8

Sources of Short-Term
Financing
Block, Hirt, and Danielsen
Foundations of Financial Management
18th edition

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 Learning Objectives
• Remember trade credit from suppliers is normally the
most available form of short-term financing.
• Recall that bank loans are usually short term and should
be paid off from funds from the normal operations of the
firm.
• Define commercial paper.
• Discuss how using accounts receivable and inventory as
collateral for a loan, the firm may be able to borrow
larger amounts.
• Define hedging and explain why it is used.

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 Trade Credit
• Approximately 40 percent of short-term
financing is in form of accounts payable or
trade credit
• Accounts payable
• Spontaneous source of funds
• Grows as business expands
• Contracts when business declines

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 Payment Period
• Trade credit usually extended for 30 to 60 days
• Extending payment period to unacceptable
length may
• Alienates suppliers
• Diminishes ratings with Dun & Bradstreet and
local credit bureaus
• Major variable in determining payment period
• Possible existence of cash discount

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 Cash Discount Policy
• Allows reduction in price if payment is made
within a specified time period
• Example: 2/10, net 30 cash discount means:
• Reduction of 2 percent if funds are remitted 10 days
after billing
• Failure to do so means full payment of amount by the
30th day
Cost of failing to take a cash discount = Discount percent____ ×
100% – Discount percent

_________360________
Final due date – Discount period
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 Net Credit Position
• Determined by examining difference between
accounts receivable and accounts payable
• Positive when accounts receivable are greater
than accounts payable and negative when the
opposite is true
• Larger firms tend to be net providers of trade
credit (relatively high receivables)
• Smaller firms typically in user position (relatively
high payables)

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 Bank Credit
• Banks provide self-liquidating loans
• Use of funds ensures built-in or automatic
repayment scheme
• Changes in banking sector today
• Centered around concept of “full-service banking”
• Expanded internationally to accommodate world
trade and international corporations
• Largest international banks expanding into the
United States through bank acquisitions and
branch offices
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 Bank Credit Continued
• Recession of 2007–2009
• Most severe since Great Depression of 1930s
• Forced many large banks to verge of collapse
• Enactment of Gramm-Leach-Bliley Act in 1999,
commercial banks and investment banks were
allowed to merge
• Mergers allowed banks to take excess risk, which
led to credit problems that started to show up in
2007

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 Bank Credit Concluded
• COVID-19 2020-2021
• Lessons learned from 2007-2009 financial crisis
created a much more stable banking system
during the pandemic
• Bank failures were not a problem.
• Small businesses were predominately affected and
faced bankruptcy
• Federal government offered loan guarantees and
payroll protection funding

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 Prime Rate and LIBOR
• Prime rate
• Rate bank charges to the most creditworthy
customers
• Increases as customer’s credit risk increases
• London Interbank Offered Rate (LIBOR)
• Rate offered to companies with
• International presence
• Ability to use London Eurodollar market for loans
• Will be replaced with the Sterling Overnight Index Average
(SONIA)

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 Figure 8-1 The Prime Rate versus
LIBOR on U.S. Dollar Deposits

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 Compensating Balances
• Minimum average account balance maintained
as alternative to fee charged by bank for services
rendered
• When interest rates are lower, compensating balance
rises
• When compensating balances are required to obtain
a loan
• Computed as a percentage of customer loans outstanding
• Computed as a percentage of bank commitments towards
future loans to given account

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 Compensating Balances Continued
• Amount that must be borrowed is calculated by taking
needed funds and dividing by (1 − c), where c is
compensating balance expressed as decimal
• For example, if $100,000 is needed, amount borrowed must
be $125,000 considering 20 percent of amount borrowed as
compensating balance, computed as:

Amount to be borrowed = Amount needed = $100,000

(1 – c) (1 – 0.2)

= $125,000

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 Maturity Provisions
• Term loan
• Credit extended for one to seven years
• Loan usually repaid in monthly or quarterly
installments
• Only superior credit applicants qualify
• Interest rate fluctuates with market conditions
• Interest rate may be tied to prime rate or LIBOR

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 Cost of Commercial Bank Financing

• Effective interest rate is based on

• Loan amount
• Dollar interest paid
• Length of loan
• Method of repayment
Effective rate = Interest × Days in year (360)
Principal Days loan is outstanding

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 Cost of Commercial Bank Financing
Continued
• In case of a discounted loan, interest is
deducted in advance and the effective rate of
interest increases
• For example:
A $1,000 one-year loan with $60 of interest deducted in
advance represents the payment of interest on only
$940, or an effective rate of 6.38 percent.

Effective rate = $60 × 360 = $60 = 6.38%

$1,000 – $60 360 $940

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 Interest Costs with Compensating
Balances
• Assuming that 6 percent is the stated annual rate, and that 20
percent 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:

Effective rate with = Interest × Days in a year (360)

compensating balances Principal – Compensating Days loan is
balance in dollars outstanding

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 Rate on Installment Loans
• Installment loans require a series of equal
payments over the life of the loan
• Effective rate of interest on installment loans
would be almost double quoted rate of interest
• Effective rate on installment loan
= 2 × Annual no. of payments × Interest
(Total no. of payments + 1) × Principal
= 2 × 12 × $60 = $1,440 = 11.08%
13 × $1,000 $13,000

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 Annual Percentage Rate
• Truth in Lending Act of 1968 requires actual
annual percentage rate (APR) given to borrower
• Annual percentage rate
• Requires use of actuarial method of compounded
interest during computation of APR
• Lender must calculate interest for period on outstanding
loan balance at beginning of period
• Based on assumptions of amortization
• According to the law, a loan amortization schedule is the
final authority in the calculation of APR

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 The Credit Crunch Phenomenon
• Federal Reserve tightens growth in money supply to
combat inflation, causing
• Decrease in lendable funds and 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, fueled by 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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 Financing through Commercial Paper
• Commercial paper represents
• Short-term, unsecured promissory note
• Usually issued to public in minimum units of $25,000
• Forms of commercial paper
• Finance paper or direct paper (paper sold by financial
firms directly to lender)
• Dealer paper (paper sold by companies through dealer
network)
• Asset-backed commercial paper
• Book-entry transactions
• Computerized handling of commercial paper where no
actual certificate created
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 Figure 8-2 Total Commercial
Paper Outstanding

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 Advantages of Commercial Paper
• May be issued at below prime interest rate
• Rate differential is normally 2 to 3 percent
• No associated compensating balance
requirements with issuance
• Associated prestige for firm to float paper in
“snobbish market” for funds

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 Limitations on the Issuance of
Commercial Paper
• Many lenders have become risk-averse after
multitude of bankruptcies, corporate fraud,
and other events
• Firms with downgraded credit rating do not
have access to market
• Associated funds are less predictable
• Lacks degree of commitment and loyalty
that is associated with more expensive bank
loans
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 Table 8-1 Comparison of Commercial Paper
Rate to Prime Rate (Annual Rate*)

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 Foreign Borrowing
• Eurodollar loan
• Denominated in dollars and made by foreign bank holding
dollar deposits
• Short term to intermediate term in maturity
• LIBOR is the base interest rate paid on loans for companies
of highest quality
• Borrow from international banks in foreign
currencies directly or through foreign subsidiary
• Converts foreign currency into dollars and sent to parent
company
• Borrowing firm may suffer currency risk

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 Use of Collateral in Short-Term
Financing
• Secured credit arrangement when
• Credit rating of borrower is too low
• Need for funds very high
• Primary concern is whether borrower can generate
enough cash flow to liquidate loan when due
• Uniform Commercial Code
• Adopted by all states
• Standardizes and simplifies procedures
• Establishes security against loan

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 Accounts Receivable Financing
• Includes
• Pledging accounts receivable as collateral for loan
• Factoring or outright sale of receivables
• Advantage
• Permits borrowing to be tied directly to level of
asset expansion at any point in time
• Disadvantage
• Relatively expensive method of acquiring funds

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 Pledging Accounts Receivable
• Lending firm decides which of the accounts
receivable it will use as collateral for a loan
• Loan percentage depends on firm’s
• Financial strength
• Creditworthiness of its accounts
• Interest rate well above prime rate
• Computed against balance outstanding

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 Table 8-2 Receivables Loan Balance

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 Factoring Receivables
• Receivables are sold outright to finance
company
• Factoring firms do not have recourse against seller
of receivables
• Finance companies may do all or part of credit
analysis to ensure quality of accounts
• Factoring firm
• Absorbs risk
• Actually advances funds to seller at lending rate

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 Factoring Receivables—Example
• If $100,000 a month is processed at 1 percent
commission, and 12 percent annual borrowing rate,
total effective cost is computed on annual basis
1%......Commission
1%......Interest for one month (12% annual/12)
2%......Total fee monthly
2%......Monthly × 12 = 24% annual rate
• Rate may not be considered high due to factors of risk
transfer, as well as early receipt of funds
• Also allows firm to pass on much of credit-checking cost
to factor
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 Asset-Backed Public Offerings of
Receivables
• Increasing trend in public offerings of security
backed by receivables as collateral
• Interest paid to owners is tax-free
• Advantages to firm
• Trade future cash flows for immediate cash
• Carries a high credit rating of AA or better
• Provides
• Corporate liquidity
• Short-term financing
• Disadvantage to buyer
• Risk associated—receivables actually being paid

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 Inventory Financing
• Factors influencing use of inventory for
financing:
• Marketability of pledged goods
• Associated price stability
• Perishability of product
• Degree of physical control that lender can exercise
over product

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 Stages of Production
• Stages of production
• Raw materials and finished goods usually provide
best collateral
• Goods in process may qualify for only small
percentage of loan

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 Nature of Lender Control
• Provides greater assurance to lender but higher
administrative costs
• Types of Arrangements
• Blanket inventory liens—Lender has general claim against
inventory
• Trust receipts (floor planning)—An instrument acknowledges
that borrower holds inventory and proceeds from sales in
trust for the lender
• Warehousing—Receipt issued, and goods can be moved only
with lender’s approval
• Public warehousing (with warehousing firm)
• Field warehousing (on borrower’s premises)

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 Appraisal of Inventory Control Devices

• Well-maintained control measures involve

• Substantial administrative expenses
• Raising overall cost of borrowing
• Extension of funds well synchronized with needs

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 Hedging to Reduce Borrowing Risk
• Engaging in transaction that partially or fully
reduces prior risk exposure
• The financial futures market
• Allows trading of financial instrument at future point
in time
• No physical delivery of goods but execution of a later
transaction that reverses initial position
• For example, initially sells a futures contract, then later
buys a contract that covers initial sale and vice versa

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 Hedging to Reduce Borrowing Risk
Continued
• In selling Treasury bond futures contract,
subsequent pattern of interest rates
determines profitability
• Purchase price of futures contract is
established at time of initial purchase
transaction

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 Hedging to Reduce Borrowing Risk
Concluded
• If interest rates increase:
• Extra cost of borrowing money to finance business
can be offset by profit of futures contract
• If interest rates decrease:
• Loss on futures contract as bond prices rise
• Offset by lower borrowing costs of financing firm

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