Sources of Short-Term Financing

(Chapter 8) (Chapter 6 pages 151 155)

Short-Term Vs. Long-Term Financing Approaches to Financing Policy Trade Credit Simple Interest Discount Interest Compensating Balance Add-On Interest Commercial Paper Use of Collateral

Short-Term Vs. Long-Term Financing

Short-term financing tends to be riskier than longterm financing: Uncertainty concerning future rates. May not be able to renew. Use of short-term financing, however, may lead to higher returns: Most frequently, short-term rates are lower than long-term rates (i.e., the term structure is normally upward sloping) Flexibility: When financing is not required, shortterm debt can be paid off.

Approaches to Financing Policy

Maturity Matching Approach A general rule of thumb is to use shortterm financing for temporary asset needs, and long-term financing for permanent asset requirements. Aggressive Approach Use more short-term financing. Conservative Approach Use less short-term financing

Maturity Matching (A Moderate Financing Approach)

Millions of Dollars
16 14 12 10 8 6 4 2 0

Temporary Current Assets

Short-Term Financing

Permanent Current Assets

Long-Term Financing

Fixed Assets
12 15 18 21 3 6 9

Time Period

Aggressive Financing (Higher Risk - Higher Expected Return)

Millions of Dollars
16 14 12 10 8 6 4 2 0

Temporary Current Assets Short-Term Financing

Permanent Current Assets

Fixed Assets
12 15 18 21 3 6 9

Long-Term Financing

Time Period

Conservative Financing (Lower Risk - Lower Expected Return)

Millions of Dollars
16 14 12 10 8 6 4 2 0

Marketable Securities

Short-Term Financing

Permanent Current Assets Fixed Assets

12 15 18 21 3 6 9

Long-Term Financing

Time Period

Trade Credit
A very large source of short-term credit Example of terms: 2/10, net 60 Free Trade Credit: Credit received during the discount period. Always use (i.e., Do not pay early). Costly Trade Credit: Loss of discount if you do not pay within the discount period. Compare the % cost with the cost of funds from other sources.

Trade Credit (Continued)

Disc % 360 % cost 100% - Disc % Total Credit Period - Disc Period (Interest Rate Per Period)(Nu mber of Interest Periods) 2 360 = .1469 14.69% 98 60 - 10

Note: The above is only an approximation due to the compounding effects: Interest rate period = 2/98 = .0204 Number of interest periods = 360/(60 - 10) = 7.2 Effective Annual Rate = (1.0204)7.2 - 1 = .1565 = 15.65%

Simple Interest Bank Loans

A single payment of principal and interest on the maturity date of the loan. One-year loan: Interest Effective Annual Rate Principal Less than one-year loan: (Approximation)

Interest 360 Effective Annual Rate Principal Days Loan is Outstandin g (Interest Per Period)(Nu mber of Interest Periods)

Discount Interest
A single payment is made on the maturity date of loan. The interest charge, however, is paid in advance. One-year loan:

Interest Effective Annual Rate Principal - Interest

Less than one-year loan: (Approximation)
Interest 360 Effective Annual Rate Principal - Interest Days Loan is Outstandin g (Interest Rate Per Period)(Nu mber of Interest Periods)

One year loan:

Compensating Balance
Interest Principal - CB CB compensati ng balance Effective Annual Rate

Less than one year loan: (Approximation)

Interest 360 Effective Annual Rate Principal - CB Days Loan is Outstandin g (Interest Rate Per Period)(Nu mber of Interest Periods)

Note: If a firm normally carries excess balances with the bank, an adjustment must be made.

Add-On Interest (Installment Loans)

Approximation:

Interest Approximat e Annual Rate (Principal )/2

Note: If a more precise annual rate is desired, use the approach discussed in the text.

Unsecured promissory notes issued to the public by large corporations Major Advantage to Issuer Interest rate is typically below the prime rate. Disadvantage to Issuer Banks provide a certain degree of loyalty, commitment, and flexibility to their customers (willing to help customers who have temporary problems). Dealers in commercial paper are much more impersonal. Direct Paper (Finance Paper) Issued by finance companies (e.g., GE Credit) directly to institutional investors. Dealer Paper Sold by companies through a dealer network.

Commercial Paper

Uses of Collateral in Short-Term Financing

Pledging Accounts Receivable
Using receivables selected by the lending institutional as collateral for a loan.

Factoring Receivables
Receivables are sold outright to a finance company.

Inventory Financing
Borrowing against inventory to acquire additional funds. Note: Accounts receivable and inventory financing can be quite expensive.