Business Finance PPT - 12 Short Term Sources of Financing

Business Finance
SHORT-TERM SOURCES OF FINANCING

Short-term Sources of
Financing
Objectives:
1. Understand the basic problems
encountered in managing the firm’s
use of short-term financing
2. State the factors in selecting the
sources of short-term funds
3. Identify the various sources of
short-term funds
4. Be able to compute the cost of the
various short-term credit
Short-term Sources of Financing
Introduction
Short-term financial
management also known as
working capital management
involves cash inflows and
outflows that occur within a year
or less.
Short-term financial management
generally addresses the following
questions:
1. What is a reasonable level of cash to
keep on hand or in a bank to pay
bills?
2. How much credit should be extended
to customers?
3. How much credit should be availed of
from suppliers?
4. When, how much and what
marketable securities should the
company invest in?
5. What level of short-term financing

should the firm use?
This chapter focuses on the other
basic problem encountered in
managing the firm’s use of short-
term financing, that is, selecting the
source of short-term financing.
Short-term funds are identified as
those that are due and payable
within a year.
Factors in selecting source of short-
term funds
1. The effective cost of credit

2. The availability of credit in the
amount needed and for the
period of time when financing is
required
3. The influence of the use of a
particular credit source on the cost
and availability of other sources of
financing, and
4. Any additional covenants of the

loans that are unique to the sources
mentioned previously.
Sources of Short-term Funds
It can be obtained through either
unsecured credit or secured loans.
Unsecured credit include all those
sources that have as their security
only the lender’s faith in the ability of
the borrower to repay the funds
when due.
Sources of Short-term Funds
Major sources of unsecured
short-term credit are
1. Accruals
2. Trade credit
3. Bank loans
4. Commercial papers
The principal suppliers of unsecured
credit include (1) commercial banks, (2)
finance companies, and (3) suppliers.
Secured loans involved the pledge of

specific assets as collateral in the event
the borrower defaults in payment of
principal or interest.
The primary sources of
collateral include accounts
receivable, marketable
securities and inventories.
If the chooses to forego a
possible cash discount
opportunity and utilize the
funds made available to finance
its working capital, then the
resulting cash, as an annualized
percent, can be very high
indeed.
Example, if the seller offers terms
of 2/10, n/30 which means a 2%
discount from purchase price if paid
in full within 10 days of the receipts
of the bill, or the net amount due
within thirty days, then the buyer
incurs an opportunity cost of 36.7%
per year if the cash discount is not
taken.
This is computed using:
Approximated Discount Rate
Effective Cost
= 100 – Discount x
of Rate
Trade Credit
360
Credit - Discount
Period Period
2% 360
= 100 % – 2 %
x 30 - 10
= 36.7%
The major disadvantage of trade credit
lies in its rather quick availability. In
fact, during periods of tight money,
trade credit may be the only source of
working capital for may small
companies. The relatively high cost of
trade credit makes it a less desirable
source of short-term financing when
compared to other alternatives.
Chronic reliance on trade credit
may in fact, impair the credit
rating of the user firm in the
long run due to its greater
impact on the liquidity risk of
the business.
Secured Short-term Financing
Secured sources of short-term credit have
certain assets of the firm pledged as
collateral to secure the loan. Upon default
of the loan agreement, the lender has first
claim of the pledged assets in addition to
its claims as a general creditor of the firm.
Hence, the secured credit agreement
offers an added margin of safety to the
lender.
Short-term financing are obtainable
through:
1. Pledging of accounts receivable
2. Factoring of accounts receivable
3. Inventory loans with
a. Floating or blanket lien
b. chattel mortgage
c. field warehouse financing agreement
d. terminal warehouse receipt
If all the accounts receivable are pledged as
collateral for the loan and the lender has no
control over the quality of the accounts
receivable being pledged, the loanable value
is set at a relative low percent generally
ranging downward from a maximum of
around 75%. However, if the lender could
select and assess the creditworthiness of
each individual account being pledged, the
loan value might reach as high as 85% or 90%
of the face value.
Cost of Financing
A disadvantage associated with this

method of financing is its relatively high
cost owing to the interest rate charged
on loan which is 2% to 5% higher than
the bank’s prime rate and processing or
handling fee of about 1% to 2% on
pledge accounts.
Illustrative Case 12.1
The XYZ Diner sells buko pie to other
restaurants on terms of net 60. The company’s
average monthly sales are P200,000; thus its
average accounts receivable balance is P400,000,
based on the two months credit period. The
company pledges all its receivables to a local bank,
which in turn advance up to 70% of the face value
of the receivables at 3% over prime and with a 1%
processing charge on all receivables pledged. XYZ
Diner follows a practice of borrowing the maximum
amount possible. The current prime rate is 12%.
What is the effective cost of
using this source of financing
for a full year?

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Business Finance

SHORT-TERM SOURCES OF FINANCING

5. What level of short-term financing

1. The effective cost of credit

4. Any additional covenants of the

Secured loans involved the pledge of

A disadvantage associated with this

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