5 5 Chapter Sources of Short-Term Financing Slides Developed by: Terry Fegarty Seneca College

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Chapt

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FinancingSources of Short-Term

Financing

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 5 – Outline (1)

• Sources of Short-term Financing • Spontaneous Financing

Trade Credit The Prompt Payment Discount Abuses of Trade Credit

• Bank Operating Loans Short Term Bank Credit Line of Credit or Revolving Credit Agreement Interest Rates on Loans Annual Interest Rate Cleanup Requirements


Chapter 5 – Outline (2)

• Short-Term Credit Secured by Current Assets Receivables Financing Pledging Accounts Receivable Factoring Accounts Receivable Inventory Financing Types of Inventory Financing

• Money Market Instruments Commercial Paper Bankers’ Acceptances Securitization of Receivables


Sources of Short-term Financing

• Spontaneous financing Accounts payable and accruals

• Bank operating loans Revolving credit agreement, line of credit

• Secured loans for accounts receivable and inventory

• Money market instruments Commercial paper Bankers’ acceptances Securitization of receivables


Spontaneous Financing

• Accruals For example, money you owe employees for work

they have performed but not yet been paid • Tend to be very short-term

• Accounts payable (AKA: trade credit) Money you owe suppliers for goods you bought on

credit Attractive source of financing

• No security required• Interest-free

Credit Terms: Terms of trade specify when you are to repay the debt


Trade Credit

• Seller lends buyer purchase price from time of shipment to time of payment

• No security and no interest• Seller may offer cash discount for early

payment• Cost of forgoing a cash discount:

% discount 365

APR = ×100% - % discount Final payment date - Last discount date


The Prompt Payment Discount

Q: Vendor offers a discount of 2% if payment is made within ten days. If the discount is not taken, full payment is due in 30 days. What is the annual cost of not accepting the 2% discount?

A:

= 37.24%

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e % discount 365 = ×

100% - % discount Final payment date - Last discount date

2 365 = ×

100 - 2 30 - 10


Abuses of Trade Credit

• Abuses of Trade Credit Terms Trade credit is now expected in many

businesses• Companies offer it because they have to

Stretching payables—a common abuse of trade credit• Paying payables beyond the due date (AKA:

leaning on the trade)• Slow paying companies receive poor credit ratings

in credit reports issued by credit agencies


Bank Operating Loans

• Represent primary source of short-term loans for most companies

• Provide financing for working capital and expenses

• Advanced against value of receivables and inventory

• Repaid from collections on receivables• May be arranged for specific transactions or as

revolving credit agreement or line of credit


Line of Credit or Revolving Credit Agreement

• Line of credit Non-binding agreement to borrow up to

predetermined limit at any time

• Revolving credit Legally commits the bank Usually secured Requires commitment fee on unborrowed

funds


Interest Rates on Loans

• Interest Rates on Loans Prime rate is rate that bank charges its largest and

most creditworthy corporate customers. Interest rates on operating loans are usually based

on bank’s prime rate plus a risk premium


Interest Rates on Loans

• Loan rates will depend upon such factors as: How intense is competition among lenders for loan

business? How large is the loan? Does borrower have good credit history? Does borrower have adequate and reliable cash flow? Does borrower have adequate security? Is loan guaranteed under a government program? What is term of the loan? What is debt-to-equity ratio?


Annual Interest Rate

where: r = Annual rate I = Interest paid (dollars) P = Principal d = Number of days loan is outstanding

I 365r = ×

P d


Example 5.1: Revolving Credit Agreement

Q: The Arcturus Company has a $10 million revolving credit agreement

with its bank at prime plus 2.5%. Prior to June, the company had borrowed $4 million that was outstanding for the entire month. On June 15, it took borrowed $2 million. Prime is 9.5% and the bank’s commitment fee is 0.25% annually.

What bank charges will Arcturus incur for the month of June?

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A: Arcturus will have to pay both interest on the money borrowed and a commitment fee on the unused balance of the revolving agreement.

Monthly interest rate: (Prime + 2.5%) 12 = 1% Monthly commitment fee: 0.25% 12 = 0.0208% $4 million was outstanding for the entire month of June

and $2 million was outstanding for 15 days of June, so the total dollar interest charges are:

15$4,000,000 0.01 + $2,000,000 $50,000

30

The commitment fee must be paid on an average of $5,000,000 that was unused during June, or:• $5,000,000 .000208 = $1,040• Total bank charges = $51,040

Example 5.1: Revolving Credit Agreement

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Clean Up Requirements

• Theoretically a firm can constantly roll-over its short-term debt Borrow on a new note to pay off an old note

• Risky for both firm and bank

• Banks require that borrowers clean up short-term loans once a year Remain out of short-term debt for certain

time period


Short-Term Credit Secured by Current Assets

• Debt is secured by the current assets being financed ( accounts receivable and inventory)

• Common in seasonal businesses such as retail


Receivables Financing

• Receivables Financing: Lenders may extend credit backed by the

value of accounts receivable Receivables may make excellent collateral:

• Fairly liquid• Easy to recover in event of default•Collectibility of accounts is key issue

Common arrangements•Pledging–Firm retains title•Factoring–Firm sells A/R


Pledging Accounts Receivable

Borrower uses A/R as collateral for a loan Accounts Receivable still belong to borrower,

which still collects the accounts Borrower promises to use collected accounts

to pay off loan Lender can provide

• General line of credit tied to all receivables• Specific line of credit tied to individual accounts

receivable Lender generally charges interest at rates

over prime, plus an administrative fee.


Example 5.2: Pledging Accounts Receivable

Q: The Kilraine Quilt Company has an average receivables balance of $100,000 which turns over once every 43 days. It generally pledges all of its receivables to the Cooperative Finance Company, which advances 75% of the total at 4% over prime plus a 1.5% administrative fee.

If prime is 5%, what total financing rate is Kilraine effectively paying for its receivables financing?

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Example 5.2: Pledging Accounts Receivable

A: Average Receivables balance: $100,000Average loan outstanding: 75% x $100,000 = $75,000 Interest rate: 5% + 4% = 9% Receivables pledged in year: $100,000 x 365 / 50 = $730,000Administrative fee: 1.5% x $730,000 = $10,950% of the average loan balance:$10,950 / $75,000 = 14.6%Annual financing cost: 9% + 14.6% = 23.6%

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Factoring Accounts Receivable

• Firm sells Accounts Receivable to lender (at a severe discount) and lending firm (factor) takes control of the accounts Accounts receivable are now paid directly to

factor Factor usually reviews accounts and only

accepts accounts it deems creditworthy


Factoring Accounts Receivable

• Factors offer wide range of services Perform credit checks on potential customers Advance cash on accounts it accepts or remit

cash after collection Collect cash from customers Assume bad-debt risk when customers don’t

pay


Inventory Financing

• Use firm’s inventory as collateral for a short-term loan

• Popular but subject to number of problems Lenders aren’t usually equipped to sell

inventory Specialized inventories and perishable goods

are difficult to market


Types of Inventory Financing

• Blanket liens—lender has a lien (claim) against all inventories of borrower

• Borrower remains in physical control of inventory

• Trust receipt (chattel mortgage agreement)—collateralized inventory is identified by serial number and can’t be sold without lender’s permission

• Borrower remains in physical control of inventory

• Warehousing—collateralized inventory is removed from borrower’s premises and placed in a warehouse (borrower’s access controlled by third party)

• When inventory is sold, lender is informed to expect money from borrower soon


Money Market Instruments

• Larger corporations may sell short-term debt instruments in the money market

• Another method to borrow to meet temporary cash needs

• Instruments include commercial paper, bankers’ acceptances and securitization of receivables


Commercial Paper

• Notes issued by large, financially-strong firms and sold to investors Unsecured (usually) Buyers are usually other corporations and

financial institutions Maturity is less than 270 days Considered very safe investment, therefore

pays a relatively low interest rate (sold at a discount)

No flexibility in repayment terms


Commercial Paper

• Annual Interest Rate on Discounted Money Market Security

where M = Maturity (face) value of the security P = Discounted price (net proceeds on issue)

d = Number of days to maturity r = Annual interest rate

d

(M-P)

P 365

r =


Bankers’ Acceptances

bankers’ acceptance—created when a bank adds guarantee of payment to the promissory note or draft of the issuer (corporate borrower)

Issuer receives money from bank. Bank then sells the bankers’ acceptance in the money market to an investor.

At maturity, bank repays face value to the investor and the issuer repays bank

Traded on a discount basis to yield interest rate slightly lower than that of commercial paper

Usual terms are 30, 60, and 90 days.


Securitization of Receivables

• Sale of receivables by large firms in public offerings arranged by securities dealers

• The issuing firm thus receives immediate cash for future cash flows

• Financing is raised at a relatively low cost, often lower than prime or commercial paper rate, because the issue is asset-backed.

Documents

5 5 Chapter Sources of Short-Term Financing Slides Developed by: Terry Fegarty Seneca College