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Chapter
8
McGraw-Hill/Irwin
Sources of ShortTerm Financing
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
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Trade credit from suppliers
Bank loans
Commercial paper
Collaterals for larger amount of borrowing
Using hedging to offset the interest rate risk
8-2
Trade Credit
• Approximately 40 percent of short-term
financing is in the form of accounts payable or
trade credit
– Accounts payable
• Grows as the business expands
• Contracts when business declines
8-3
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
8-4
Cash Discount Policy
• Allows reduction in price if payment is made
within a specified time period
8-5
Cash Discount Policy
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
“ company is paying more than required in order to keep the funds
until the last day.”
= 2 / 98 X 360 / (30 -10) = .02 X 18 = .36 =36%
8-6
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)
8-7
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’
– Deregulation has created greater competition
among other financial institutions
8-8
Bank Credit (cont’d)
• Recession of 2007–2009
– The longest on record since the Great Depression
of the 1930s
– Forced many large banks on the verge of collapse
– Commercial banks and investment banks were
allowed to merge.
– These combinations were responsible for banks
to take excess risk which led to the credit
problems that started to show up in 2007.
8-9
Prime Rate and LIBOR
• Prime rate
– The 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
• to use the London Eurodollar market for loans
8-10
Prime Rate versus LIBOR on U.S.
Dollar Deposits
8-11
Compensating Balances
• An average minimum account balance to be
maintained as an alternate for fee charged by
the bank for services “Money from a loan that a borrower keeps in
an account with a lender providing some surety that the lender will be repaid”
– When interest rates are lower, the compensating
balance rises
– Required account balance computed on the basis
of:
• Percentage of customer loans outstanding
8-12
Compensating Balances (cont’d)
• The amount that must be borrowed is calculated by taking
the needed funds and dividing by (1 − c), where c is the
compensating balance expressed as a decimal.
• For example, if $100,000 is needed, the amount borrowed
must be $125,000 considering 20% of amount borrowed as
the compensating balance. This is computed as:
Amount to be borrowed= Amount needed ÷ (1 – c)
Amount to be borrowed= $100,000 ÷ (1 – 0.2)
Amount to be borrowed = $125,000
8-13
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
8-14
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
Effective rate = Interest
Principal
×
Days in the year (360)
Days loan is outstanding
8-15
Cost of Commercial Bank Financing
Example:
Mr. Jones borrows $4,500 for 90 days and pays $75 interest.
×
Effective rate = Interest
Principal
= 75
4500
X
360
90
Days in the year (360)
Days loan is outstanding
= 6.7 %
8-16
Cost of Commercial Bank Financing
(cont’d)
• In case of discounted loan – interest is
deducted in advance – effective rate
increases
Effective rate =
on discounted loan
Interest
Principal-interest
×
Days in the year (360)
Days loan is outstanding
8-17
Interest Costs with Compensating
Balances
• Assuming that 6% is the stated annual rate and that 20% compensating
balance is required;
Effective rate with
compensating balances
=
=
Interest
(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
×
compensating balances (Principal – Compensating
balance in dollars)
year (360)
Days loan is
outstanding
8-18
Rate on Installment Loans
• Installment loans require a series of equal
payments over the period of the loan
– Effective rate of interest on installment loans
would be almost double the quoted rate of interest
Effective rate on installment loan = 2 × Annual no. of payments × Interest
(Total no. of payments + 1) × Principal
8-19
Annual Percentage Rate
• Truth in Lending Act of 1968 requires the
actual APR to be given to the borrower
• Annual percentage rule:
– 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
8-20
Financing Through Commercial
Paper
• Commercial paper represents a:
– short-term, unsecured promissory note
– issued to the public in minimum units of $25,000.
• Forms of commercial paper:
– Finance paper/direct paper ((paper sold by financial firms
directly to the lender)
– Dealer paper (paper sold by companies through dealer
network)
8-21
Advantages of Commercial Paper
• May be issued at below the prime interest
rate. As indicated in the last column of Table
8–1, this rate differential is normally 2 to 3
percent
• No associated compensating balance
requirements
8-22
Comparison of Commercial Paper
Rate to Prime Rate
Table 8-1
8-23
Limitations on the Issuance 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
8-24
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 paid on loans for companies of
the highest quality
• Borrow from international banks in foreign currency:
– Through foreign subsidiary, which converts foreign
currency into dollars and send to the parent company
– Borrowing firm may suffer currency risk
8-25
Use of Collateral in Short-Term
Financing
“Assets pledged as security for a loan. In the event
that a borrower defaults on the terms of a loan, the
collateral may be sold, with the proceeds used to
satisfy any remaining obligations. High-quality
collateral reduces risk to the lender and results in a
lower rate of interest on the loan”
8-26
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
8-27
Accounts Receivable Financing
• Includes:
– Pledging accounts receivables
– Factoring or an outright sale of receivables
8-28
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 “Eligibility of an individual
or firm to borrow money”
• Interest rate is well above the prime rate
8-29
Factoring Receivables
Factoring Receivable :
“Companies sometimes need cash before customers
pay their account balances. In such situations, the
company may choose to sell accounts receivable to
another company that specializes in collections. This
process is called factoring, and the company that
purchases accounts receivable is often called a
factor.”
www.youtube.com/watch?v=XVmfxfDPFPQ
8-30
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
8-31
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
8-32
Inventory Financing
• Factors influencing use of inventory for
financing:
– Marketability of the pledged goods
– Associated price stability
– Perishability of the product
– Degree of physical control that the lender can
exercise over the product
8-33
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
8-34
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 in trust for the lender
– Warehousing
• A receipt issue – goods can be moved only with the lender’s
approval
• Public warehousing (with a warehousing firm)
• Field warehousing (on the borrowers premises)
8-35
Appraisal of Inventory Control
Devices
• Well-maintained control measures involve:
– Substantial administrative expenses
– Raise overall cost of borrowing
– Extension of funds is well synchronized with
needs
8-36
Hedging to Reduce Borrowing Risk
Hedging:
“To reduce the risk of an investment by making
an offsetting investment. There are a large number of hedging
strategies that one can use. To give an example, one may
take a long position on a security and then sell short the same
or a similar security. This means that one will profit (or at least
avoid a loss) no matter which direction the security's price
takes. Hedging may reduce risk, but it is important to note that
it also reduces profit potential.”
8-37
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
8-38
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
– The purchase price of the futures contract is established
at the time of the initial purchase transaction
Sales price, June 2011 Treasury
bond contract* (sale occurs in January 2011.)……………$100,000
Purchase price, June 2011 Treasury
bond contract (purchase occurs in June 2011)……………. $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
8-39
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
• There will be a loss on the futures contract as the bond
prices rise
• This is offset by the lower borrowing costs of the
financing firm
8-40