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8
Sources of ShortTerm Financing
Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
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Trade credit from suppliers.
Bank loans.
Commercial paper.
Borrowing in foreign markets.
Using collaterals like accounts receivable
and inventory for larger loans.
8-2
Financing Arrangements
• Lines of credit are sometimes referred to as
a revolving credit facility where interest cost:
– Is based on LIBOR (the London Interbank
Offering 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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Trade Credit
• 40 percent of short-term financing is in the
form of accounts payable or trade credit.
– Accounts payable
• Spontaneous source of funds.
• Growing as the business expands.
• Contracting when business declines.
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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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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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Net-Credit Position
• Determined by examining the difference
between accounts receivable and accounts
payable.
– It is 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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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.
8-8
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.
8-9
Prime Rate versus LIBOR on U.S.
Dollar Deposits
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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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Compensating Balances - Example
• If one needs $100,000 in funds, he/ she must borrow $125,000 to
ensure the intended amount will be available. This would be calculated
as:
Amount to be borrowed = Amount needed
(1 - c)
= $100,000
(1 – 0.2)
= $125,000
– Where ‘c’ is the compensating balance expressed as a decimal.
• To check on this calculation, the following can be done:
$125,000 Loan
- 25,000 20% compensating balance requirement
$100,000
Available funds
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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.
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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 X Days in the year (360)
Principal
Days loan is outstanding
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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
X 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 period of the loan.
– Federal legislation prohibits a misrepresentation
of interest rates, however this may be misused.
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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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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 inflationladen inventory and receivables.
– Massive withdrawals of savings deposits at
banking and thrift institutions, fuelled by the
search for higher returns.
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The Credit Crunch Phenomenon
(cont’d)
• Credit conditions can change dramatically
and suddenly due to:
– Unexpected defaults.
– Economic recessions.
– Other economic setbacks.
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Financing Through Commercial
Paper
• Short-term, unsecured promissory notes
issued to the public.
– Finance paper/ direct paper
• Sold by financial firms, directly to the lender.
– Dealer paper
• Sold by industrial companies, use of intermediate
dealer network for its distribution.
• Book-entry transactions
– Computerized handling of commercial paper,
where no actual certificate is created.
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Total Commercial Paper Outstanding
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Advantages of Commercial Paper
• Fuelled by the rapid growth of money-market
mutual funds, and their need for short-term
securities for investments.
• No associated compensating balance
requirements.
• Associated prestige for the firm to float their
paper in an elite market.
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Comparison of Commercial Paper
Rate to Prime Rate (annual rate)
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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.
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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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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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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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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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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 determine and 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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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 mush of the credit-checking cost
to the factor.
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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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Inventory Financing
• Factors influencing use of inventory:
– Marketability of the pledged goods.
– Associated price stability.
– Perish-ability of the product.
– Degree of physical control that the lender can
exercise over the product.
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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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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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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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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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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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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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