short term financing

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2. Learning Objectives
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The needforshort-termfinancing.
The advantagesanddisadvantagesof short-term
financing.
Types ofshort-term financing.
Computation of the cost of trade credit, commercial
paper,andbank loans.
How touseaccountsreceivableandinventoryascollateral
forshort-term loans.

3. W h y D o F irms Ne e d Short-term
Financing?
Cash flow from operations maynot be sufficient to keep up with
growth-relatedfinancing needs.
Firms mayprefer to borrownowfor their inventory or other short
term asset needs rather than wait until they have saved
enough.
Firms prefer short-term financing instead of long- termsourcesof
financingdueto:
• easieravailability
• usuallyhaslowercost(rememberyield curve)
• matchesneedforshorttermassets, likeinvento3ry

4. Sources of Short-
term Financing
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Short-term Loans.
•borrowingfrombanksandotherfinancial
institutionsforoneyearor less.
Trade Credit.
•borrowingfrom suppliers
CommercialPaper.
•onlyavailabletolargecredit-worthy
businesses.

5. Type of short term Loans
P ro m i s s o r y N o t e
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•A legal IOU that spells out the terms of the loan
agreement,usually the loan amount,the termof the
loanandtheinterest rate.
•Often requires that loan be repaid in full with
interestattheendoftheloan period.
•Usually with a Bank or Financial Institution;
occasionally with suppliers or equipment
manufacturers

6. Types of short-term loans:
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Line of Credit
•The borrowing limit that a bank sets for a firm after
reviewingthecash budget.
•The firm can borrow up to that amount of money
withoutasking,sinceit is pre-approved
•Usually informal agreement and may change over
time
•Usually covers peak demand times, growth
spurts,etc.

7. TradeCredit
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Trade creditistheactofobtainingfundsbydelaying paymentto
suppliers,whotypicallygrant30daystopay.
The costoftradecreditmaybesomeinterestcharge thatthe
supplierchargesontheunpaidbalance.
More often,it isintheformofalostdiscountthatwould be
giventofirmswhopay earlier.
Credit hasacost.
Thatcostmaybepassedalongtothe customerashigherprices,
(furnituresales,OfficeMax), orbornebytheselleraslower
profits, orsomeof both.

8. Estimation of Cost of Short-Term
Credit
Calculationiseasiestif theloanisforaoneyear
period:
Effective InterestRateisusedtodeterminethecostof
thecredittobeabletocompare differingterms.
Effective
Interest Rate
Cost (interest + fees)
Amount you get to use
=
Example: Youborrow$10,000fromabank,ata
stated rateof10%,andmustpay$1,000interestatthe
endof theyear. Youreffectiverateisthesameasthe
stated rate: $1,000/$10,000=.10=10%
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9. VariationsinLoanTerms
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A discountloanrequiresthatinterestbepaidup
frontwhentheloanis given.
This changes theeffectivecost intheprevious
examplesinceyouonlygettouse:
($10,000- $1,000)= $9,000.
Effective rate(APR) =$1,000/$9,000=.1111=
11.11%.

10. Variations in Loan terms
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 yourcompensatingbalancerequirement is$500,thenthe
amountyoucanuseisreducedby thatamount.
Effective Rate(APR)fora$10,000simpleinterest 10%loan
witha$500compensatingbalance =
$1,000/($10,000-$500)=.1053=10.53%.10

11. BothDiscountInterest
andCompensatingBalance
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Sometimes, lenders will require both discount interest
(paidinadvance)andacompensating balance.
If theinterestis$1,000andthecompensating balance
is$500,thentheeffectiverate(APR) becomes:
$1,000 / $10,000- $1,000- $500
$1,000 / $8,500= 11.76%

12. Cost of Shor t Term Credit
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COST OF TRADE CREDIT .
•Typicallyreceiveadiscountif youpayearly.
•Statedas: 2/10,net 60
Purchaserreceivesa2%discountif
paymentismadewithin10daysofthe
invoicedate,otherwisepaymentisdue
within60daysoftheinvoicedate.
•Thecostisintheformofthelostdiscountif
youdon’ttake it.

13. Calculating APR (sameasEIR)
$ Interest=RatexPrinciplexTime
i.e. Int = 6% x $1,000 x 90/360 = $15
APR=$Interest (cost) x
$Net Borrowed
APR=$15 x
$1,000
1
Time
1/ 90 = 1.5% x 4= 6.0%
360
Sayyouhavealoanfeeof$5.00, then
= 2.0%x4=8.0%APR =$15+$5 x1/90
1,000 360

14. Cost of TradeCredit2/10net
6 0
Assumeyourpurchaseis$100list price.
If youtakethediscount,youpayonly$98.Ifyoudon’t takethediscount,youpay
$100.
Therefore, you (buyer) are paying $2 for the privilege of borrowing $98 for the
additional50days.(Note:thefirst 10daysarefreeinthisexample).
APR =$2/$98x365/50=14.9%(Ifyoupayin60days)
What if 2%/10,net30
APR =$2/$98x365/20=37.25%! (Ifyoupayin30 days)
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15. CommercialPaper
Commercial paperis quotedonadiscountbasis,
meaningthattheinterestissubtractedfromtheface
valuetoarriveat theprice. See3stepsbelowfor
calculation:
Step 1: Computethediscount(D)fromfacevalueofthe
commercialpaper
• Discount(D)=(Discountratexparx DTG)/365
• DTG=daystogo(tomaturity)
Step 2: Compute theprice=Facevalue - Discount
Step 3: ComputeEffectiveAnnualRate(APR):
$interest youpay/$yougetto use

16. Cost of Commercial Paper
Example .
$1 million issue of 90 day commercial paper
quoted at 4% discount rate.

17. Cost of Commercial Paper
Step 1: Calculate D = .04 x $1 mill. x 90/360 =
$10,000
Step 2: Calculate price (amount you get)
= $1,000,000 - $10,000 = $990,000
Step 3: Calculate effective rate (APR)
= $10,000 / $990,000 = 1.010% x 4 = 4.04%

18. Accounts receivable as Collaterals
A 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

19. Cost of Borowing against
Receivable
Average monthly sales = $100,000
60 dayterms,soaverageAcctRec balance= $200,000
Bank loans70% ofAcctsRec = $140,000
Interest is3% overprime(say8%) = 11% x $140,000=
$15,400
1% feeonall receivables = 1%x$100,000x12 =
$12,000
APR = $15,400+$12,000 x 1/1 = 19.57%!
$140,000

20. Inventor yasColateral
A majorproblemwithinventoryfinancingisvaluingthe
inventory.
For thisreason,lenderswill generallymakealoanin the
amountofonlyafractionofthevalueofthe inventory.
Thefractionwilldifferdependingonthetype of
inventory.
If inventoryislonglived,i.e. lumber,they(lenderora
customer)mayloanyouupto75%oftheresale value.
If inventoryisperishable,i.e., lettuce,youwon’t get
much

21. D I F F E R E N T F I N A N C I N G
O P T I O N S
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22. QUE STI ONS TO AS K WHE N
LO O K I N G F O R F I N A N C I N G
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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?

23. QUESTIONS LENDERS WIL
L ASKBEFORETAKING
DECISION
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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

24. F I N A N C I N G M E T H O D S
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SHORT TERM FINANCING
LONG TERM FINANCING

25. S H O R T T E R M L O A N S
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 less2.4

26. C R E D I T L I N E S
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
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.

27. A S S E T - B A S E D F I N A N C I N G
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

28. FACTORING
Similar 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 short-term financing
.

29. T E R M L O A N S
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.

30. L E A S I N G
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.

31. VENTURE CAPITAL
One 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.

32. LETTER 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 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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33. ANGEL INVESTING
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Angel 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.

34. PRI VATE EQUI TY F U N D S
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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.

35. THANK YOU
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