1. Chapter 08
• Sources of Short-Term Financing
By
Md. Shahedur Rahaman Chowdhury
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2. Chapter Outline
• Trade credit from suppliers
• Bank loans
• Commercial paper
• Borrowing larger amounts
• Using hedging to offset the risk
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3. Financing Arrangements
• Lines of credit are sometimes referred to as
a revolving credit facility where interest cost:
– Is based on LIBOR (the London Interbank
Offered Rate)
– Is based on the company’s senior unsecured
credit rating – a percentage margin
• Primary aim of the borrowing firms:
– Minimize cost
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4. Trade Credit
• Approximately 40 percent of short-term
financing is in the form of accounts payable
or trade credit
– Accounts payable
• Is a Spontaneous source of funds
• Grows as the business expands
• Contracts when business declines
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5. Payment Period
• Trade credit is usually extended for 30–60
days
• Extending the payment period to an
unacceptable period results in:
– Alienate suppliers
– Diminished ratings with credit bureaus
• Major variable in determining the payment
period:
– The possible existence of a cash discount
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6. Cash Discount Policy
• Allows reduction in price if payment is made
within a specified time period
– Example: A 2/10, net 30 cash discount means:
• Reduction of 2% if funds are remitted 10 days after
billing
• Failure to do so means full payment of amount by the
30th day
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7. Net-Credit Position
• Determined by examining the difference
between accounts receivable and accounts
payable
– Positive if accounts receivable is greater than
accounts payable and vice versa
– Larger firms tend to be net providers of trade
credit (relatively high receivables)
– Smaller firms in the relatively user position
(relatively high payables)
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8. Bank Credit
• Provide self-liquidating loans
– Use of funds ensures a built-in or automatic
repayment scheme
• Changes in the banking sector today:
– Centered around the concept of ‘full service
banking’
– Expanded internationally to accommodate world
trade and international corporations
– Deregulation has created greater competition
among other financial institutions
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9. Prime Rate and LIBOR
• Prime rate
– Rate a bank charges to its most creditworthy
customers
– Increases as a customer’s credit risk increases
• LIBOR (London Interbank Offered Rate)
– Rate offered to companies:
• Having an international presence
• Ability to use the London Eurodollar market for loans
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10. Prime Rate versus LIBOR on U.S.
Dollar Deposits
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11. Compensating Balances
• A fee charged by the bank for services
rendered or an average minimum account
balance
– When interest rates are lower, the compensating
balance rises
– Required account balance computed on the
basis of:
• Percentage of customer loans outstanding
• Percentage of bank commitments towards future
loans to a given account
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12. Maturity Provisions
• Term loan
– Credit is extended for one to seven years
– Loan is usually repaid in monthly or quarterly
installments
– Only superior credit applicants, qualify
– Interest rate fluctuates with market conditions
• Interest rate may be tied to the prime rate or LIBOR
8-12

13. Cost of Commercial Bank Financing
• Effective interest on a loan is based on
the:
– Loan amount
– Dollar interest paid
– Length of the loan
– Method of repayment
– Discounted loan – interest is deducted in
advance – effective rate increases
Effective rate = Interest × Days in the year (360)
Principal-interest Days loan is outstanding 8-13

14. Interest Costs with Compensating
Balances
• Assuming that 6% is the stated annual rate and that 20% compensating
balance is required;
Effective rate with = Interest
compensating balances (1 – c)
= 6% = 7.5%
(1 – 0.2)
• When dollar amounts are used and the stated rate is not known, the
following can be used for computation:
Days in a
Effective rate with = Interest × year (360)
compensating balances Principal – Compensating Days loan is
balance in dollars outstanding
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15. Rate on Installment Loans
• Installment loans require a series of equal
payments over the period of the loan
– Federal legislation prohibits a misrepresentation
of interest rates, however this may be misused
Effective rate on installment loan = 2 × Annual no. of payments × Interest
(Total no. of payments + 1) × Principal
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16. Annual Percentage Rate
• Truth in Lending Act of 1968 requires the
actual APR to be given to the borrower
• Annual percentage rule:
– Protects unwary consumer from paying more
than the stated rate
– Requires the use of the actuarial method of
compounded interest during computation
• Lender must calculate interest for the period on the
outstanding loan balance at the beginning of the
period
– It is based on the assumptions of amortization
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17. The Credit Crunch Phenomenon
• The Federal Reserve tightens the growth in the
money supply to combat inflation – the affect:
– Decrease in funds to be lent and an increase in interest rates
– Increase in demand for funds to carry inflation-laden inventory and
receivables
– Massive withdrawals of savings deposits at banking and thrift
institutions, fuelled by the search for higher returns
• Credit conditions can change dramatically and
suddenly due to:
– Unexpected defaults
– Economic recessions
– Changes in monetary policy
– Other economic setbacks
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18. Financing Through Commercial
Paper
• Short-term, unsecured promissory notes
issued to the public
– Finance paper / direct paper
– Dealer paper
– Asset-backed commercial paper
• Book-entry transactions
– Computerized handling of commercial paper,
where no actual certificate is created
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19. Total Commercial Paper
Outstanding
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20. Advantages of Commercial Paper
• May be issued at below the prime interest
rate
• No associated compensating balance
requirements
• Associated prestige for the firm to float their
paper in an elite market
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21. Disadvantages of Commercial Paper
• Many lenders have become risk-averse
post a multitude of bankruptcies
• Firms with downgraded credit rating do not
have access to this market
• The funds generation associated with this
is less predictable
• Lacks the degree of commitment and
loyalty associated with bank loans
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22. Foreign Borrowing
• Eurodollar loan
– Denominated in dollars and made by foreign
bank holding dollar deposits
– Short-term to intermediate terms in maturity
– LIBOR is the base interest paid on loans for
companies of the highest quality
• One approach – borrow from international
banks in foreign currency
– Borrowing firm may suffer currency risk
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23. Use of Collateral in Short-Term
Financing
• Secured credit arrangement when:
– Credit rating of the borrower is too low
– Need for funds is very high
– Primary concern – whether the borrower can
generate enough cash flow to liquidate the loan
when due
• Uniform Commercial Code
– Standardizes and simplifies the procedures for
establishing security against a loan
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24. Accounts Receivable Financing
• Includes:
– Pledging accounts receivables
– Factoring or an outright sale of receivables
• Advantage:
– Permits borrowing to be tied directly to the level
of asset expansion at any point of time
• Disadvantage:
– Relatively expensive method of acquiring funds
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25. Pledging Accounts Receivables
• Lending firm decides on the receivables that
it will use as a collateral
• Loan percentage depends on the firms:
– The financial strength
– The creditworthiness
• Interest rate is well above the prime rate
– Computed against the balance outstanding
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26. Factoring Receivables
• Receivables are sold outright to the finance
company
– Factoring firms do not have recourse against the
seller of the receivables
– Finance companies may do all or part of the
credit analysis to ensure the quality of the
accounts
– Factoring firm is:
• Absorbing risk – for which a fee is collected
• Actually advancing funds to the seller – paid a lending
rate
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27. Factoring Receivables – Example
• If $100,000 a month is processed at a 1% commission, and a
12% annual borrowing rate, the total effective cost is computed
on an annual basis
1%......Commission
1%......Interest for one month (12% annual/12)
2%......Total fee monthly
2%......Monthly X 12 = 24% annual rate
• The rate may not be considered high due to factors of risk
transfer, as well as early receipt of funds
• It also allows the firm to pass on much of the credit-checking cost
to the factor
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28. Asset Backed Public Offering
• There is an increasing trend in public
offerings of security backed by receivables
as collateral
– Interest paid to the owners is tax free
– Advantages to the firm:
• Immediate cash flow
• High credit rating of AA or better
• Provides
– Corporate liquidity
– Short-term financing
– Disadvantage to the buyer:
• Risk associated – receivables actually being paid
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29. Inventory Financing
• Factors influencing use of inventory:
– Marketability of the pledged goods
– Associated price stability
– Perishability of the product
– Degree of physical control that the lender can
exercise over the product
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30. Stages of Production
• Stages of production
– Raw materials and finished goods usually
provide the best collateral
– Goods in process may qualify only a small
percentage of the loan
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31. Nature of Lender Control
• Provides greater assurance to the lender but
higher administrative costs
• Types of Arrangements:
– Blanket inventory liens
• Lender has a general claim against inventory
– Trust receipts (floor planning)
• An instrument – the proceeds from sales go to the lender
– Warehousing
• A receipt issue – goods can be moved only with the lender’s
approval
• Public warehousing
• Field warehousing
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32. Appraisal of Inventory Control
Devices
• Well-maintained control measures involves:
– Substantial administrative expenses
– Raise overall cost of borrowing
– Extension of funds is well synchronized with
needs
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33. Hedging to Reduce Borrowing Risk
• Engaging in a transaction that partially or
fully reduces a prior risk exposure
• The financial futures market:
– Allows the trading of a financial instrument at a
future point in time
– No physical delivery of goods
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34. Hedging to Reduce Borrowing Risk
(cont’d)
– In selling a Treasury bond futures contract, the
subsequent pattern of interest rates determine if
it is profitable or not
Sales price, June 2006 Treasury
bond contract* (sale occurs in January 2006.)……………$100,000
Purchase price, June 2006 Treasury
bond contract (purchase occurs in June 2006)……………. $95,000
Profit on futures contract………….…………………………….$5,000
* Only a small percentage of the actual dollars involved must be invested to
initiate the contract. This is known as the margin
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35. Hedging to Reduce Borrowing Risk
(cont’d)
– If interest rates increase
• The extra cost of borrowing money to finance the
business can be offset by the profit of the futures
contract
– If interest rates decrease
• A loss is garnered on the futures contract as the bond
prices rise
• This is offset by the lower borrowing costs of the
financing firm
– The purchase price of the futures contract is
established at the time of the initial purchase
transaction
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36. End
Q
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37. Q&A
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38. Thank You.
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