available. At times, even the corporate credit cards provide credit limits
whose caps are high enough to allow the purchase of new equipment.
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6. Disadvantages of Short Term Loans:
The following are the disadvantages of short-term loans:
A firm that has easy access to short-term loans may become more
relaxed in the way they manage their working capital.
Firms with slow-moving inventories may end up with an even tighter
financial position. As short-term loans mature and money is still tied up
to inventories, the firm’s short liquidity will be compromised; as a result,
it may not be able to settle its long-term obligations.
Short-term loans, may not be strategically aligned with the firm’s long-
term objectives. The firm will have to use the long-term sources of funds
such as long-term loans for project that require larger funds, and with a
duration that is estimated to last for more than one year. The role of
the finance manager is to properly evaluate each project proposal or
program to make sure that there is a proper matching of which sources
of funds to use.
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2
3
7. Suppliers of Short Term Funds
Trade Creditors
Order fulfillment
Commercial banks
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03
02 07
05
06
04
Insurance Companies
Company Accruals
Factors
Finance companies
8. Trade Creditors
Suppliers extend credit to a firm. In effect, this becomes a source of fund
because money that should have been allocated for the payment of
suppliers (including inventories) may now be use for something else. A trade
credit is unsecured. If a firm purchase machineries and equipment, it does
not qualify as trade credit because the loan is secured by the machineries
and equipment which serves as collateral. Furthermore, purchase of high
peso value equipment is on installment or several payments in equal
increments over a specified period of time. Trade creditors, depending on the
amount of the supplies or inventories purchased, may require a firm to
submit a promissory note. The loan is still unsecured but the promissory note
serves as the written promise by the firm to pay the supplier the amount
owed with in the specified term stated on the letter. Promissory notes are
often used as evidence when cases involving uncollected debt are taken to
court for litigation.
9. What finance managers need to realize is that the trade credits do not
come without cost to the firm as suppliers, provide firms with discounts if they
settle account early. If a firm does not pay within the period when the
discount may be availed, then that becomes a cost for the firm. It is
computed as follows:
Annual cost of not taking
discount
=
Discount
1 - Discount
x
360 Days
Number of discount
day's credit - period
10. Annual cost of not taking
discount
If a firm’s supplier offers a credit term of 3/7, net 45, this means that the firm
will get a 3% discount on invoice if it paid within 7 days after delivery date. If unpaid
after 7 days, the due date will be in 45 days. The annual cost of not taking discount is
computed as follows:
= x
0.03
1 - 0.03
360
45 days - 7 days
Annual cost of not taking
discount
=
0.03
0.97
x
360
38
Annual cost of not taking
discount
= 29.28 %
11. Comercial Banks
Commercial banks are considered the “department store for
finance” because they cater to a variety of savers and borrowers. As
such commercial banks also offer a wide array of products and
services to suit the diverse needs of their clients.
Commercial banks offer short-term loans to firm to finance business
activities. Again, short-term loans are loans that will mature within 1
year or less. As discussed earlier, short-term loans may either secured
or unsecured. Commercial banks also offer intermediate or medium-
term loans and long-term loans to individual and business clients. An
intermediate loan is a loan that will mature in 1-10 years. On the other
hand, a long-term loan is a loan that will mature in 10 years or more.
Nowadays, big commercial banks have an even more diversified list of
financial products that are offered to clients. In the Philippines, the most
notable commercial banks offer not just savings and loans. They also offer
investment products such as those similar to mutual funds, retirements
funds, and even specialized products designed for the needs of OFW and
their families.
12. Finance Companies
Finance companies are firms whose line of business is to provide short-
term and intermediate loans to both consumers and other businesses.
Just like commercial banks, loans are granted by finance companies may
either be secured or unsecured. There are finance companies that only
cater to the needs of small businesses or small to medium enterprises.
There also finance companies whose main core of business is the
purchase of installment receivables from retailers of automobiles,
household appliances, machineries and equipment and other durable
goods sold on the installment payment plan. After the purchase is
complete, the debtors are then notified that they are now dealing with a
different company for the repayment of the installment
loan.
13. Factors
Factoring is a financial service, wherein a factor purchases accounts
receivables. The factors become the owner of the receivables and are now
responsible in collecting those from customers. The factors also assume
the risk of incurring credit losses such as bad debts. There is no recourse of
action against the sellers of those receivables even in cases of default. On
the other hand, the factors do not take responsibility for disputes
concerning shipments and/or defective goods.
For the borrowing firm, factoring becomes immensely helpful as the
receivables become collateral for a loan (something that the firm may not
even have such as a parcel of land or requirement that may be use as
collateral.
Factoring is more expensive than the regular loan or other financing
schemes, but this works best for new businesses that have yet to establish
a relationship with banks and other financial institutions.
14. Company Accruals
An accrual is an expense that has been incurred by the firm but has not
yet paid. Similar to the trade credits, accruals, in effect, provide a short-term
financing for firms because money could be used to either support
operations or pay other financing obligations. There are two major types of
accruals: accrued wages and salaries and accrued taxes.
Commercial Papers
Firms issue commercial papers either directly investors or through dealers
in exchange for a minimum commission. A commercial paper is an
unsecured debt with fixed maturity. Businesses issue commercial papers to
finance their short-term working capital needs. Firms on the other hand,
issue commercial papers at a discount which serves as the interest. The
rates applied are higher on commercial papers with longer terms to
maturity.
15. For instance, XYZ Inc. will issue commercial papers with a face value of
P10,000 each. It will be sold to investors for only P9,000. This means that the
earning of an investors is P1,000 or 10%.
Since commercial paper is an unsecured debt, this is only an option for
large companies with good credit ratings. Interest rates are low on
commercial papers. Investors who purchase commercial papers from firms
normally use this for temporary parking of funds until they find another
investment that will pay a higher
return.
16. Uses of Short-term Funds
1 To support seasonal increase in demand for its products and/or
services - an increase in demand will require the firm to purchase
more inventories and supplies. Additional manpower will require more
funds devoted to salaries. A firm engage in manufacturing of breads
and pastries will require twice the amount of the flour as early as
November in order to support the increase demand during holidays. A
local construction supply company, on the other hand, will require
additional capital during summer months when most construction
work funded by both private individuals and government agencies
take place.
Payment for short-term obligations- Firms need to satisfy
their financial obligations. At times, they have to resort to
short-term loans in order to repay other obligations such as
money owed to suppliers and tax liabilities.
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3
5
4
Funding for short-term projects and/or programs- Short-term
programs and plans are identified during the annual planning
of any firm. Even that point, the finance manager should already
have an idea of whether there would be sufficient funds or not.
Allowance for receivables- It may take some time before the firm
is able to collect money that is owed to them by customers.
Before sales are actually converted into cash, the firm has to
supply funding to cover maturing obligations and to replenish
inventory.
Funding for unforeseen events- there could be a host of
unforeseen events that may affect the firm’s operations. Such
events may be economic such as a sharp increase in the prices
of inputs and prime commodities, a natural calamity such as a
storm causing damage to a portion of a firm’s building, or
anything that may arise as a result of firm’s operations like a
defective product that negatively affected a customer.
18. Intermediate Term-Financing
1
Intermediate-term financing is commonly used for the
acquisition of assets that would otherwise be hard to finance
using short-term loans or when internal funds are not sufficient.
2
Intermediaries-term financing refers to the loans that will
mature in more than one year but in less than ten years.
Although intermediate-term loans may also used by the firm for
operational concern, the funds obtained from such loans are
mostly allotted for asset expansion and medium-term projects
and programs. The following advantages will be enjoyed by the
firm under this type of financing:
Large firms typically have access to capital markets but not
small to medium enterprises. Just like short-term loans,
intermediate-term financing provides smaller firm access to
funds.
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3
5
4
The process involved in the raising of funds through
intermediate-term financing is not as regulated as in the
process of raising funds through bonds or stocks in the capital
markets.
Interest paid in loans is a tax deductible.
It is typically easier to structure intermediate-term loans. The
size of the funds and the repayment schedules allowed firms to
be flexible in the way they devote funds to asset acquisition and
to projects or programs.
Providers of Intermediate Term-Financing
1. Commercial banks
2. Finance companies
3. Factors
4. Insurance
5. Government
20. Long Term Financing
a.
b.
A long-term source of funds or long-term financing is tapped by
firms to funds their long-term capital requirements. Long-term
financing is used for the following:
c.
d.
Acquisition of equipment and machineries
Acquisition of furniture and fixtures
Building of a new plant
Major upgrade of facilities- either for expansion or just mere
compliance with regulatory requirements such as food
manufacturing company wanting to comply with Good
Manufacturing Practices (GMP) standards.
e..
e. Acquisition of an existing firm
21. 1
f. To organize a new venture or additional strategic business unit
Two ways by which a firm can finance its long-term
capitalization requirements: sale of share and sale of bonds.
Stock Financing
Is the sale of stocks for the firm to raise long-term funds. When share of
stocks are sold to investors, the effect is the increase of equity. One distinct
advantage of stock financing is that stock do not mature. In the case of
bonds, issuing companies have to go through the process of renewing them
once they are matured. Another advantage of stock financing is that stocks
do not require payment of interest. Issuing companies have to pay dividends
to stockholders only when they are earnings and the board of directors
declares payment of dividends.
22. Two Types of Corporate Stock:
Common Stock
Preferred Stock
Is the type of corporate stocks issued by all corporations. After
payment to creditors, and preferred stocks owners, holders of
common stocks are the last ones paid out of earnings or in the
case of liquidation of assets.
Fixed dividends are paid on preferred stocks. Firms are only
allowed one-time issue of common stocks while preferred
stocks may be issued several times.
23. Corporate Bonds
1
A bond is a long-term debt either by a firm or by the government. A
corporate bond is a bond issued by the private corporation to raise
funds for the long-term projects and programs. Bonds may be
distinguished from stocks by the following characteristics:
2
When a firm sells bonds to the investing public, it means that it will
owe money to the investors. With stocks, the investors become co-
owner of the company.
In the event of liquidation, holders of bonds are prioritized over
stockholders.
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4
Interest payments on bonds are fixed while dividends paid to
stocks depends on the firm’s earnings.
Bonds have a fixed maturity date. Stocks do not have maturity
date.
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5
2
1
Owners of bonds do have voting rights.
Financial institutions or intermediaries need a way to evaluate the
credit worthiness of potential clients (individuals or firms who apply
for credit). There are five characteristics of a borrower that financial
institution use to evaluate their credit worthiness:.
Character- this refers to the applicant’s reputation. The reason
why in the credit application, the loan applicant is required to
write down the names and contact information of the reference.
The 5Cs of Credit
Capacity- this measure one’s capacity to pay. In credit
application, the applicant is required to list down sources of
income, expenses and debt the purpose of such list is to
measure if one has a capacity to pay.
25. 3
5
Capital (equity)- from the perspective of the lender, this
minimize the risk of default.
Collateral- this is the property that is issued to secure the loan.
Long-term loans for larger amounts are typically required to
have collateral.
4
Conditions of the loan- factors such as amount of principal,
interest rate, and terms of payment all have an influence of the
lender’s decision to approve or disapprove the loan application.