This document discusses short-term financing options for businesses including trade credit, commercial paper, and bank loans. It describes the advantages of short-term financing over long-term options and outlines three main types: short-term loans, trade credit, and commercial paper. Key details on calculating costs and effective interest rates for each type are provided. The use of accounts receivable and inventory as collateral for short-term loans is also explained.

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Short TermShort Term
FinancingFinancing
By: Nerissa E. Maglalang

2.  The need for short-term financing.
 The advantages and disadvantages
of short-term financing.
 Three 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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3.  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
 matches need for short term assets, like inventory
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4.  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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5.  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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6.  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. 6

7.  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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8.  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.
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Effective
Interest Rate
Cost (interest + fees)
Amount you get to use
=
Example:Example: You borrow Php10,000 from a bank, at a
stated rate of 10%, and must pay Php1,000 interest at
the end of the year. Your effective rate is the same as
the stated rate: Php1,000/10,000 =.10 = 10%

9.  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:
(Php10,000 - Php1,000) = Php9,000.
 Effective rate (APR) =
Php1,000/Php9,000 = .1111 = 11.11%.
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10.  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 Php10,000 simple
interest 10% loan with a Php500
compensating balance = Php1,000/
(Php10,000-$500) = .1053 = 10.53%.
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11.  Sometimes, lenders will require both
discount interest (paid in advance) and
a compensating balance.
 If the interest is Php1,000 and the
compensating balance is Php500, then
the effective rate (APR) becomes:
 Php1,000 / Php10,000 - Php1,000 -
Php500
 Php1,000 / Php8,500 = 11.76%
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12.  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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13. Interest = Rate x Principle x Time
 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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14.  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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15.  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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16.  1 million issue of 90 day commercial paper
quoted at 4% discount rate.
Step 1:Step 1: Calculate D=.04 x1 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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17.  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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18.  Average monthly sales = 100,000
 60 day terms, so average Acct Rec.bal. =
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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19.  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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20. The End!
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