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Trade credit

Trade credit is an agreement between two businesses wherein one buys on


credit or account. Trade credit provides the most flexible source of financing.
It also serves as the primary source of spontaneous funds since it arises on
ordinary course of business.

For the lending party to influence the borrowing party to pay and do not
stretch the payment period of their trade credit, they put credit term wherein
a discount may be taken if amount borrowed is paid on a given period. For
example, the term given is 2/10, N/30, this means that 2% discount may be
taken if the amount borrowed is paid within 10 days from the receipt of the
bill. Opportunity cost lost on this term if the discount is not taken may be
computed as:

Approximate effective cost of trade credit = .02/(1-.02) X 360/(30-10)


= 36.7%

Short-term Bank loans

Commercial banks take the second most important source of short term
financing. They provide nonspontaneous funds. These bank loans can have a
maturity date as early as 60 to 120 days from the date of inception of the
loan. Bank short term loans can also mature up to one to three years after
the inception of the loan. The terms depend on the bank and the amount of
money borrowed.

Many banks may also require collateral, depending again, on the amount
borrowed. The smaller the loan, the less apt the lender or bank is to ask for
collateral.

When the bank loan is approved, the agreement is executed by signing a


promissory note. The note may entail the following:

1. Amount borrowed
2. Interest rate
3. Repayment schedule
4. Any collateral that might have to be put up as a security for the loan,
and
5. Any other terms and conditions to which the bank and the borrower
may have agreed.

Line of Credit
A firm may arrange a credit arrangement with large commercial banks if
they still don’t wish to borrow until the funds is actually needed. The
arrangement may be in the form of:

1. Line of Credit
a. Informal arrangement with bank
b. The bank lends up to a specified maximum amount during a
designated period
2. Revolving Credit Agreement
a. Formal line of credit
b. Legal commitment by bank to extend credit up to some
maximum amount for a few months or several years.

Commercial Paper

Commercial paper is an unsecured short-term promissory note with fixed


maturity of 1 to 270 days. It is sold by a highly credit-worthy firms and
approval by the Securities and Exchange Commission is necessary before
such promissory note is issued. Commercial paper is usually sold at
a discount from face value, and carries higher interest repayment dates
than bonds. Large firms use commercial papers to finance their working
capital because it is much less expensive than the cost of trade credit.

Secured Short-Term Financing


Secured short-Term financing is a term wherein certain assets of the firm are
pledged as collateral to secure the borrowings. The 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