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Chapter 8. Sources of Short-Term Financing. Chapter 8 - Outline . Sources of Short-Term Financing Trade Credit Net Credit Position Bank Credit Terminology Types of Bank Loans Corporate and Foreign Borrowing Terminology Accounts Receivable Financing.

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chapter 8

Chapter 8

Sources of Short-TermFinancing

chapter 8 outline
Chapter 8 - Outline
  • Sources of Short-Term Financing
  • Trade Credit
  • Net Credit Position
  • Bank Credit Terminology
  • Types of Bank Loans
  • Corporate and Foreign Borrowing Terminology
  • Accounts Receivable Financing
sources of short term financing
Sources of Short-Term Financing

There are various sources of short-term funds available to a firm:

– Trade Credit from Suppliers

– Bank Loans

– Corporate Promissory Notes

– Foreign Borrowing

– Loans Against Receivables and Inventory

trade credit
Trade Credit
  • The largest source of short-term financing for a firm. Approximately 40 percent of short-term financing is in the form of accounts payable or trade credit
    • Accounts payable
      • Is a Spontaneous source of funds
      • Grows as the business expands
      • Contracts when business declines
  • Extending the payment period to an unacceptable period results in:
    • Alienate suppliers
    • Diminished ratings with credit bureaus
  • It is usually a 30-60 day grace period before a bill is due
  • A cash discount is often given if payment is made within a specified time

– Ex., 2/10 net 30 means a 2% discount is given if paid in 10 days; if not, the full amount is due in 30 days

net credit position
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)
cash discount policy
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
  • Cost of NOT taking a discount:
bank credit terminology
Bank Credit Terminology

Prime Rate:

– the interest rate charged to a bank’s best customers

– acts as a benchmark for calculating other interest rates

Compensating Balance:

– when a bank requires a minimum average account balance for business customers in order to qualify for a loan

– can be thought of as a form of collateral

Effective Interest Rate:

– the actual interest rate or “true” cost of a loan

– also known as the annual percentage rate (APR)

types of bank loans
Types of Bank Loans

Discounted Loan:

– when a bank deducts the interest on the loan in advance and lends the balance

Installment Loan:

– calls for a series of equal payments over the life of the loan

– ex., most car loans and home mortgages

Compensating Balance Loan:

– when a compensating balance is required as part of the loan

effective rates for different types of bank loans
Effective Rates for Different Types of Bank Loans

Effective Rate = Interest / $ Received x 360 / Days loan is outstanding

Or % / 1 x 360 / Days loan is outstanding

For Discounted Loan subtract Interest from Principal (or int. % from 1) when computing denominator.

For Compensating Balance Loan:

Subtract Compensating Balance from Principal (or % CB from 1) when computing denominator.

  • If discounted loan with compensating balance, then subtract interest plus compensating balance (or % and CB%).

For Installment Loan, the approximation for annualizing is:

2 x Annual # of payments / Total number of payments + 1

(instead of x 360 / days loan is outstanding – note that all annualizing shown ignores compounding of interest)

corporate and foreign borrowing terminology
Corporate and Foreign Borrowing Terminology

Commercial Paper:

– a short-term unsecured promissory note issued to the public in minimum units of $25,000

– total amount of commercial paper outstanding has increased greatly in recent years

Eurodollar:

– a U.S. dollar held or deposited in a foreign bank

– loans from foreign banks denominated in American dollars are called Eurodollar loans

advantages of commercial paper
Advantages of Commercial Paper
  • May be issued at below the prime interest rate
  • No associated compensating balance requirements
  • Associated prestige for the firm to float their paper in an elite market
disadvantages of commercial paper
Disadvantages 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
accounts receivable financing
Accounts Receivable Financing
  • A/R financing includes 2 choices:

– pledging accounts receivable as collateral for a loan

OR

– an outright sale (also called factoring) of receivables to a bank or finance company

  • Tends to be a relatively expensive source of financing
the credit crunch phenomenon
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 inflation-laden inventory and receivables
    • Massive withdrawals of savings deposits at banking and thrift institutions, fuelled by the search for higher returns
  • Credit conditions can change dramatically and suddenly due to:
    • Unexpected defaults
    • Economic recessions
    • Changes in monetary policy
    • Other economic setbacks