This document discusses various types of short-term financing. It defines short-term financing as financing for one year or less, including short-term loans from banks, trade credit from suppliers, and commercial paper. The document outlines the advantages of short-term financing over long-term options and describes how firms can use accounts receivable and inventory as collateral for short-term loans. Various short-term financing sources and their costs are defined, including calculations for determining effective interest rates.

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Short TermShort Term
FinancingFinancing

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Learning ObjectivesLearning Objectives
The 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 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

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Sources of Short-termSources of Short-term
FinancingFinancing
Short-term Loans.
• borrowing from banks and other financial
institutions for one year or less.
Trade Credit.
• borrowing from suppliers
Commercial Paper.
• only available to large credit- worthy
businesses.

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Types of short-termTypes 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-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
over time
• Usually covers peak demand times, growth
spurts,etc.

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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.

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Estimation of Cost of Short-TermEstimation of Cost of Short-Term
CreditCredit
Calculation 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 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 =
11.11%.

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Variations in LoanVariations 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 InterestBoth Discount Interest
and Compensating Balanceand Compensating Balance
Sometimes, 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 TermCost of Short Term
CreditCreditCost 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.

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Calculating APRCalculating APR (same as(same as
EIR)EIR)
$ 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%
$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 netCost 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 30
APR = $2/$98 x 365/20 = 37.25%! (If you pay in 30 days)

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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
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 - Discount
Step 3: Compute Effective Annual Rate (APR):
$ interest you pay/ $ you get to use

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Cost of Commercial PaperCost 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 asAccounts Receivable as
CollateralCollateral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.

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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 =
$15,400
1% fee on all receivables = 1% x $100,000 x 12 =
$12,000
APR = $15,400 + $12,000 x 1/1 = 19.57%!
$140,000

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Inventory as CollateralInventory as Collateral
A 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 FINANCINGDIFFERENT FINANCING
OPTIONSOPTIONS

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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?

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QUESTIONS LENDERS WILLQUESTIONS LENDERS WILL
ASK BEFORE TAKINGASK 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 FINANCING
LONG 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 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
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 - BASEDASSET - BASED
FINANCINGFINANCINGA 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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FACTORINGFACTORING
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 of
short-term financing.

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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.

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LEASINGLEASING
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.

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VENTURE CAPITALVENTURE 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.

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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
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 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
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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