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1. Introduction to Short-term Financing
1. Management of working capital. Management of working capital also includes management of current liabilities. When business firms need to borrow money for short-term needs, such as inventory buildup, they usually want to use short-term financing. In a normal economy, short-term interest rates are generally lower than long-term rates. Management wants to minimize borrowing costs and look at all possible sources of short-term financing. This article (8001) discusses the costs and benefits of different types of short-term corporate financing.
2. Trade Credit
1. Trade Credit Terminology. Trade credit is reflected on a firm's balance sheet as ____( Critical Concept ). Accounts payable is ________( Key Term ). A supplier usually extends trade credit for a short amount of time, usually 30-60 days. This is called the payment period.
2. Cash Discount. Suppliers, or grantors of trade credit, often offer a cash discount to firm's who pay their bills early. The discount is offered to firms who pay during the discount period, which is shorter than the payment period. The amount of the discount varies. See Trade Credit (52.0K)
3. Cost of Failing to Take the Discount. If a firm does not take the cash discount offered by a supplier, there is a cost associated with not taking the discount. The cost of failing to take the discount is calculated as:________( Critical Concept ). If the cost of failing to take the discount is expensive, then the firm should consider borrowing money at a cheaper rate so it can take the discount. See Trade Credit (52.0K) .
4. Net Credit Position. Firms must keep an eye on their net credit position. The net credit position is defined as . See Net Credit Position (57.0K) .
3. Bank Credit
1. Bank credit as a source of financing. As an additional source of short-term financing, business firms can use bank credit. They can borrow short-term money from their bank. Since bank deregulation, banks have become more competitive and business firms have a wider variety of choices. There are a number of bank terms with which to become familiar.
2. Bank terminology
1. Prime rate. The prime lending rate is defined as ____( Key Term ). In order to see the relationship between the prime lending rate and other interest rates, take a look at this chart . It shows you the prime rate over the last ten years and its relationship to other interest rates commonly used. See this website for a table of key interest rates.
2. LIBOR. The LIBOR or London Interbank Offered Rate is the European equivalent of the U.S. prime rate. Those companies with an international presence shop around for the best interest rate and will compare the prime rate and the LIBOR to determine where to borrow money. Take a look at this article for more explanation of LIBOR.
3. Compensating balance. A compensating balance is defined as ____( Key Term ). It is calculated as the ratio of the amount borrowed to 1 minus the required compensating balance. Loans that require compensating balances carry higher interest rates.
4. Effective interest rate. The effective rate is the actual cost of a loan taking the way interest is calculated in to account. It is also referred to as the ____( Key Term ). See Bank Credit Terminology (66.0K) for a summary of bank terminology. Banks are required to disclose the APR to borrowers.
5. Maturity. By definition, short-term bank loans are generally granted with a maturity of less than a year. In recent years, more term loans are being offered with maturities of 1-7 years repaid in installments.
3. Types of Bank Loans
1. Simple Interest Loan. The interest is paid when the loan is due. The effective interest rate for a simple interest loan is calculated as ____( Critical Concept ).
2. Discounted Loan. The interest due on the loan is borrowed as part of the loan. This means the interest rate is higher than on the simple interest loan. The effective interest rate for a discount loan is calculated as ____( Critical Concept ).
3. Loans with compensating balances. The interest due on the loan is higher than on the simple interest loan due to the compensating balance. The effective interest rate on a loan with a compensating balance is calculated as ____( Critical Concept ).
4. Installment Loan. Installment loans are generally the most expensive of the bank loans. Installment loans generally refer to loans that are paid off by monthly payments. The effective interest rate on an installment loan is calculated as ____( Critical Concept ).
4. Financing Through Commercial Paper.
1. Commercial Paper Defined. Commercial paper represents ____( Key Term ). It is available to only the largest and most creditworthy firms as a source of financing. The market for commercial paper has experienced a large increase over the years. See Slide 4 (36.0K) .
1. Direct Paper. Direct paper, also called finance paper, is sold primarily by ____( Critical Concept ).
2. Indirect Paper. Indirect paper, also called dealer paper, is sold by other types of firms that have to make their own selling network.
3. Advantages of Commercial Paper
1. Interest Rate. Commercial paper can be sold below the prime interest rate.
2. Compensating Balance. Commercial paper can be sold with no compensating balance requirement.
3. Prestige. There is a certain amount of prestige for a firm to be able to float its own commercial paper.
4. Disadvantage of Commercial Paper
1. Thin Market. Commercial paper is not as liquid as some market securities.
2. Unpredictable Funding. There is no relationship or loyalty like there is when a firm takes out a bank loan.
5. Foreign Borrowing
1. Banks may make Eurodollar loans. See Corporate and Foreign Borrowing Terminology (61.0K) .
6. Accounts Receivable Financing
1. Accounts receivable may be used as collateral for short-term loans. Since accounts receivable is an asset on the firm's books, it can be used as collateral by the firm. There are two types of accounts receivable financing:
1. Pledging accounts receivable. When a firm pledges its accounts receivable, it uses them as collateral for a short-term loan.
2. Factoring accounts receivable. When a firm factors accounts receivable, it sells them outright in return for a short-term loan. See Accounts Receivable Financing (51.0K) .
3. Asset Based Public Offerings. Firms sell their accounts receivable through public offerings of securities back by receivables. Advantages include that the firm trades future cash flows for immediate cash. A problem is that receivables may not actually be paid. The creation of asset-backed securities is called ____( Critical Concept ). Read more about accounts receivable securitization here .
7. Inventory Financing
1. Pledging Inventory. Firms may pledge their inventory as collateral for a short-term loan. Finished goods is a more preferred form of inventory as collateral than raw materials or work in progress. Three types of inventory control for pledged inventory are ____, ____ and ____( Critical Concept ).
2. Blanket Inventory Lien. A lien is simply placed on the inventory. It is not tagged or stored in any way.
3. Trust Receipts. Trust receipts are given to the lender to verify that the firm is holding its inventory as collateral.
4. Warehousing. Warehousing is the strictest form of inventory control. The lender actually takes control of the inventory. The borrower makes arrangements to have the inventory placed under the lender's control.
8. Hedging through the Use of Financial Futures
   1. A financial manager can buy and sell financial futures as hedges, or safeguards, against currency and interest rate fluctuations in the loan market.