Short term financing is that form of financing which includes borrowing or lending of funds for
a short period of time. It refers to the finance obtained on short term basis, usually one year or
less in duration.
Short term financing is secured financing the current assets and inventories. Short term finance
is also known as working capital, which is the excess of current assets over current liabilities.
Current liabilities become due within the year and indicate the amount of short term financing.
Short term credit is defined as any liability originally scheduled for payment within one year. ----
Brigham.
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 1 of 24
Why Do Firms Need Short-term Financing?
Cash flow from operations may not be sufficient to keep up with growth-related
financing needs.
Firms may prefer to borrow now for their inventory or other short term asset needs
rather than wait until they have saved enough.
Firms prefer short-term financing instead of long-term sources of financing due to:
easier availability
usually has lower cost
matches need for short term assets, like inventory
Disadvantages:
Frequent maturity
High cost- The rate of interest paid on short-term is usually higher than that on long-
term credit.
Spontaneous Financing
- Spontaneous financing is raised from the normal course of business operation.
- The major spontaneous sources of short term financing are trade credit, advance and
accrual payments.
- They are naturally from the firm's day-to-day transactions.
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 2 of 24
Definition of Trade Credit (Accounts Payable):
Firms generally make purchases from others firms on credit, recording the debt as account
payable. This type of financing is called trade credit; trade credit is a kind business credit which
is extended by the seller of goods to the buyer of the same at levels of production and
distribution process down to the retailer.
I. Trade credit is a spontaneous source of financing in the sense that it arises from ordinary
business transactions. -Brigham.
II. Trade credit refers to accounts payable that arise from the purchase of goods & services.
-Benton.
So, trade credit has been defined as the short term credit by a supplier to a buyer connection
with the purchase of goods for ultimate resale.
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 3 of 24
must be paid within 30 days.
4. Net Period with Cash Discount: In addition to expending credit, the seller may offer a
cash discount if the bill is paid during the early part of the net period. For example, the
term 2/10, net 30 indicate that the seller offers a 2 percent discount if the bill is paid
within 10 days, otherwise the buyer must pay the full amount within 30 days.
5. Seasonal Dating: In a seasonal business, sellers frequently use dating to encourage
customers to place their order before a heavy selling period.
Features:
Advantages:
Availability
Low cost
Low risk
Flexibility
Increasing sales
Increasing profit
Firm’s Solvency
Disadvantages:
Quick repayment
Deprive of discount
Increasing of tax
Purchase of high rate
Free trade credit: Credit which received during the discount period is called free trade
credit
Costly trade credit: Credit which taken is excess of free credit whose cost is equal to the
discount is called costly trade credit.
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Cost of Trade Credit
A. There is no cost of trade credit in two ways:
(i) If, there is no cash discount on the transactions.
(ii) There is cash discount on the transactions and the buyer accepts the opportunity.
So, the buyer can get to rebate the full payment
B. There is cost of trade credit in two ways:
i) Mention the amount of discount and payment date.
ii) The buyer would not be able to receive the opportunity. The buyer pays the full some
specified future date. This arrangement is employed when the seller wants the amount at
last date, so the cost of trade credit is raised.
M = Number of Period
360
M
Credit Period Discount Period
Example-01: Lemon & Company has purchased goods on 2/10, net 30 credit terms. If the
company would not able to get the cash discount opportunity, what is the cost of the trade
credit?
2 360 2 360
Kt 0.020408 18 0.3673 36.73%
100 - 2 30 10 98 20
Example-02: Khokon & Company has bought goods on 2/10, net 30 credit terms. If the company
would not able to receive the cash discount opportunity, what is the effective cost of the trade
credit?
Solution:
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 6 of 24
Here,
EAR 1 0.020408 1
18
Example-03:
Shoton& Company has purchased some goods on 2/10, net 30 credit terms. If the
discount period is stretched by 5 days, what is the cost of the trade credit?
Solution:
= *
= *
=0.020408*24
=48.98%
Example-04:
Emdad & Company has purchased some goods on 2/10, net 30 credit terms. If the
payment period is stretched by 10 days, what is the cost of the trade credit?
= *
= *
=0.020408*12
=0.2449
=24.49%
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 7 of 24
Advance Payment
Advance payment is the amount made by customers constitutes the main item of different
income. Deferred income represents funds received by the firm for goods and services which it
has agreed to supply in future. These receipts increase the firm’s in the form of cash, therefore
this constitute an important source of financing.
Advance payment is the payment that is not recorded as revenue until goods, services have
been delivered to the customers.
These payments are common in case] expensive products or services like possession of shop,
connection of phone, gas line, electricity line where the product or service is short supply.
Accrued Expenses
Accrued expenses represent a liability that a firm has to pay for the services which it has
already received. Thus they represent a spontaneous, interest free source of finance.
Accrued expenses represent the amounts that have been earned by parties but have not been
paid by the company. The most important accruals are wages, salaries, taxes and interest
expenses.
Negotiated Financing
The principal sources of short-term negotiated loans are commercial banks and finance
companies. With both money market credit and short-term loans, financing must be arranged
on a formal basis.
Commercial Paper:
Commercial paper represents an unsecured, short term negotiable promissory note sold in
the money market. Generally quite large firms of unquestionable financial soundness are
able to issue commercial paper. Most paper has maturities ranging from 3 to 270 days.
Commercial paper is unsecured promissory notes issued by the most creditworthy companies
to borrow funds on a short term basis.
Commercial paper market is composed of the (1) dealer and (2) direct-placement markets.
Advantage:
Cheaper than a short-term business loan from a commercial bank.
Dealers require a line of credit to ensure that the commercial paper is paid off.
Letter of credit (L/C) -- A promise from a third party (usually a bank) for payment in the event
that certain conditions are met. It is frequently used to guarantee payment of an obligation.
Best for lesser-known firms to access lower cost funds.
Bankers’ Acceptances
- Short-term promissory trade notes for which a bank (by having “accepted” them) promises
to pay the holder the face amount at maturity.
- Used to facilitate foreign trade or the shipment of certain marketable goods.
- Liquid market provides rates similar to commercial paper rates.
Unsecured Loans -- A form of debt for money borrowed that is not backed by the pledge
of specific assets.
Secured Loans -- A form of debt for money borrowed in which specific assets have been
pledged to guarantee payment.
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Definition of Bank Loan (Unsecured)
Banks are a major source of unsecured short term loans to business. The major type of loan
made by banks to business is the short-term, self-liquidating loan. These loans at intended
merely to carry the firm through seasonal peaks in financing needs,
Unsecured short-term financing is short term financing obtained without pledging specific
assets as collateral. -L.J. Gitman.
So, unsecured short term bank loan is typically regarded as self-liquidating in the sense that the
assets purchased with the proceeds generate sufficient cash flows to pay the loan in less than
one year.
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Differences between line of credit and revolving credit agreements
Important When any firm applied for loan than In this method these paper may not be
papers the firm must be submitted audited submitted.
financial statement of cash budget
with application
Transaction Loan:
- Borrowing under a line of credit or a revolving credit agreement is not appropriate when
the firm needs short term funds for only one specific purpose.
- Transaction Loan -- A loan agreement that meets the short-term funds needs of the firm for
a single, specific purpose.
- For these types of loan, a bank evaluates each request by the borrower as a separate
transaction. In these evaluations, the cash flow ability of the borrower to pay the loan is
usually of paramount importance.
- The loan is paid off at the completion of the project by the firm from resulting cash flows.
Compensating Balance:
- In addition to charging interest on loans, banks may require the borrower to maintain not-
interest bearing demand deposit balance at the bank in direct proportion to the amount of
fund borrowed either the commitment. This minim balance is known as compensating
balance.
- For Example: If a firm needs TK. 80, 00,000 to pay off outstanding obligation, but it must
maintain a 20% compensating balance, then it must borrow 100, 00,000 to obtain a usable
TK. 80,00,000.
- So, Non-interest bearing demand deposits maintained by a firm to compensate a bank:
services/provided, credit line or loan is called compensating balance.
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Cost of Borrowing/ Cost of Bank Loan (Unsecured)
Effective Interest Rate is used to determine the cost of the credit to be able to compare
differing terms.
Example: You borrow $10,000 from a bank, at a stated rate of 10%, and must pay $1,000
interest at the end of the year.
Your effective rate is the same as the stated rate: $1,000/$10,000 = .10 = 10%
Prime Rate -- Short-term interest rate charged by banks to large, creditworthy customers
Discount Basis: With a discount interest loan, the bank deducts the interest in
advance. Thus, the borrower receives less than the face value of the loan.
EAR=
1000 1000
Effective Annual Rate= 0.1111 11.11%
10,000 1000 9000
Example:
On a one year TK. 100,000 loan with a 10% rate discount basis, what is the effective cost of
the loan?
EAR=
=11.11%
Effective Annual Rate of Credit =11.11%
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Revolving Credit:
In revolving credit agreement, the bank assures the borrower that a specified amount of funds will
be made available regardless of the scarcity of money the bank guarantees the availability of funds,
a commitment fee is normally charged on the average unused balance of the loan amount.
EAR=
Example:
$1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was
$600,000; a required 5% compensating balance on borrowed funds; and a .5% commitment fee
on $400,000 of unused credit.
What is the cost of borrowing?
Compensating balance:
If the bank requires a compensating balance, the amount of the required balance exceeds the
amount of the firm would normally hold on deposit. Then the excess must be deducted at
starting time and then has the effect added back when the loan matures. It has the effect of
raising the effective rate on the loan.
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Example:
With a simple interest loan of TK. 100,000 at 12% for 3 months, what is the effective cost
of the loan?
Solution:
=.1255
=12.55%
Installment Basis:
Bank charges add-on interest on various types of installment loans. The term add-on means that
the interest is calculated and then added to the amount borrowed to obtain the total amount to be
paid back in equal installments.
EAR=
P = Annual Installments
C = Amount of Interest
A = Amount of Loan
N = Number of Installments
Accounts from firms with weak credit ratings and substantially overdue accounts may not be
acceptable as collateral. The amount of the loan is less than the full face value of the accounts
receivable pledged as collateral.
(ii)Non-notification Basis:
If the loan is made on a non-notification basis, the borrowing customers do not know their
accounts have been pledged, and they continue to pay the borrower in the usual manner. The
borrower is supposed to repay the lender as payments are received. Non notification reduces
the lenders administrative expense but its success depends on the honesty of the borrower.
The selling of receivables to a financial institution, the factor, usually “without recourse
(meaning that the selling firm would not be liable for any receivables not collected by the
factor).”
Here, instead of offering a lender a claim against accounts receivable, the firm sells them
outright. The factor selects the accounts receivable it is willing to buy from a manufacturer.
Factors prefer to buy accounts that are not overdue and that are from high quality firms.
- Factor is often a subsidiary of a bank holding company.
- Factor maintains a credit department and performs credit checks on accounts.
- Allows firm to eliminate their credit department and the associated costs.
- Contracts are usually for 1 year, but are renewable
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- Factor receives a commission on the face value of the receivables.
Inventory-Backed Loans
Inventory is the stock of the product a company is manufacturing for sale and components that
make up the product. There are three of inventories: raw materials, work in process and
finished goods.
Inventories’ represent a reasonably liquid asset and are, therefore suitable as security for short
term loan. The lender determines a percentage advantage against the market value of the
inventory as collateral. Funds are obtained against the security of inventory in order to finance
the storage, processing or goods. Inventory is widely used as collateral against loans.
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 16 of 24
Terminal Warehouse Receipt -- A receipt for the deposit of goods in a public warehouse
that a lender holds as collateral for a loan.
Field Warehouse Receipt -- A receipt for goods segregated (separated) and stored on
the borrower’s premises (but under the control of an independent warehousing
company) that a lender holds as collateral for a loan.
Summary:
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 17 of 24
Problem
Note; For ease of calculation, 360 rather than 365 is used as the number of days in the year.
365
Discount Rate Credit Period Discount Period
EAR 1 1
100 - Discount Rate
Cost
Effective Interest Rate=
Usable Fund
Cost=Interest+Fees
Problem-1
The Roman & company is going to buy its raw materials on following credit terms:
Forgo cash discount granted on basis of 2/10, net 40.
Forgo cash discount granted on basis of 3/10, net 50.
You are required to calculate the cost of following trade credit.
Solution:
Discount rate 365
Cost of Trade Credit=
100 - Discount Rate Credit Period Discount Period
Option-I:
Credit Period=40
Discount Period=10
Discount rate=2
2 365
100 2 40 10
0.2482 24.82%
Option-II
Credit Period=50
Discount Period=10
Discount rate=3
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 18 of 24
3 365
100 3 50 10
0.2822 28.22%
365
2
EAR (1 ) 4010 1
100 2
EAR (1 0.020408)12.166 1 0.2786 27.86%
Problem-2
Kona & Company wants to buy materials on the following credit terms:
A. 2/20, net 50, if account payable is stretched by 20 days.
B. 3/15, net 60, if discount period is stretched by 5 days.
Find out the cost of trade credit and which alternative is better?
Solution:
Alternative-A
Credit Period=50+20=70
Discount Period=20
Discount rate=2
2 365
100 2 70 20
0.1489 14.89%
Alternative-B
Credit Period=60
Discount Period=15+5=20
Discount rate=3
3 365
100 3 60 20
0.2822 28.22%
As alternative-A has the cost of trade credit is lower than the alternative-B, so alternative A is
better.
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 19 of 24
Problem-03
A company wants to borrow Tk.5 lac from a bank for its working capital requirement. It has the
following alternatives:
A. 15% interest with 10% compensating balance
B. 16% interest with 15% compensating balance
Which alternative is the better for the company?
Solution:
Alternative-A
Loan amount=5,00,000
Interest=5,00,000 X 0.15=75,000
Compensating Balance=5,00,000 X0.10=50,000
75,000
EAR= 100 16.67%
500,000 50,000
Alternative-B
Interest=5,00,000 X 0.16=80,000
Compensating Balance=5,00,000 X0.15=75,000
80,000
EAR= 100 18.82%
500,000 75,000
Financing Decision Table
Alternatives Actual Cost Decision
Alternative-A 16.67% Better Alternative
Alternative-B 18.82%
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 20 of 24
Problem-04
A company wants to borrow Tk.1 lac from a bank for its working capital requirement. It has the
following alternatives:
A. 12% advance interest with 15% compensating balance
B. 10% advance interest with 20% compensating balance
C. 16% advance interest with compensating balance
Solution:
Alternative-A
Where,
Loan Amount =100000
Interest =100000 0.12 12000
Com. Bal. =100000 0.15 15000
EAR=Effective Annual Rate?
Interest
EAR=
Loan CompensatingBalabce Interest
12000
100000 15000 12000
=16.44%
Alternative-B
Where,
Interest =100000 0.10 10000
Com.Bal=100000 0.20 20000
EAR= Effective Annual Rate?
Interest
EAR=
Loan CompensatingBalabce Interest
12000
100000 15000 12000
=16.44%
Alternative-C
Where,
Interest =100000 0.16 16000
EAR=Effective Annual Rate?
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 21 of 24
Interest CommitmentFee
EAR=
LoanAmount InterestAmount
16000
100000 16000
=19.05%
Problem -5
Lubahoney Company has got a loan of Tk 80000 from a bank on revolving credit agreement.
The bank will charge 12% interest per year & 2% commitment fee on an unused portion of the
credit. If the company uses 80% of this loan, What is the effective cost?
Solution:
Where,
Usable loan= 80000 0.80 64000
Interest= 64000 0.120 7680
Commitment Fee= (80000-64000)X0.02= 16000 0.02 320
EAR=?
Interest commitmentFee
EAR=
UsableLoan
7680 320
=
64000
=12.50%
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 22 of 24
Problem -6
Muaz& company can borrow Tk.1o lac at the rate of interest 10% from a bank payment would
be made monthly installment for 1 year. What is the effective annual rate of the loan?
Where,
P=Annual Installments=12
C= Amount of interest = 1000000 0.10 100000
A=Amount of loan=10,00,000
N= Number of Installments=12
EAR= Effective Annual Rate=?
2 PC
EAR=
A N 1
2 12 100000
=
100000012 1
=18.46%
Problem -7
Muaz & company can borrow Tk.12 lac at the rate of 10% advance interest from a bank.
Payment would be made monthly installment for 9 months. What is the effective annual rate of
the loan?
MKT-102 Managerial Finance-Study Note for EMBA Program, PSTU, by Ahmed Sabbir Page 23 of 24
Problem-08:
Kona Real Estate Ltd. borrows TK. 5 million on monthly installment basis at interest fate of 9%, with
the loan to be repaid in a year at monthly installments. What is the effective cost of the loan?
Here,
P=12
C= Amount of Interest = 5,00,000 x 0.09 = 45,000
N=12
A=5,00,000.
EAR =
=16.62%
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