Welcome To
2023
Lecturer: Abdirisak Ali Mohamed
CHAPTER 02: Sources of Short-
term Financing
In Chapter 02 we will examine:
The cost and availability of the
various sources of short-term
funds. The sources are:
Trade credit from suppliers,
Bank loans,
Corporate promissory notes,
foreign borrowing, and
3 loans against Receivables and
1) TRADE CREDIT
Trade credit is from the suppliers of
goods or services.
Approximately 40 percent of short-
term financing is in the form of
accounts payable or trade credit.
Payment Period
Trade credit is usually extended for 30
to 60 days.
Course outline
Cont….
Cash Discount Policy
A cash discount allows a reduction in
price if payment is made within a
specified time period.
A 2/10, net 30 cash discount means we
can deduct 2 percent if we remit our
funds 10 days after billing,
But failing this, we must pay the full
amount by the 30th day.
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Example
On a $100 billing, we could pay $98 up to the
10th day or $100 at the end of 30 days.
If we fail to take the cash discount, we will get
to use $98 for 20 more days at a $2 fee.
The standard formula for this example is:
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Net Credit Position
We defined before that A/receivable is a use of funds and A/
payable as a source of funds.
The firm should closely watch the relationship between the two to
determine its net trade credit position.
Net trade credit is positive when accounts receivable are greater than
accounts payable and vice versa.
If a firm has average daily sales of $5,000 and collects in 30 days, the
accounts receivable balance will be $150,000.
If this is associated with average daily purchases of $4,000 and a 25-
day average payment period, the average accounts payable balance
is $100,000—indicating $50,000 more in credit is extended than
received.
Larger firms tend to be net providers of trade credit (relatively high
receivables), with smaller firms in the user position (relatively high
2) BANK CREDIT
Commercial Banks Provide These Services:
Accepting Deposits,
Making Loans,
Processing Checks
Investment Services,
A Credit Card Operation,
Real Estate Lending,
Data Processing Services,
Cash Management Services Domestically and
Internationally,
Pension Fund Management
Prime Rate and LIBOR
The prime rate is the rate a bank charges
its most creditworthy customers, and it
usually increases as a customer’s credit
risk gets higher.
London Interbank Offered Rate
(LIBOR) is used by companies with an
international presence or those
sophisticated enough to use the London
Eurodollar market for loans.
Forexample, in the summer of 2009, LIBOR
one-year loans were at 1.24 percent
versus a U.S. prime rate of 3.25 percent.
Compensating Balances
In providing loans and other
services, a bank may require that
business customers either pay a fee
for the service or maintain a minimum
average account balance, referred to
as a compensating balance.
In some cases both fees and
compensating balances are required.
For example, if you need $100,000
in funds, you must borrow $125,000 to
1 ensure the intended amount will be
Cost of Commercial Bank Financing
It is easy enough to observe that
$60 interest on a $1,000 loan for
one year would carry a 6 percent
interest rate, but what if the same
loan were for 120 days? We use the
formula:
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Cont…..
If the bank uses a discounted
loan and deducts the interest in
advance, 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.
Interest Costs with
Compensating Balances
Assume that 6 percent is the stated
annual rate and that a 20 percent
compensating balance is required.
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Cont…
In the prior examples, if dollar amounts
are used and the stated rate is unknown,
Formula 8–5 can be used.
The assumption is that we are paying $60
interest on a $1,000 loan, but are able to
use only $800 of the funds.
The loan is for a year.
Rate on Installment Loans
The most confusing borrowing arrangement to
the average bank customer or a consumer is
the installment loan.
An installment loan calls for a series of
equal payments over the life of the loan.
Assume that you borrow $1,000 on a 12-
month installment basis, with regular monthly
payments to apply to interest and principal,
and the interest requirement is $60.
Find the effective rate of interest.
FINANCING THROUGH COMMERCIAL PAPER
For large and prestigious firms,
commercial paper may provide an outlet
for raising funds.
Commercial paper represents a short-
term, unsecured promissory note issued
toAdvantages
the public ofinCommercial
minimum Paper
units of
$25,000.
1) Commercial paper may be issued at below the
prime interest rate
2) No compensating balance requirements are
associated with its issuance
3) It gives prestige to the issuing company
Disadvantages of Commercial Paper
1) Commercial paper is less predictable
2) loyalty and commitment is unavailable in
USE OF COLLATERAL IN SHORT-TERM
FINANCING
Almost any firm would prefer to borrow on an
unsecured (no-collateral) basis;
but if the borrower’s credit rating is too low or its
need for funds too great, the lending institution
will require that certain assets be pledged.
A secured credit arrangement might help the
borrower obtain funds that would otherwise be
unavailable.
ACCOUNTS RECEIVABLE FINANCING
Accounts receivable financing may
include pledging accounts receivable
as Collateral for a loan or an outright
sale (factoring) of receivables.
A drawback is that this is a relatively
expensive method of acquiring funds, so it
must be carefully compared to other
forms of credit.
Table 8–2: Receivables loan balance
INVENTORY FINANCING
We may also borrow against
inventory to acquire funds.
Raw materials and finished goods
are likely to provide the best
collateral,
While goods in process may qualify
for only a small percentage loan.
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