Short-Term Financing

Outline
1. Short-term Financing Concept
2. Sources of Short-Term Financing
3. Costs of Short-Term Financing
Concepts
Working Capital Terminologies
• Working Capital Management
• Controlling working capital and short-term liabilities
• Working Capital
• Refers to cash, marketable securities, receivables and
inventories
• Two types: Gross Working Capital and Net Working Capital
• Gross Working Capital - those used in operations and turn over
• Net Working Capital – Current Assets – Current Liabilities or
• Current Assets – (Current Payables + Accruals)
• Working Capital Policy
• A policy which decides the level of each type of current asset
to hold and how to finance current assets
 What is the appropriate
level of current assets to be
maintained?
Current Asset Investment Policies
1. Relaxed/Liberal/Conservative
• Businesses prefer to have substantial amount of current assets
• Sales are stimulated by the use of credit policy that provides
liberal financing to customers, resulting to high levels of
receivables
• Appropriate if leads to greater profitability
• Main Advantage:
• Ready current assets in case of contingencies and good investment
opportunities
• Main Disadvantage:
• Excessive working capital may lead to idle current assets
• Opportunity cost is high – would have earned returns had the company
invested idle assets
Current Asset Investment Policies
2. Restricted/Aggressive
• Holding of current assets is minimized
• Current assets are turned over more frequently
• Main Advantage:
• Current assets are put to better use, earning returns
• Main Disadvantage:
• May not have the ability to meet short term obligations if forecasting
goes wrong
• Risk of stock-out which leads to lost sales – an opportunity cost
• May not able to sort out good investment opportunities and take
advantage of them due to lack of current assets to use
• Difficulty in overcoming contingencies
Current Asset Investment Policies
3. Balanced/Moderate
• Trade-off between risk and profitability
• Between relaxed and aggressive
How should these assets be
financed?
Current Asset Financing Policies
1. Moderate/Maturity Matching/Self-Liquidating
• Matches the maturity of a financing source with specific
financing needs
• Short-term temporary assets are financing with short-term
liabilities
• Short-term permanent assets and long-term assets are funded
by long-term financing assets
Current Asset Financing Policies
2. Aggressive
• Finances short-term and long-term assets with short-term
financing only
• Strictly short-term sources – greatest use of debt
• Advantages:
• Flexible and easier to acquire because of less stricter requirements
• Disadvantages:
• If interest rates rise, can lead to bankruptcy because of high interest
expenses
Current Asset Financing Policies
3. Conservative
• Finances both permanent and temporary assets from long-term
sources
• Strictly long-term only – least use of debt
• Advantages:
• More liquid than those that adopt aggressive policies
• Disadvantages:
• Pays interest for a long period and only benefits for a short period
Sources of Short-term Financing
ST Financing
• Refers to any credit with a maturity period of less than
or within one year from the time the credit is granted
• In other words – any debt scheduled for repayment
within one year
• Major Sources of ST Financing:
1. Accruals
2. ST Accounts Payable (Supplier’s Trade Credit)
3. Bank Loans
4. Commercial Papers/Loans
5. Pledging and Factoring of Receivables
ST Financing
• May also be secured or unsecured
• From the borrower’s perspective, ST credit is more risky
than LT credit
• Always have a required payment around the corner
• May have trouble rolling over loans
Sources of ST Financing
1. Accrued Liabilities/Expenses
• Spontaneous source – continually recurring short-term
liabilities, especially wages, bills, and taxes
• Incurred but not yet paid
2. Accounts Payable (Trade Credit)
• Incurred in the ordinary course of business
• A/R is to seller, A/P is to buyer
• Not required to make payment on the date of purchase
3. Bank Loans
• Usually supported by a promissory note and involves
originating fees
• Usually requires proof of capacity to pay the loan
Sources of ST Financing
4. Commercial Papers
• Unsecured short-term promissory notes of large firms, usually
payable within 270 days
• Only companies with high-credit rating are allowed to issue
them with the approval of the Securities and Exchange
Commission
• Remember that this is a type of money-market security
5. Pledging and Factoring Accounts Receivable
• Pledging – using A/R as collateral for the borrowings
• Factoring – selling A/R to a financing company subject to
factoring fee or factor’s fee
Factors in Selecting the Source
1. Availability of Amount Needed
• Readily available is preferred over those acquired later on
2. Cost of Credit
• Higher cost, lower net income due to interest expense and
other fees
3. Repayment Terms
• Lump-sum or installment
• Depends on borrower’s capacity
4. Financing Requirements
• Voluminous requirements
• Case-to-case basis
Costs of Short-Term Financing
Accrued Liabilities
• Continually recurring ST liabilities which remain unpaid
by the business for a period of time
• Increase automatically or spontaneous sources of funds
of the business
• Is there a cost to accrued liabilities?
• No, since no interest of any form is imposed on the business at
the time of payment
• Hence, they are “free” in a sense
• However, these are not often used by businesses
because they have little degree of control over accruals
A/P or Suppliers’ Trade Credit
• Largest source of short-term credit, easy to get, but
costly
• Need to determine the “true price” of the credit sale
• Cost of A/P refers to the cost of not taking the discount
• Two options:
1. Take the discount, pay earlier, and finance the payment
through bank loan
2. Not take the discount
• When should the business take the discount?
• Compare the interest rate of the bank and cost of A/P
• If the interest cost is lower than the cost of A/P, take the
discount
Formula for Cost of Trade Credit
Nominal Annual Cost of Trade Credit
First side of the formula refers to the
cost of foregoing the discount
!% '($
ANC = & Second side of the formula refers to the
#$$% %!% )! %!*
number of times the cost is incurred by
not taking the discount
Effective Annual Rate of Trade Credit

!%
EAR = 1 + n -1 EAR gives the true cost
#$$%%!%
Cost of Trade Credit
With terms 2/10, n/30, find the nominal rate
Cost of Trade Credit
With terms 1/10, n/40, find the nominal rate and effective
rate
Cost of Trade Credit
Paningning Trading ordinarily purchases raw materials
amounting to P200,000 with the terms 2/15, net 30.
Paningning Trading operates at 360 days a year.

Required:
1. Gross price
2. Net price/true price
3. Annual cost of trade credit
4. Effective annual cost
5. Assuming banks are charging 15% interest on loans,
should Paningning Trading avail of the discount and
pay within 15 days from purchase?
Cost of Bank Loans
• Depends on the interest imposed by the bank
• Methods of imposing interest:
1. Simple interest rate
2. Discounted interest rate
3. Add-on interest rate
4. Interest rate with compensating balance
Cost of Bank Loans – Simple Interest
• Borrower receives the face value of the loan and pays
the interest only at the maturity date
• Payment at maturity date equals the principal amount
borrowed plus interest
• Things to take note:
1. If the term is one year or more, nominal annual rate is equal
to the effective annual rate
2. If the term is less than one year, the nominal annual rate is
lower than the effective annual rate
Formula – EAR for Simple Interest
If one year or more

!
EAR =
"#$

If less than one year

EAR = (1+PIR)PT – 1
PIR = Periodic interest rate (nominal annual rate divided by PT)
PT = Periodic term (360 divided by the term of borrowing)
Cost of Bank Loans – Simple Interest
Pasarakoplease Merchandising borrowed P300,000 from
Mint Bank at 15% simple interest for one year.

Compute:
1. Interest
2. Effective annual rate
Cost of Bank Loans – Simple Interest
Kapyotlangunta Merchandising borrowed P500,000 from
DiNalian Bank at 15% simple interest for 90 days.

Compute:
1. Interest
2. Effective annual rate
Cost of Bank Loans – Simple Interest
Mini Eleven Mercantile borrowed P800,000 from Bangko de
Silya at 14% simple interest.

A. If the the loan is for one year and six months

Compute:
1. Interest
2. Effective Annual Rate

B. If the loan is for 180 days

Compute:
1. Interest
2. Effective Annual Rate
Cost of Bank Loans – Discounted Interest
• “Discount” - interest is deducted in advance from the
amount of the loan (principal)
• Compare:
1. In simple interest, the full amount of the principal is received
by the borrower at the beginning of the term, and he pays
the principal and the interest at the date of maturity.
2. In discounted interest, the borrower receives the net
proceeds of the loan, which is the principal deducted in
advance by the interest, but only pays the principal amount
of the loan at the date of maturity.
• Also Take Note: EAR is always greater than nominal
annual rate for discounted interest
Formula
If one year or more

!
EAR =
"#$

If less than one year

! PT
EAR – (1+ ) -1
"
Cost of Bank Loans – Discounted Interest
Justin Habieber borrowed P300,000 from Enjelicious
Bank at 12% discounted rate for one year.

Compute:
1. Discount
2. Net Proceeds
3. EAR
Cost of Bank Loans – Discounted Interest
Big Gaon Trading borrowed P200,000 from Amare Bank
at 9% discounted rate for 1 year and 6 months.

Compute:
1. Discount
2. Net Proceeds
3. EAR
Cost of Bank Loans – Discounted Interest
Tika’s Son’s Merchandising borrowed P200,000 from
Creativas Bank for 90 days at 12% discounted rate.

Compute:
1. Discount
2. Net Proceeds
3. EAR
Considerations in Loan Applications
5 C’s of Credit
1. Character – willingness to repay the loan
2. Capacity – ability to generate cash flows
3. Collateral – security pledged for payment of the loan
4. Capital – financial resources available
5. Condition – current economic or business conditions
 5’Cs of Credit – Case Study
Mr. Joe Salazar applied for a PHP1.5 million loan in behalf of his
business, “Joe’s Restaurant”, for additional capital in 2015. He is
the Chairman of the Board of Joe’s Restaurant. In their meeting,
the Board decided to open an additional branch for the
restaurant. Joe’s Restaurant currently has 3 branches in Metro
Manila and would like to open up a small branch in Quezon City.
Joe’s Restaurant has been in the business for 12 fruitful years and
has been a previous borrower of the bank. The company had
previous late payments before but the reasons are usually
justifiable, and the balance of the loan, along with any penalties, if
any, is paid. The three branches earn a net income of
PHP900,000/ year. The lot where the main restaurant is located is
pledged as collateral to the bank. This property is valued at PHP2
million. Shown below is an excerpt from Joe’s Restaurant’s 2014
consolidated audited financial statements.
5’Cs of Credit – Case Study
5’Cs of Credit – Case Study

Character
• Check Joe Restaurant’s payment history and experience
in the business.
• This will prove Mr. Salazar and the Restaurant’s ability to
manage the business well.
5’Cs of Credit – Case Study

Capacity
• Positive income from the business and positive cash
flows from operations proves the borrower’s capacity.
• Current assets also show that the borrower has funds
easily available for repayment if necessary.
• Existence of net current assets
5’Cs of Credit – Case Study

Collateral
• The property pledged serves as collateral
5’Cs of Credit – Case Study

Capital
• The audited financial statements give a preview of the
borrower’s resources
• Mr. Salazar’s capital is in good condition
5’Cs of Credit – Case Study

Condition
• The income statement shows that the business is earning
and is even growing.
• The business has already grown to 3 branches
• May also consider current economic conditions relating
to the food industry
Cost of Commercial Papers
• Unsecured promissory notes issued by large companies
authorized by the Securities and Exchange Commission
• Formula:

!"!# (
EAR = +
$% &! &!# (*+ ÷-./)

I = Interest
I = Issuance Costs
FV = Face Value
DM = Days to maturity
Cost of Commercial Papers
Magnum Company has been authorized by the SEC to
issue commercial papers for short-term funds. Magnum
plans to issue a P50-million commercial paper for 240
days at an annual discounted interest rate of 15%. The
company expects to incur P80,000 for the issuance of the
promissory notes.

Compute:
1. Interest
2. Issuance Costs
3. Net Proceeds
4. EAR
Cost of Factoring Receivables
• Usually made by smaller banks – banks sell their
receivables to bigger banks
• Subject to several factoring fees, also known as
discounting of receivables
• Formula:

!"#$ (
EAR = +
%& (*+ ÷-./)
I = Interest
OC = Other Charges
NP = Net Proceeds
Cost of Factoring Receivables
Umbay Empire Company is in need of short-term funds.
Umbay Empire factors its P2,000,000 receivable to Artful
Life Bank for 60 days under the following credit terms:
interest of 1.2% per month, factoring fee of 1%, factor’s
holdback at 5%.

Determine:
1. Interest
2. Factoring Fee
3. Factor’s Holdback/Reserve
4. Net Proceeds
5. EAR