Chapter 15Short-Term Financing

Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection < Inventory > < Receivable > < Float >

Time ==> Accounts Disbursement < Payable > < Float > Cash Invoice Received Payment Sent Disbursed

Order Order Sale Payment Sent Cash Placed Received Received Accounts Collection < Inventory > < Receivable > < Float >

Time ==> Accounts Disbursement < Payable > < Float > Cash Invoice Received Payment Sent Disbursed

Learning Objectives Formulate a short-term financing strategy.

Choose the appropriate financing instrument.

Compute the effective cost of financing.

Financing and the Cash Flow Timeline

A deficit cash position may result from the interaction of inefficient or inappropriate working capital policies

Management should first evaluate its working capital policies to ensure the most efficient stream of cash flow from operations

Once this is done, then a short-term financing strategy should be developed

Short-Term FinancingStrategies

Fixed Assets

Permanent Current Assets

Temporary Current Assets

Time

$

Total Assets

Short-Term FinancingStrategies (Cont.)

Aggressive Financing Strategy- financing the new current assets with liabilities having comparable maturities

Management relies heavily on short-term financing and minimizes long-term financing

Net Working Capital position and Current ratios are reduced, impairing solvency

Beneficial when short term financing is cheaper than long term sources

Exposes to refinancing risk as credit me tighter in future periods and interest rate risk during inflation

Short-Term FinancingStrategies: Aggressive

Time

$

Short-Term Financing

Long-Term

Financing

Total Assets

Short-Term FinancingStrategies (Cont.)

Conservative Financing Strategy- use the long term sources of financing to meet working capital requirements

Improve solvency as current assets will be higher than current liabilities

Expensive because long term sources are more costly than short term sources.

Reduced refinancing and interest rate risk.

Short-Term FinancingStrategies: Conservative

Time

$

Long-Term

Financing

Excess Liquidity

Short-Term FinancingStrategies (Cont.)

Moderate Financing Strategy- combination of both aggressive and conservative strategies.

SHORT -Term Financing Strategies: Moderate

Time

$

Long-TermFinancing

Short-TermFinancing

ExcessLiquidity

Financing Alternatives Lines of Credit: Maximum loan amount a lender is willing to

provide to a client upon demand.• Borrower can use line whenever they choose, avoiding the

loan application process

Committed line of credit: formal, written agreement that binds the lender to provide a maximum funds at the borrower’s bequest• Such agreement requires a commitment fee to pay • Typically have covenants to ensure that the borrower

maintains a certain level of financial health

Uncommitted Line of Credit: not a binding obligation for the lender• Lenders like the flexibility offered by uncommitted lines, which

free the bank from providing funds in the event of financial deterioration by the borrower.

Lines of Credit (Cont.) Direct Costs

• Interest rate: applied on amounts drawn from the line

• Commitment fee: only relevant for committed lines and is a stated proportion of the unused portion of the line.

Indirect Costs• Compensating Balance: restricts fund availability;

reduces net loan proceeds and increasing the effective cost of line.

Other Short term Financings

Banker’s Acceptance – Is a time draft drawn against a commercial bank but with payment at maturity guaranteed by the bank.

Letter of credit : a promise to a party upon presentation of a draft or bill, provided that the party complies with certain documentary requirements as stated in the agreement between the bank and customer.

Standby letter of Credit : Which guarantees that the bank will make funds available if the company cannot or does not wish to meet a major financial obligation.

Reverse Repurchase agreement : is the other side of repurchase agreement transaction where the corporate manager may negotiate with its bank to sell the bank a specific dollar amount of marketable securities.

Commercial paper Commercial paper is a short term

promissory note issued by a corporation for fixed maturity at a fixed discount rate.• Discount basis commercial paper• Interest bearing commercial paper

Effective Interest Rate

Out of pocket Expenses 365Effective rate = -------------------- x ------- (16.1) Usable funds M

Commercial Paper Out of pocket costs

• Interest expense

• Commitment fee

• Dealer fee

Usable funds

• Discounted price (Face value less interest)

Credit Line Out of pocket costs

• Interest expense

• Commitment fee

Usable funds

• Net proceed after keeping the compensating balance

Summary Short-term financing alternatives in this

chapter differ from spontaneous financing sources such as payables and accruals.

The chapter began with a discussion of financing three financing strategies.

Then discussion focused on the major forms of short-term financing available.

The chapter concluded with a discussion of calculating the effective cost of financing with commercial paper and credit lines.