UNIVERSITY OF MAKATI

J.P Rizal Extension, West Rembo, Makati City SHORT-TERM FINANCING

SECTION 5.0: OVERVIEW FINANCING PLAN SHORT-TERM LONG-TERM ASSET LIQUIDITY LOW LIQUIDITY HIGH LIQUIDITY High profit Moderate profit High risk Moderate risk Moderate profit Low profit Moderate risk Low risk

PROF. MARLO D. GILE

SECTION 5.1: SOURCES OF SHORT-TERM FINANCING 1. Short-term loans borrowing from banks and other financial institutions for one year or less. 2. Trade credit borrowing from suppliers 3. Commercial paper only available to large credit-worthy businesses SECTION 5.2: TPYES OF SHORT-TERM LOANS 1. Promissory note A legal IOU that spells out the terms of the loan agreement, usually the loan amount, the term of the loan and the interest rate. Often requires that loan be repaid in full with interest at the end of the loan period. Usually with a bank financial institution; occasionally with suppliers or equipment manufacturers 2. Line of credit The borrowing limit that a bank sets for a firm after reviewing the cash budget. The firm can borrow up to that amount of money without asking, since it is pre-approved Usually informal agreement and may change over time Usually covers peak demand times, growth spurts, etc. 3. Trade credit Trade credit is the act of obtaining funds by delaying payment to suppliers, who typically grant 30 days to pay. The cost of trade credit may be some interest charge that the supplier charges on the unpaid balance. More often, it is in the form of a lost discount that would be given to firms who pay earlier. Credit has a cost. That cost may be passed along to the customer as higher prices or borne by the seller as lower profits, or some of both. SECTION 5.3: ESTIMATION OF COST OF SHORT-TERM CREDIT 1. Calculation is easiest if the loan is for a one year period 2. Effective interest rate is used to determine the cost of the credit to be able to compare differing terms. Effective interest rate = cost (interest + fees) Amount you get to use

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UNIVERSITY OF MAKATI
J.P Rizal Extension, West Rembo, Makati City SHORT-TERM FINANCING PROF. MARLO D. GILE

Example: You borrow P10,000 from a bank, at a stated rate of 10%, and must pay P1,000 interest at the end of the year. Your effective rate is the same as the stated rate: P1,000/P10,000 = .10 = 10% SECTION 5.4: VARIATIONS IN LOAN TERMS 1. A discount loan requires that interest be paid up front when the loan is given. 2. This changes the effective cost in the previous example since you only get to use:(P10,000 - P1,000) = P9,000. 3. Effective rate (APR) = P1,000/P9,000 = .1111 = 11.11%. 4. Sometimes lenders require that a minimum amount, called a compensating balance be kept in your bank account. It is taken from the amount you want to borrow. 5. If your compensating balance requirement is P500, then the amount you can use is reduced by that amount. 6. Effective Rate (APR) for a P10,000 simple interest 10% loan with a P500 compensating balance = P1,000/(P10,000-P500) = .1053 = 10.53%. 7. Sometimes, lenders will require both discount interest (paid in advance) and a compensating balance. 8. If the interest is P1,000 and the compensating balance is P500, then the effective rate (APR) becomes: 9. P1,000 / P10,000 - P1,000 - P500 10. P1,000 / P8,500 = 11.76% SECTION 5.5: COST OF TRADE CREDIT 1. Typically receive a discount if you pay early. 2. Stated as: 2/10, net 60 Purchaser receives a 2% discount if payment is made within 10 days of the invoice date, otherwise payment is due within 60 days of the invoice date. 3. The cost is in the form of the lost discount if you dont take it. 4. CALCULATING EFFECTIVE PERCENTAGE RATE (APR) Interest = principal x rate x time Example: Borrow P10,000 at 8.5% for 9 months Interest = P10,000 X .085 X 9/12 = P637.50 We can use the simple relationship: Interest = principal X rate X time: To solve for rate, and get the APR: APR (rate)= . Interest . Principal X time Principal = . Interest . Rate X time Time = . Interest . Principal X rate Example: If you pay P637.50 in interest on P10,000 principal for 9 months. What is the APR? 8.5% 5. Assume your purchase is P100 list price at 2/10 net 60. 6. If you take the discount, you pay P98. If you dont take the discount, you pay P100.

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UNIVERSITY OF MAKATI
J.P Rizal Extension, West Rembo, Makati City SHORT-TERM FINANCING PROF. MARLO D. GILE

7. Therefore, you (buyer) are paying P2 for the privilege of borrowing P98 for the additional 50 days. (Note: the first 10 days are free in this example). 8. APR (nominal cost of credit)= P2/P98 x 365/50 = 14.9% (If you pay in 60 days) 9. or; if the firm can forego discount and pay on day 60, a. Determine the net daily purchase = 98/365 = .27 b. Payable level, if the firm takes discounts i. Payables = .27 (10) = 2.7 c. Payables level, if the firm takes no discounts i. Payables = .27 (60) = 16.2 d. Credit breakdown: i. Total trade credit = 16.2 ii. Free trade credit = (2.7) iii. Cost of trade credit 13.5 e. The firm loses 1% of 100 equals to P2 of discounts to obtain 13.5 in extra credit f. In view thereof, the cost of the trade credit if pay in 60 days is 14.9% = 2/13.5 10. What if 2%/10, net 30 11. APR = P2/P98 x 365/20 = 37.25%! (If you pay in 30 days) SECTION 5.6: COMMERCIAL PAPER 1. Commercial paper is quoted on a discount basis, meaning that the interest is subtracted from the face value to arrive at the price. See 3 steps below for calculation: Step 1: Compute the discount (D) from face value of the commercial paper Discount (D) = (Discount rate x face x DTG)/time DTG = days to go (to maturity) Step 2: Compute the price = Face value - Discount Step 3: Compute Effective Annual Rate (APR): P interest you pay/ P you get to use x time 2. Example: P1M issue of 90 days commercial paper quoted at 4% discount rate, what is the cost of commercial paper? 4.04% a. Or; Determine the net daily cost = 990,0000/360 = 2,750 i. Payable level, if paid in 90 days = P247,500 b. Credit breakdown: i. Total debt P247,500 ii. Free 0 iii. Cost of commercial paper P247,500 c. In view thereof, the cost of commercial paper if pay in 90 days is 4.04% = 10,000/247,000 SECTION 5.7: BANK LOANS 1. The firm can borrow P100,000 for 1 year at an 8% nominal rate. 2. Interest may be set under one of the following scenarios: a. Simple annual interest i. 8,000 = (100,000*8%) b. Discount interest

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UNIVERSITY OF MAKATI
J.P Rizal Extension, West Rembo, Makati City SHORT-TERM FINANCING PROF. MARLO D. GILE

i. Amount borrowed = amount needed / (1-discount) ii. 100,000/(1-.08) = 108,696 c. Discount interest with 10% compensating balance i. Amount borrowed = amount needed / (1-discount-comp. bal.) ii. 100,000/(1-.08-.1) = 121,951 iii. Interest = .08(121,951)= 9,756 iv. Effective cost = 9,756/100,000 = 9.756% d. Installment loan, add-on, 12 months i. Interest = .08(100,000) = 8,000 ii. Face amount = 100,000 + 8,000 = 108,000 iii. Monthly payment = 108,000/12 = 9,000 iv. Approximate cost = interest/ (principal/2) 1. 8,000/50,000 = 16% SECTION 5.8: COLLATERAL IN SHORT-TERM FINANCING 1. Pledging Accounts Receivable Using receivables selected by the lending institutional collateral for a loan. 2. Factoring Receivables Receivables are sold outright to a finance company. 3. Inventory Financing Borrowing against inventory to acquire additional funds. as

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