Short Term Financing

Source of Short-Term Financing

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CONTENT

I.

Short Term Financing………………………...3

Account payable management………..…4 Accruals……………………………………………...5 Bank loan…………………………………………...7 Commercial paper……………………….…….11

Reference/Bibliography …………………………..12

Short Term Financing

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The ultimate source of capital is, of course, the investor, but there are a number of ways by which a business may endeavor to obtain the finance it requires with the maximum of certainty and the minimum of expense. When seeking to capitalize a business, it is essential to know the amount of finance required, and the type of undertaking and its relevant circumstances. However, it is equally important that the search for funds should be made when the appeal is likely to have the desired effect. It is necessary, therefore, to consider the various methods of raising capital together with the conditions in which a business finds it expedient to apply them. The repayment term of short term financing is usually shorter than one year. Creditworthiness is an important aspect which the entrepreneur or the venture must satisfy before any short term financing will be granted. The following aspects are considered when assessing creditworthiness. Character: The reputation of honesty and reliability. Capacity: The business sense of the borrower, the level of experience and business history. Circumstances: The general business circumstances in the industry and the economy. Insurance Cover: The extent of the cover of insurable risks taken out by the borrower. Guarantees: The lender may require the borrower to use assets to guarantee the loan.

Different Aspects of Short Term Finance

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Important sources • • • •

Trade cycle Accrual Bank loan Commercial paper

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Account payable management. Accounts payable are the major source of unsecured shot-term financing for business firms. They result from transaction in which merchandise is purchased but no formal note is signed to show the purchaser's liability to the seller. The purchaser in effect agrees to pay the supplier the amount required in accordance with credit terms normally stated on the supplier’s voice. Role in the cash conversion cycle: Cash conversion cycle is the period between the payment to its creditors and receipts from its suppliers. But here we discuss the management by the firm of the time that elapse between its purchase of raw material and its mailing payment to the supplier. This activity is account payable management. The firm's goal is to pay as slowly as possible without damaging its credit rating. This means that accounts should be paid on the last day possible, given the suppliers stated credit terms. For example, if the terms are net 30, than the account should be paid 30 days from the beginning of the credit period, which is typically either the date of invoice or the end of the month (EOM), in which the purchase was made. This allows for the maximum use of an interest-free loan from the supplier and will not damage the firm's credit rating (because the account is paid within the stated credit terms). Analyzing Credit Terms: The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchase. Because the suppliers cost of having its money tied up in merchandise after it is sold is probably reflected in purchase price, the purchaser is already indirectly paying for this benefit. The purchaser should therefore carefully analyze credit terms that include a cash discount; it has two options- to take the cash discount or to give it up. Taking the cash discount: If a firm intends to make a cash discount, it should pay on the last day of the discount period. There is no cost associated with taking a cash discount.

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Give Up the Cash Discount: - If the firm choose to give up the cash discount, it should pay on the final day of the credit period. There is an implicit cost associated with giving up a cash discount. The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days. In other words, the amount is the interest being paid by the firm to keep its money for a number of days. Effects of Stretching Accounts Payable: A strategy that is often employed by a firm is stretching accounts payable- that is, paying bills as late as possible without damaging its credit rating. Such a strategy can reduced the cost of giving up a cash discount. Source: Suppliers of merchandise Cost or condition: No stated cost except when a cash discount is offered for early payment. Characteristics: Credit extended on open account for 0 to 120 days. It is largest source of short term financing. Formula: Cost of giving up cash discount =

CD 100-CD

Approximate cost of giving up cash discount =

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360 N CD

360 N

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Accruals A spontaneous source of short term business financing is accruals. Accruals are liabilities for service received for which payment has yet to be made. The most common items accrued by a firm are tax and wages. Because taxes are paid to the government, their accrual cannot be manipulated by the firm. However the accruals of the wages can be manipulated to some extent. These is accomplished by delaying payment of wages, there by receiving the interest free loan from the employees who are paid after some time. Source: The main sources of the accruals are employees and government. Cost and condition: It is a cost free, interest free, & non conditional loan Characteristics: it is a result of wages and taxes which are paid at discrete point of time. Hard to manipulate this kind of source. Formula: Annual saving = (cost of fund (in %)

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payroll amount)

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Bank loan Banks are the major source of unsecured short term loans to business. The major types of loan made by the banks to the business are the short term, self-liquidating loan. That is an unsecured short term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid. Banks lends unsecured, short-term funds in three basic ways: through single- payment notes, lines of credit, and revolving credit agreements.

1. Single- payment notes: A short-term, one-time loan made to a borrower who needs funds for a specific purpose for a short period. The instruction is the note, signed by the borrower, that state terms of the loan, including the length of the loan and the interest rate. Source: It can be obtained from a commercial bank by a creditworthy business borrower. Cost and condition: prime plus 0% to 4% risk premium – fixed or floating rate. Characteristics: A single- payment loan used to meet a fund shortage expected to last only a short period of time. Formula: Annual percentage cost= interest cost + commitment fee Net amount used

Effective annual rate For a discount loan

=

Interest amount . amount borrowed- interest

365 . no. of days fund used

100%

360/no. of days

Effective annual rate=

1

+ interest cost + commitment fee Net amount used

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2. Lines of credit: an agreement between a commercial bank and a business specifying the amount of unsecured short term borrowing the bank will make available to the firm over the given period of time. It is not guaranteed loan but indicates that if the bank has a sufficient fund available, it will allow the credit is the maximum amount the firm can owe the bank at any point of time. Sources: It can be obtained from a commercial bank by a creditworthy business borrower. Cost and condition: prime plus 0% to 4% risk premium – fixed or floating rate. Often must maintain 10% and 20% compensating balance and clean up the line annually. Characteristics: A prearranging borrowing limited under which funds, if available, will lend to allow the borrowing to the seasonal needs. Formula: Annual percentage cost= interest cost + commitment fee Net amount used

365 . no. of days fund used

360/no. of days

Effective annual rate =

1

+ interest cost + commitment fee Net amount used

1

3. Revolving credit agreements: A line of credit guaranteed to a borrower by a commercial bank regards less of the scarcity of money. the interest rate and other requirement are similar to those for the line of credit.

Source: It can be obtained from a commercial bank by a creditworthy business borrower. Cost and condition: Prime plus 0% to 4% risk premium – fixed or floating rate. Often must maintain 10% and 20% compensating balance and pay a commitment fee approximately 0.5% of the average unused balance.

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Characteristics: A line of credit agreement under which the availability of the fund is guaranteed. Often period greater than one year. Formula: Annual percentage cost= interest cost + commitment fee Net amount used

365 . no. of days fund used

360/no. of days

Effective annual rate=

1

+ interest cost + commitment fee Net amount used

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COMMERICAL PAPER Large, well-established companies sometimes borrow on a short-term basis through commercial paper & other money market instruments. Commercial paper represents an unsecured, short-term, negotiable promissory note sold in the money market. Because these notes are a money instruments, only the most creditworthy companies are able to use commercial paper as a source of short-term financing. The commercial paper market is composed of two parts: the dealer market and the direct-placement market. Industrial firms, utilities, and medium sized finance company all the commercial paper through dealers. The dealer organization is composed of a half dozen major dealers who purchase commercial paper from the issues and, in turn, sell it to investors. The typical commission a dealer earns is 1\8 percent, and maturities on dealer-placed paper generally range from 30 to 90 days. Although the dealer market has been characterized in the past by significant number of issues who borrowed on a seasonal basis, the trend is definitely toward financing on a revolving or more permanent basis. Source: business firm both non financial and non-financial. Cost and condition: Generally 2% to 4% below the prime rate of interest. Characteristics: An unsecured short term promissory note issued by the most financially sound firm. Formula: Annual percentage cost= Interest cost + placement cost Net amount used

360 . maturity date

360/no. of days

Effective annual rate=

1

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+ interest cost + placement cost Net amount used

1

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Reference/Bibliography A. B. C. D.

“Financial management” – L. J. Gitman Internet search four write book others

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