Learning ObjectivesLearning Objectives
The need for short-term financing.
The advantages and disadvantages of
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.
Why Do Firms NeedWhy 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
Sources of Short-termSources of Short-term
• borrowing from banks and other financial
institutions for one year or less.
• borrowing from suppliers
• only available to large credit- worthy
Types of short-termTypes of short-term
• 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
Types of short-termTypes 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
• Usually covers peak demand times, growth
Trade CreditTrade Credit
Trade 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.
Estimation of Cost of Short-TermEstimation of Cost of Short-Term
Calculation is easiest if the loan is for a one year
Effective Interest Rate is used to determine the cost of
the credit to be able to compare differing terms.
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%
Variations in Loan TermsVariations in Loan Terms
A 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 =
Variations in LoanVariations in Loan
TermsTermsSometimes 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
Effective Rate (APR) for a $10,000 simple interest
10% loan with a $500 compensating balance =
$1,000/($10,000-$500) = .1053 = 10.53%.
Both Discount InterestBoth Discount Interest
and Compensating Balanceand Compensating Balance
Sometimes, lenders will require both discount
interest (paid in advance) and a compensating
If the interest is $1,000 and the compensating
balance is $500, then the effective rate (APR)
$1,000 / $10,000 - $1,000 - $500
$1,000 / $8,500 = 11.76%
Cost of Short TermCost of Short Term
CreditCreditCost of Trade Credit
• Typically receive a discount if you pay early.
• Stated as: 2/10, net 60
Purchaser 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.
Calculating APRCalculating APR (same as(same as
$ Interest = Rate x Principle x Time
i.e. Int = 6% x $1,000 x 90/360 = $15
APR = $ Interest (cost) x 1
$ Net Borrowed Time
APR = $15 x 1 / 90 = 1.5% x 4 = 6.0%
Say you have a loan fee of $5.00, then
APR = $15 + $5 x 1/90 = 2.0% x 4 = 8.0%
Cost of Trade Credit 2/10 netCost of Trade Credit 2/10 net
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 30
APR = $2/$98 x 365/20 = 37.25%! (If you pay in 30 days)
Commercial PaperCommercial Paper
Commercial 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
Step 1: Compute the discount (D) from face value of the
• Discount (D) = (Discount rate x par x DTG)/365
• DTG = days to go (to maturity)
Step 2: Compute the price = Face value - Discount
Step 3: Compute Effective Annual Rate (APR):
$ interest you pay/ $ you get to use
Cost of Commercial PaperCost of Commercial Paper
ExampleExample$1 million issue of 90 day commercial paper quoted at 4%
Step 1:Step 1: Calculate D = .04 x $1 mill. x 90 = $10,000
Step 2:Step 2: Calculate price (amount you get)
= $1,000,000 - $10,000
Step 3:Step 3: Calculate effective rate (APR)
= $10,000 / $990,000 = 1.010% x 4 = 4.04%
Accounts Receivable asAccounts 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
Accounts receivable can also be sold outright. This is
known as factoring.
Cost of Borrowing against ReceivablCost of Borrowing against Receivabl
Average monthly sales = $100,000
60 day terms, so average Acct Rec balance = $200,000
Bank loans 70% of Accts Rec = $140,000
Interest is 3% over prime (say 8%) = 11% x $140,000 =
1% fee on all receivables = 1% x $100,000 x 12 =
APR = $15,400 + $12,000 x 1/1 = 19.57%!
Inventory as CollateralInventory as Collateral
A major problem with inventory financing is valuing the
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
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
DIFFERENT FINANCINGDIFFERENT FINANCING
QUESTIONS TO ASK WHENQUESTIONS 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/INVESTOR
WHAT 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?
QUESTIONS LENDERS WILLQUESTIONS LENDERS WILL
ASK BEFORE TAKINGASK BEFORE TAKING
INFORMATION TO DERTERMINE
HOW THE BUSINESS IS MANAGED
THE SIZE OF THE LOAN AS
COMPARED TO HOW MUCH YOU
COMPANY’S ABILITY TO
LIQUIDATE ITS CURRENT ASSETS
FINANCING METHODSFINANCING METHODS
SHORT TERM FINANCING
LONG TERM FINANCING
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
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.
CREDIT LINESCREDIT LINES
The 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
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
ASSET - BASEDASSET - BASED
FINANCINGFINANCINGA lender accepts as collateral the
assets of a company in exchange for a
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
Similar to accounts receivable financing with one
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
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
TERM LOANSTERM LOANS
Use 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.
This 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.
VENTURE CAPITALVENTURE CAPITAL
One problem many new businesses face is raising
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
LETTER OF CREDITLETTER OF CREDIT
A letter of credit is a guarantee from a
bank that a specific obligation will be
honored by the bank if the borrower fails
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
ANGEL INVESTINGANGEL INVESTING
Angel investor or Business angel is an
affluent individual who provides capital
for a start – up business usually in
exchange for convertible debt or
A small but increasing number of angel
investors are organizing themselves into
angel networks or angel groups to share
research and pool their investment
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