Chapter-04 Short-Term Financing PDF

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Chapter Four Short-Term Financing Chapter Outline 4.1 4.2

What is Short-Term Financing? Different Types of Short-Term Financing & their Sources.

4.1 What is Short-Term Financing? Funds available for the period of one year or less are called Short-Term Financing. The main purpose of short term financing is to fulfill the requirement for working capital of the business. The working capital is required to purchase raw materials, paying wages to labor, to incur the different types of administrative & marketing expenses on a daily basis. To incur all of these costs, short term financing is required. There are two portions in current assets. Permanent component & Fluctuating component. Short term financing is needed for the fluctuating portion of the current assets. Usually intermediate term or long term sources are used to finance the permanent component.

Characteristics of Short-Term Financing: Compare to intermediate & long term sources of financing, the short term financing has the following features: 1. 2. 3. 4. 5. 6. 7. 8.

The Duration of the short term funds is one year or less. The main Purpose of the short term financing is to fulfill the needs for working capital. Short term financing is Costly & Risky because within a very short period of time the borrower has to repay the debts. No Collateral is usually required because the loans are repaid on the basis of daily cash inflows or sales revenue. Short term financing is a Revolving credit because if the borrower/buyer could repay the bill within due date, then he could enjoy another extension of credit by lender/supplier. Short term financing from financial institutions can be easily renewed if the borrower can repay the debts within due date & fulfill all the terms & conditions. The Size & Nature of short term borrowers are quite large since small, medium, large, i.e. every kinds of manufacturing & business organizations need short term financing to continue their day to day operations. Since the purpose of short term financing is to invest in current assets, so the Amount required is relatively small.

4.2 Different Types of Short-Term Financing & their Sources. The sources of short-term financing can be categorized into two groups: A.

Spontaneous Financing. 1.

Trade Credit. i. Open Account. ii. Notes Payable. iii. Trade Acceptance

2. 3.

Advances from Customers & Deferred Income. Accrued Expenses.

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B.

Negotiated Financing. 1.

Money Market Credit. i. Commercial Paper. ii. Banker’s Acceptance.

2.

Short-Term Unsecured Bank Loan. i. Line of Credit. ii. Revolving Credit. iii. Single Payment Credit Transaction Loan.

3.

Secured Short-Term Bank Credit. i. Accounts Receivable Financing. ii. Inventory of Goods Financing.

Spontaneous Financing 1. Trade Credit Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses. For example, Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders. For many borrowers in the developing world, trade credit serves as a valuable source of alternative data for personal and small business loans. Here are many forms of trade credit in common use. Various industries use various specialized forms. They all have, in common, the collaboration of businesses to make efficient use of capital to accomplish various business objectives. According to J.F.Weston & E.F. Brigham: “ Trade credit is an interim debt arising from credit sales & recorded as an account receivable by the seller & as an accounts payable by the buyers.” The features of trade credit are:          

Credit sale or purchase. Less formality. The duration of the credit usually one to three months. Financing volume is relatively high if the frequency of transactions is large. The purpose of trade credit is to buy raw materials. No collateral is required. Continuing credit facility can be enjoyed by the buyers. Trade credit is provided against those purchases where the purpose is resale of the same but not consumption. Trade credit is widely available. The main foundation of trade credit is the mutual trust & relationship between buyer & seller.

There are three types of Trade Credit: i. Open Account: An open account transaction is a sale where the goods are shipped and delivered before payment is due, which is usually in 30 to 90 days. Obviously, this option is the most advantageous to the importer in terms of cash flow and cost, but it is consequently the highest-risk option for an exporter. Because of intense competition in export markets, foreign buyers often press exporters for open account terms. In addition, the extension of credit by the seller to the buyer is more common abroad. ii. Notes Payable: A promissory note is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee,

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under specific terms. The terms of a note usually include the principal amount, the interest rate if any, the parties, the date, the terms of repayment (which could include interest) and the maturity date. Sometimes, provisions are included concerning the payee's rights in the event of a default, which may include foreclosure of the maker's assets. Demand promissory notes are notes that do not carry a specific maturity date, but are due on demand of the lender. Usually the lender will only give the borrower a few days notice before the payment is due. For loans between individuals, writing and signing a promissory note are often instrumental for tax and record keeping. iii. Trade Acceptance: Bill of exchange that is accepted (signed) only by the drawee (party on whom it is drawn, usually a buyer or importer), and is not countersigned by the drawee's bank. Such bills are only as good as the drawee's creditworthiness.

Terms of Sale Supplier, upon acceptance of an Order placed by Buyer, will supply the products and services specified in the Order (the “Work”) to Buyer, pursuant to the terms and conditions of this Agreement and its exhibits and Supplier’s acceptance of such order submitted by Buyer is expressly limited to the terms and conditions of this Agreement notwithstanding any contrary provision contained in Buyer’s purchase orders, invoices, acknowledgements or other documents. The details of the Work (e.g. quantity, price, and product specifications) shall be set forth in the relevant Order. Terms 1. 2.

3. 4.

5. 6.

The prices payable by Buyer for goods and services to be supplied by Supplier under this Agreement will be specified in the applicable Order. Unless otherwise expressly stated in an Order, all prices exclude shipping and taxes. Payment terms are net thirty (30) calendar days from the date of the invoice. If Buyer does not pay an invoiced amount within terms, Buyer will in addition pay finance charges of one and one-half percent (1.5%) per month on the late balance and Supplier reserves the right to a. Withhold shipment of the Work until full payment is made; and/or b. Revoke any credit extended to Buyer. In the event that Buyer’s account is more than ninety (90) days in arrears, Buyer shall reimburse Supplier for the reasonable costs, including attorney’s fees, of collecting such amounts from Buyer. In the event of any dispute regarding an invoice, no finance charges will apply in the event that Buyer provides written notice of the dispute prior to the due date for such payment. Upon reasonable request by the Supplier, Buyer shall provide copies of its most recent audited financial statements or other reasonable evidence of its financial capacity and such other information as Supplier reasonable requests to determine credit status or credits limits. Buyer shall provide notice within five (5) business days of the occurrence of any event which materially affects Buyer’s ability to perform its obligations under this Agreement including but not limited to: a. The material default of any supplier or sub-contractor; b. Labor strike or dispute; or c. Material uncured default with respect to any debt obligations of Buyer. Pricing schedules (whether attached to this Agreement or an Order) are subject to change upon a change in the price of applicable raw materials (as reflected on a recognized trade or commodity pricing tracker) in excess of five percent (5%) from the date of such schedule. Unless otherwise specified in the Order, Work will be delivered FOB Supplier’s manufacturing facility and will be shipped to Buyer via carriers selected by Supplier.

Credit Terms with Discounts

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When a seller offers credit terms of net 30 days, the net amount for the sales transaction is due 30 days after the sales invoice date. To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a customer. Upon receiving the goods the customer finds that $100 of the goods are not acceptable. The customer contacts Gem and is instructed to return the unacceptable goods. This means that Gem's net sale ends up being $900; the customer's net purchase will also be $900 ($1,000 minus the $100 returned). It also means that Gem's net receivable from this customer will be $900. Unfortunately, companies who sell on credit often find that they don't receive payments from customers on time. In fact, one study found that if the credit term is net 30 days, the money, on average, arrived 45 days after the invoice date. In order to speed up these payments, some companies give credit terms that offer a discount to those customers who pay within a shorter period of time. The discount is referred to as a sales discount, cash discount, or an early payment discount, and the shorter period of time is known as the discount period. For example, the term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days, the net purchase amount (without the discount) is due 30 days after the invoice date. Using the example from above, let's illustrate how the credit term of 2/10, net 30 works. Gem Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to Gem within a few days. At that point, the net amount owed by the customer is $900. If the customer pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900) from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid within the 10-day discount period. Let's assume that the sale above took place on the first day that Gem was open for business, June 1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882 from the buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The above transactions are reflected in Gem's general ledger as follows: Date

Account Name

Debit

June 1

Accounts Receivable Sales

1,000

June 1

June 6

June 6

Credit

1,000

Cost of Goods Sold (80% of 800 1,000) Inventory

800

Sales Returns and Allowances Accounts Receivable

100 100

Inventory Cost of Goods Sold

80 80

June 11

Cash 882 Sales Discounts (2% of 900) 18 Accounts Receivable 900 If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place will be the following entry on July 1:

Date

Account Name

Debit

4

Credit

July 1

Cash

900 Accounts Receivable

900

Examples of Amounts due Under Varying Credit Terms

The following chart shows the amounts a seller would receive under various credit terms for a merchandise sale of $1,000 and an authorized return of $100 of goods. Credit Terms Brief Description Net 10 days The net amount is due within 10 days of the invoice date. Net 30 days The net amount is due within 30 days of the invoice date. Net 60 days The net amount is due within 60 days of the invoice date. If paid within 10 days of the invoice date, the buyer may deduct 2% from the 2/10, n/30 net amount. ($900 minus $18) 2/10, n/30 If paid in 30 days of the invoice date, the net amount is due. If paid within 10 days of the invoice date, the buyer may deduct 1% from the 1/10, n/60 net amount. ($900 minus $9) 1/10, n/60 If paid in 60 days of the invoice date, the net amount is due. The net amount is due within 10 days after the end of the month (EOM). In Net EOM 10 other words, payment for any sale made in June is due by July 10.

Amount To Be Received $900 $900 $900 $882 $900 $891 $900 $900

Costs of Trade Credit There is a cost associated with having trade credit granted to your company by your suppliers. Suppliers are probably in the same position you are regarding cash flow, so the purchase price of what you purchase from the suppliers is often higher than if you were paying cash. Not only do you have to absorb the higher purchase price, but you have to figure in the actual cost of trade credit. Prompt Payment

Visible Costs

Hidden Costs

None Costs Passed on to Buyer by Seller for: 1. Carrying Costs. 2. Credit Checking. 3. Bad-Debt Losses.

Delayed Payment 1. 2.

Cost of forgoing cash discount. Penalty charge for late payment. Costs of Paying Late.

Figure 4.1 Trade Credit Use & Costs. 1.

Prompt Payment – Visible Costs: If the firm pays its supplier exactly on time, taking all cash discounts on their discount date & paying all other bills on the due date, trade credit has no visible costs.

2.

Prompt Payment – Hidden Costs: Some credit sales will result in bad debt losses. The supplier also has to pay for the funds used to produce products; consequently, they can scarcely afford to grant credit to customers costlessly. In addition, the credit-granting procedure usually involves some credit-checking operation, which supplier either performs themselves or purchase from a credit checking agency.

3.

Delayed Payment – Visible Costs: There are two kinds of costs to consider here: i. Cost of forgoing cash discount. ii. Penalty charge for late payment

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In case of forgoing cash discount: Visible Annual Cost of forgoing cash discount = [% cash discount/ (100% - % cash discounts)] X 365/N In case of Penalty Charges on Late payment: Visible Annual Costs of Penalty Charge = % Penalty Per Year X Number of Periods Per Year.

4.

Delayed Payment – Hidden Costs: The firm could reduce the visible costs of forgoing cash discounts by not paying the full amount of the bill by the due date. Although this practice reduces the visible cost of forgoing cash discounts, as shown above, it increases the hidden costs that arises due to the possible deterioration of the firm’s credit rating. If a firm is known as a slow payer, it suppliers may offer lessfavorable trade credit terms, particularly when money is tight.

Factors Determining the Terms of Trade Credit          

Policies of Sales Administration. Sales Volume. Financial Condition of the Seller. Nature & Behavior of the Buyer. Financial Condition & Goodwill of the Buyer. Risk of Credit. Distance & Communication between Buyer & Seller. Nature & Size of the Market. Nature of Goods & Services. Trade Cycle.

Factors Determining the Volume of Trade Credit                

Capital Structure Policy. Nature of Buying Company. Size of the Buying Company. Nature of Goods & Services. Ability to Repay the Credit. Liquidity Position. Market Condition. Availability of Fund from other Sources. Seasonal Variations of Demand & Supply. Sales/Credit Policy of the Seller. Attitude of the Seller. Ability & Willingness of the Seller. Repayment Habit. Understanding of the Seller about the Buyer. Overall Capital Market Conditions. Overall Economic Conditions of the State.

Advantages of Trade Credit         

Widely Available. Possibility of More Profit by Increasing Sale. Less Formality. Financing Volume is Relatively High. Less Costly. No need for Collateral. Benefit of Increased Volume of Credit. Development of Mutual Trust & Good Relation. Flexibility in Determining the Volume of Credit.

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 

Less Risk of Bad Debt. Only & Last Resorts for Small Traders.

Disadvantages of Trade Credit     

Shorter Payment Period. High Cost of Forgoing Cash Discount. High Price of Goods. Possibility of Bad Debt Loss. No Tax Exemption.

2. Advances from Customers & Deferred Income. Another common way of short term financing is advances from customers before purchasing products or receiving services. Usually before purchasing heavy duty equipments or any other fixed assets, buyer pays in advance to the vendor either full or partial price of the asset. In such cases, the seller or the vendor does not need his own fund from the day of advanced receipts to the day of delivery of the product. The seller does not need to pay any interest to the buyer for such kind of advances & that’s why there is no cost of capital for this fund is required.

3. Accrued Expenses An even more automatic source of short-term funds than trade credit is accruals, also knows as accrued expenses. Since – by definition – accruals permit the firm to receive some service before paying for it, accruals are a form of short term funds supplied to the firm at no explicit cost. Furthermore, accruals expand automatically as the firm’s operations expand. The main components of accrued expenses are wages & taxes.

Negotiated Financing 1. Money Market Credit Generally large & reputed firms can collect short term funds from money market by using the following two instruments: a.

Commercial Paper: In the global money market, commercial paper is an unsecured promissory note with a fixed maturity of 1 to 364 days. Commercial paper is a money-market security issued (sold) by large corporations to get money to meet short term debt obligations (for example, payroll), and is only backed by an issuing bank or corporation's promise to pay the face amount on the maturity date specified on the note. Since it is not backed by collateral, only firms with excellent credit ratings from a recognized rating agency will be able to sell their commercial paper at a reasonable price. Commercial paper is usually sold at a discount from face value, and carries higher interest repayment rates than bonds. Typically, the longer the maturity on a note, the higher the interest rate the issuing institution must pay. Interest rates fluctuate with market conditions, but are typically lower than banks' rates.

Effective Interest Rate = [(Face Value – Sale Price)/ Sale Price] X [360 days/Repayment Periods in Days] The commercial paper can be sold in two ways:  

The Issuing Company may Directly Sale the commercial paper to the targeted Investors (buyers), or The Issuing Company may sale the commercial paper to the Dealers & the dealer resale the papers to the investors in the market place.

Advantage of commercial paper:

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High credit ratings fetch a lower cost of capital. Wide range of maturity provides more flexibility. It does not create any lien on asset of the company. Tradability of Commercial Paper provides investors...