SHORT-TERM FINANCING

I. OVERVIEW
Short-term financing refers to financing needs for a period of time that is within one year.

Nominal rate VS Effective rate

 Interest rate is the general term used for financing cost from borrowed funds.
 Nominal rate is the basis of cash payments on borrowings.
 Effective rate is the basis of determining the interest expense on borrowings.
 Formula:
o Interest = Principal X Nominal rate X Time
o Nominal rate = (Interest ÷ Principal) X Time
o Effective rate = (Financing cost ÷ Net Proceeds) X (365/Credit period)

Simple VS Compounded effective interest

Simple effective interest Compounded effective interest
 This assumes that the borrower had to  The borrower had to borrow money
borrow money only ones in a given every time the obligation matures.
year.

II. SOURCES OF SHORT-TERM FINANCING COST

Classification:
1. Unsecured loans – do not have collateral attached to the obligation.
a. Trade credit or spontaneous sources of financing.
 Financing that arises from the normal course of business. Trade credit is a
major source of financing for small firms.
b. Commercial bank loan
 The major type of loan made by banks to businesses is the short-term,
self-liquidating loan. These loans are intended merely to carry the firm
through seasonal peaks in financing needs that are due primarily to
buildups of inventory and accounts receivable.
c. Commercial paper
 This is a form of financing that consists of short-term, unsecured
promissory notes issued by firms with a high credit standing. Most
commercial paper has maturities ranging from 90 to 270 days.
2. Secured loans – have collateral attached to it.
a. Receivable financing
 Two commonly used means of obtaining short-term financing with
accounts receivable are pledging accounts receivable and factoring
accounts receivable. Actually, only pledge of accounts receivable creates a
secured short-term loan.
b. Inventory financing
 This is a credit obtained by businesses to pay upfront for products that
will not be sold immediately. The loan is collateralized by inventory.
III. UNSECURED SOURCES OF FINANCING

1) Spontaneous source of financing/Trade credit

Cost of failing to take a cash discount = % Discount X 365 days

100% - % Discount Credit period – Discount period
Illustration:
Assuming annual credit purchases of P720,000 with terms of 2/10, n/30. The company does not take
the discount and pays in 30 days and 360 days is used.

Required:
a) Compute for total accounts payable, breakdown the accounts payable into free trade credit
and non-trade credit.

Solution:

Daily credit purchases ÷ 360 days = P720,000 ÷ 360 days = P2,000

Total accounts payable = P2,000 X 30 days = P60,000

Free trade credit = P2,000 X 10 days = P20,000

Non-free trade credit = P2,000 20 days = P40,000

b) Compute the effective interest rate.

Solution:

Cost of failing to take a cash discount = 2% X 360 days

100% - 2% 30 – 10

Cost of failing to take a cash discount = 37.24 %

2) Commercial bank loan financing

Cost of term loans = Interests X 365 days

Principal – interest – compensating balance Days loan outstanding

Amount to be borrowed = Amount needed

(1 – interest % – compensating balance %)

Illustration:
Principal P100,000
Nominal rate 12%
Period 120 days
Compensating balance 8%

Required:
1) Compute for the effective interest assuming: (use 360 days)
a. Discounted and with compensating balance requirement
 Solution:
Interest deducted in advance = P100,000 X 12% X120/360 = P4,000

Cost of term loans = P4,000 X 360 days

P100,000 – P4,000 – P8,000 120 days

Cost of term loans = 13.63%

b. Discounted but no compensating balance requirement

Solution:

Cost of term loans = P4,000 X 360 days

P100,000 – P4,000 120 days

Cost of term loans = 12.50%

c. Simple interest with compensating balance requirement

Solution:

Cost of term loans = P4,000 X 360 days

P100,000 – P8,000 120 days

Cost of term loans = 13.04%

d. Simple interest but no compensating balance requirement

Solution:

Cost of term loans = P4,000 X 360 days

P100,000 120 days

Cost of term loans = 12%

2) Re-compute above assuming the company has:

 P5,000
Solution:

a. Discounted and with compensating balance requirement

Compensating balance (P100,000 X 8%) P8,000

Existing deposit (5,000
)
Deficient P3,000

Cost of term loans = P4,000 X 360 days

P100,000 – P4,000 – P3,000 120 days
Cost of term loans = 12.90%

b. Discounted but no compensating balance requirement

Cost of term loans = P4,000 X 360 days

P100,000 – P4,000 120 days

Cost of term loans = 12.50%

c. Simple interest with compensating balance requirement

Solution:

Cost of term loans = P4,000 X 360 days

P100,000 – P3,000 120 days

Cost of term loans = 12.37%

d. Simple interest but no compensating balance requirement

Solution:

Cost of term loans = P4,000 X 360 days

P100,000 120 days

Cost of term loans = 12%

 P10,000 deposited with the bank which will serve as compensating balance
requirement.

Solution:

a. Discounted and with compensating balance requirement

Compensating balance (P100,000 X 8%) P8,000

Existing deposit (10,000
)
Excess (IGNORE) P2,000

Cost of term loans = P4,000 X 360 days

P100,000 – P4,000 120 days

Cost of term loans = 12.50%

b. Discounted but no compensating balance requirement

 Cost of term loans = P4,000 X 360 days
P100,000 – P4,000 120 days

Cost of term loans = 12.50%

c. Simple interest with compensating balance requirement

Solution:

Cost of term loans = P4,000 X 360 days

P100,000 120 days

Cost of term loans = 12%

d. Simple interest but no compensating balance requirement

Solution:

Cost of term loans = P4,000 X 360 days

P100,000 120 days

Cost of term loans = 12%

3) Assuming the P100,000 is the net proceeds, compute for the principal and effective interest
assuming:
a. Discounted and with compensating balance requirement
Solution:

Principal = P100,000
(100% - 4% - 8%)

Principal = P113,636

Interest = 113,636 X 12% X 120/360 = P4,545

Cost of term loans = P4,545 X 360 days

P113,636 – P4,545 – P9,091 120 days

Cost of term loans = 13.64%

b. Discounted but no compensating balance requirement

Solution:

Principal = P100,000
(100% - 4%)

Principal = P104,167

Interest = 104,167 X 12% X 120/360 = P4,167

 Cost of term loans = P4,167 X 360 days
P104,167– P4,167 120 days

Cost of term loans = 12.50%

c. Simple interest with compensating balance requirement

Solution:

Principal = P100,000
(100% - 8%)

Principal = P108,695

Interest = 108,695 X 12% X 120/360 = P4,348

Cost of term loans = P4,348 X 360 days

P108,695 – P8,696 120 days

Cost of term loans = 13,04%

d. Simple interest but no compensating balance requirement

Solution:

Principal = P100,000
100%

Principal = P100,000

Interest = 100,000 X 12% X 120/360 = P4,000

Cost of term loans = P4,000 X 360 days

P100,000 120 days

Cost of term loans = 12%

3) Cost of Installment loans

Cost of Installment loans = 2 X # of installments X interest

(1 + # of installments) X Principal

Illustration:
Principal P100,000
Nominal rate 12%
Term Installment loan

Compute for the effective interest assuming the following installment payments:
1) Monthly
 2) Quarterly
3) Semi-annual
4) Annual
5) Re-compute monthly payments assume a 2 year loan
6) Re-compute the effective interest assuming the loan requires compensating balance of 8% of
principal.

Solution:
1) Monthly

Cost of Installment loans = 2 X 12 X 12,000

(1 + 12) X 100,000

Cost of Installment loans = 22.15%

2) Quarterly

Cost of Installment loans = 2 X 4 X 12,000

(1 + 4) X 100,000

Cost of Installment loans = 19.2%

3) Semi-annual

Cost of Installment loans = 2 X 2 X 12,000

(1 + 2) X 100,000

Cost of Installment loans = 16%

4) Annual

Cost of Installment loans = 2 X 1 X 12,000

(1 + 1) X 100,000

Cost of Installment loans = 12%

5) Re-compute monthly payments assume a 2 year loan

Cost of Installment loans = 2 X 24 X 12,000

(1 + 24) X 100,000

Cost of Installment loans = 23.04%

 6) Re-compute the effective interest assuming the loan requires compensating balance of 8% of
principal.

Cost of Installment loans = 2 X 12 X 12,000

(1 + 12) X (100,000 – 8,000)

Cost of Installment loans = 24.08%

Revolving Credit Agreement VS Credit Line

Revolving Credit Agreement and Credit Line are financing arrangements made between a lending
institution and a business or an individual.

Revolving Credit Agreement Credit Line

 The lender sets aside funds that the  It is a one-time agreement and when
borrower can use at his discretion. The the credit line is paid off, the account is
borrowed portion can use at his closed.
discretion.
 The borrowed portion is subject to
interest and the borrowed portion is
subject to commitment fee.

Illustration:
Clifford Texas Oil arranged a P10,000,000 involving credit arrangement with a group of small banks.
The firm paid an annual commitment fee of one-half percent of the unused balance of the loan
commitment. On the used portion of the loan, Clifford paid 10.5% annual, simple interest basis.
Clifford borrowed P6,000,000 immediately after the agreement was signed and repaid the loan at the
end of the year.

Required:
a) Compute for the total financing cost of the loan agreement for one year
Solution:

Interest on the borrowed portion (P6M X 10.5%) P630,000

Commitment fee on the not borrowed portion (P4M X 0.5%) 20,000
Total financing cost P650,000

b) Compute for the effective rate of the loan

Solution:

Effective interest rate = Financing cost

Net proceeds

Effective interest rate = 650,000

6,000,000

Effective interest rate = 10.83%

 3) Cost of commercial paper

Discount + Flotation cost + (Nominal interest X credit

Cost of commercial paper = period/365 days) X 365 days
Issue price - Flotation cost Credit period

Flotation cost is the general term used for issue cost, it can denote stock issue cost, or commercial
paper issue cost.

Illustration:
Face value P1,000
Issue price P920
Term 120 days

Use 360 days.

Required:
a) Compute for the effective interest.
b) Compute for the effective interest assuming flotation cost of P10 is required
c) Compute for the effective interest assuming commercial paper carries 6% nominal rate
d) Compute for the effective interest assuming flotation cost of P10 is required and contains 6%
nominal rate.

Solution:
a) Compute for the effective interest.

Effective interest rate = P1,000 – P920 X 360 days

P920 120 days

Effective interest rate = 26.09 %

b) Compute for the effective interest assuming flotation cost of P10 is required

Effective interest rate = (P1,000 – P920) + P10 X 360 days

P920 – P10 120 days

Effective interest rate = 29.67 %

c) Compute for the effective interest assuming commercial paper carries 6% nominal rate

Effective interest rate = (P1,000 – P920) + (1,000 x 6% x 120/360) X 360 days

P920 120 days

Effective interest rate = P80 + P20 X 360 days

 P920 120 days
Effective interest rate = 32.61 %

d) Compute for the effective interest assuming flotation cost of P10 is required and contains 6%
nominal rate.

Effective interest rate = (P1,000 – P920) + P10 + (1,000 x 6% x 120/360) X 360 days
P920 – P10 120 days

Effective interest rate = P80 + P10 + P20 X 360 days

P920 – P10 120 days
Effective interest rate = 36.26 %

IV. SECURED SOURCES OF FINANCING

Formula:

Effective interest rate = Financing cost X 365 days

Net proceeds Credit period

Pledging of Accounts Receivable

Illustration:
XYZ Co. assigned P700,000 of accounts receivable to First Bank under a non-notification basis. First
bank advances 80% less a service charge of 2%. XYZ Co. signed a 120 day promissory note that
provides for interest of 12% on the unpaid loan balance.

Required:
 Compute for the cash received by the company.
 Compute for the effective interest rate.

Solution:
 Compute for the cash received by the company.

Accounts Receivable pledged P700,000

% of advance allowed by First bank 80%
Amount of loan (Principal) P560,000
Bank service charge (P560,000 X 2%) (11,200)
Cash received by XYZ P548,800

 Compute for the effective interest rate

Effective interest rate = (560,000 X 12% X 120/360) + 11,200 X 360 days

P548,800 120 days
 Effective interest rate = 18.37 %

Inventory serves as a collateral

Illustration:
The Aville Supply Co. is considering obtaining a loan from Sales Finance Company secured by
inventories under a field warehousing arrangement. It would be permitted to borrow up to P500,000
under such an arrangement at an annual interest rate of 10%. The additional cost of maintaining a
field warehouse is P15,000 per year. It borrowed P400,000 during the year.

Required:
 Compute for the financing cost of the loan.
 Compute for the effective interest rate.

Solution:
 Compute for the financing cost of the loan.

Interest on the borrowed portion (P400,000 X 10%) P40,000

Cost of field warehouse 15,000
Total financing cost P55,000

 Compute for the effective interest rate.

Effective interest rate = Financing cost

Net proceeds

Effective interest rate = 55,000

400,000

Effective interest rate = 13.75%

V. LEVERAGE
Leverage refers to an investment strategy of using borrowed funds to improve overall company
profitability. Financial leverage should not be confused with operating leverage. Operating
leverage is a strategy of increasing overall profitability by increasing sales units.

 Operating Leverage – concerned with the relationship between earnings before interest and
taxes and sales revenue.

Operating Leverage = Contribution margin

Earnings before interest and taxes

Operating Leverage = % change in EBIT

% change in Sales

 Financial leverage – concerned with the relationship between earnings per share (EPS) and
EBIT.
Financial Leverage = EBIT
Earnings Before Tax but after interest

Financial Leverage = % change in EPS

% change in EBIT

Earnings Per Share = Earnings Before Interest but After Tax - Preferred Dividends
Average Ordinary Shares Outstanding

 Total leverage = concerned with the relationship between Sales and earnings per share.

Total Leverage = Contribution margin

Earnings Before Tax

Total Leverage = % change in EPS

% change in sales

Illustration:
The Sterling Co. Income Statement is as follows:

Sales (20,000 units at P60 each) P1,200,000

Variable cost @ 30 (600,000)
Contribution margin 600,000
Fixed cost (400,000)
EBIT 200,000
Interest expense (50,000)
Earnings before tax 150,000
Income tax (45,000)
Earning after tax P105,000

Required:
 Compute for:
o DOL
o DFL
o DTL

Solution:
 Compute for:
o DOL

Operating Leverage = Contribution margin

Earnings before interest and taxes

Operating Leverage = P600,000

P200,000

Operating Leverage = 3X
 o DFL

Financial Leverage = EBIT

Earnings Before Tax but after interest

Financial Leverage = P200,000

P150,000

Financial Leverage = 1.33 X

o DTL

Total Leverage = Contribution margin

Earnings Before Tax

Total Leverage = P600,000

150,000

Total Leverage = 4X