Transcript Ross Template - Texas Christian University

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
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
 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
 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
 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
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
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 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
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
 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




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
 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 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