4. Short-Term (Working Capital) Financing

Question 1

What is financial structure?

Answer 1

The mix of liabilities (LT and ST) and owner’s equity accounts of a firm.
Financial structure includes capital structure.

Question 2

What is capital structure?

Answer 2

The long-term sources of funding (LT debt and owners’ equity).

Question 3

What is short-term financing? What is it also called?

Answer 3

The funding provided by obligations which become due within one year (i.g. current liability).
Also called working capital.

Question 4

Short-term financing: What are examples of primary forms?

Answer 4

Trade accounts payable.
Accrued accounts payable (e.g. wages, taxes, etc).
Short-term notes payable.
Lines of credit, revolving credit and letters of credit.
Commercial paper.
Pledging and factoring accounts receivable.
Inventory secured loans.

Question 5

Payables: what is it?

Answer 5

Occur through the acquiring of goods/services financed by incurring an obligation to pay in the future.
Financing of certain assets (supplies, inventory etc) is highly flexible; liability occurs concurrent with the acquisition of goods/services.

Question 6

Payables: what is the item widely used?

Answer 6

Trade accounts payables.

Question 7

Payables: What are advantages of trade accounts payable?

Answer 7

• Easy to use; little legal documentation required
• Flexible; they expand and contract with needs (i.e. purchases)
• Interest normally is not charged
• Collateral normally not required; they are unsecured
• Discounts often are offered for early pmt

Question 8

Payables: What are disadvantages of trade accounts payable?

Answer 8

• Require pmt in the short-term
• The effective cost is higher if discounts are not taken
• Financing they provide is use specific - their use finances only the assets acquired through trade accounts

Question 9

What is the annual percentage rate (APR) for;

2/10, n/30?

Answer 9

APR = [(discount lost / principal) x 1] / Time fraction of year.
APR = [(.02/.98) x 1] / (20/360) = 36.73%

Question 10

Payables: What is Accrued accounts payable?

Answer 10

Results from acquiring cash and other benefits financed by an obligation to be satisfied in the future.

Question 11

Payables: Examples of accrued accounts payable?

Answer 11

• Salaries and wages payable.
• Taxes payable.
• Unearned revenue, including gift and other prepaid cards - The time between when the benefit or cash is received and the obligation is satisfied provides short-term financing.

Question 12

Payables: Accrued accounts payable: Advantages?

Answer 12

• Easy to use; occur in the normal course of business
• Flexible; they expand/contract with activity
• Collateral normally not required. though some creditors may have specific legal claims.

Question 13

Payables: Accrued accounts payable: Disadvantages?

Answer 13

• Required pmt in the short-term

* Some financing is use specific; many things can’t be financed through accrued account.

Question 14

Payables: What is short-term notes payable?

Answer 14

Result from acquiring cash through borrowing with repayment due in one year or less.

Question 15

Payables: What are characteristics of ST notes payables?

Answer 15

• Typically a promissory note is required
• Interest rate charged is based on credit rating of borrower
• A compensating balance may be required

Question 16

Payables: What is compensating balance? How does it affect effective cost of borrowing?

Answer 16

An amount that must be maintained in a demand deposit account with lender.
It increases effective cost of borrowing.

Question 17

Payables: ST notes payable: Advantages?

Answer 17

• Commonly available for creditworthy firms
• Flexible; amounts and periods can be varied with needs
• Collateral normally is not required; they are unsecured
• Provides cash for various purposes

Question 18

Payables: ST notes payable: Disadvantages?

Answer 18

• Poor credit rating will mean a higher interest rate and possibly require collateral
• Require repayment in the short term
• Compensating balance would increase the effective cost and reduce funds available
• Refinancing would be necessary, if the note can’t be paid when due

Question 19

Payables: Cost of borrowing and effective interest rate: EX:

Borrowed $20,000, one-year, 6% interest, 10% compensating balance.

Answer 19

Cost of borrowing: 20,000 x 6% = 1,200
Net proceeds = 20,000 - (10% x 20,000) = 18,000.
Effective interest rate = 1,200/18,000 = 6.7%

Question 20

Standby Credit and Commercial Paper: What is standby credit?

Answer 20

An arrangement to have financing available for a specific purpose or period of time.

Question 21

Standby Credit and Commercial Paper: What are 3 forms of standby credit?

Answer 21

• Line of credit
• Revolving credit
• Letter of credit

Question 22

Standby Credit and Commercial Paper: What is line of credit?

Answer 22

Informal agreement whereby a financial institution agrees to a maximum amount of credit that will be extended at any one time

• Not legally binding on financial institution
• Provides reasonable assurance of funds
• Available funds generally can be used for any purpose

Question 23

Standby Credit and Commercial Paper: What is revolving credit?

Answer 23

Formal agreement whereby a financial institution or other lender agrees to a maximum amount of credit that will be extended.
*Like a line of credit, but with a legally binding agreement

Question 24

Standby Credit and Commercial Paper: What is letter of credit?

Answer 24

A conditional commitment by a financial institution to pay a third party in accordance with specified terms and conditions.

• Example: Pmt to 3rd party upon proof of shipment of goods
• Provides 3rd party assurance of pmt without the buyer (also the borrower) having to pay in advance
• Often used in connection with foreign transactions

Question 25

Standby Credit and Commercial Paper: Standby credit: advantages?

Answer 25

* Commonly available for creditworthy firms * Highly flexible; credit used, and debt incurred, only when needed * Usually no collateral required; it is unsecured * Both line of credit and revolving credit provide cash for general use

Question 26

Standby Credit and Commercial Paper: Standby credit: disadvantages?

Answer 26

* Poor credit rating will mean a higher interest rate and possibly require security * Typically involves a fee * Require satisfaction in the short term * Required compensating balance increase effective cost and reduces funds available for use * Line of credit not legally binding on financial institution

Question 27

Standby Credit and Commercial Paper: What is commercial paper?

Answer 27

Short-term, unsecured promissory notes sold by large, highly-creditworthy firms. * Most are for 180 days or less * If more than 270 days, SEC registration is required * May be sold directly to investors or through dealers * May be sold on discounted bases or with interest paid over the short life of the note

Question 28

Standby Credit and Commercial Paper: Commercial Paper: Advantages?

Answer 28

* Interest rate generally lower than other ST sources * Large amount can be obtained * Compensating balances are not required * No assets need to be pledged as collateral; unsecured * Provides cash for general use

Question 29

Standby Credit and Commercial Paper: Commercial Paper: Disadvantages?

Answer 29

* Only available to most creditworthy firms * Requires satisfaction in the ST, usually of a large amount * Lacks flexibility of extension or other accommodations (as compared with bank loans)

Question 30

Receivables/Inventory: What is pledging A/R? How is the level of borrowing available determined?

Answer 30

Using A/R as security for ST borrowing (A fee based on the value of A/R pledged is usually charged) Level of borrowing: *Creditworthiness of the A/R *Level of leader's recourse against borrower

Question 31

Receivables/Inventory: Pledging A/R/: What are advantages?

Answer 31

* commonly available * Flexible; as new A/R occur, they can be used as security * compensating balances are not required * Provides cash for general use * Lender may provide billing and collections services, usually for a fee

Question 32

Receivables/Inventory: Pledging A/R/: What are disadvantages?

Answer 32

* Accounts are committed to lender as security (no control) * Cost of pledging A/R may be greater than other sources of ST financing * Requires repayment in the short term

Question 33

Receivables/Inventory: What is factoring?

Answer 33

The sale of A/R.

Question 34

Receivables/Inventory: Factoring: what is buyer called?

Answer 34

Factor

Question 35

Receivables/Inventory: Factoring: what are terms of sale?

Answer 35

* Without recourse: The factor bears the risk associated with collectibility, except in the case of fraud * With recourse: The factor has recourse against the seller for some or all of the risk associated with uncollectibility of the receivables.

Question 36

Receivables/Inventory: Factoring: what does factor charge and how is it determined?

Answer 36

A factor's fee based on: * Creditworthiness and length of maturity of the receivables * Extent to which the factor assumes risk of uncollectibility

Question 37

Receivables/Inventory: Factoring: Advantages?

Answer 37

* Commonly available * Flexible; as new accounts receivables occur, they can be sold * compensating balance is not required * Provides cash for general use * Buyer generally assumes billing and collection responsibilities

Question 38

Receivables/Inventory: Factoring: Disadvantages?

Answer 38

* cost may be greater than certain other sources of ST financing * if sold with recourse, selling firm may have an on-going risk * sale of A/R may alienate customers

Question 39

Receivables/Inventory: What is inventory secured loan?

Answer 39

Occur when a firm pledges all or part of its inventory as collateral for a short-term loan.

Question 40

Receivables/Inventory: Inventory secured loan: How is the amount that can be borrowed determined?

Answer 40

Depends on value and marketability of the inventory.

Question 41

Receivables/Inventory: Inventory secured loan: What are arrangements?

Answer 41

* Floating lien agreement * Chattel mortgage agreement * Field warehouse agreement * Terminal warehouse agreement

Question 42

Receivables/Inventory: Inventory secured loan: What is floating lien agreement?

Answer 42

Borrower gives a lien on all of its inventory, but retains control of its inventory which it continuously sells and replaces.

Question 43

Receivables/Inventory: Inventory secured loan: What is chattel mortgage agreement?

Answer 43

Lender has a lien against specifically identified inventory, borrower retains control of that inventory, but can't sell it without lender approval.

Question 44

Receivables/Inventory: Inventory secured loan: What is field warehouse agreement?

Answer 44

Inventory remains at borrower's warehouse, but under the control of an independent third party

Question 45

Receivables/Inventory: Inventory secured loan: What is terminal warehouse agreement?

Answer 45

Inventory is moved to a public warehouse and placed under the control of an independent third party

Question 46

Receivables/Inventory: Inventory secured loan: how is the cost of inventory secured loan determined?

Answer 46

Depends on; Nature of inventory Credit standing of the borrower Specific type of security agreement used

Question 47

Receivables/Inventory: Inventory secured loan: Advantages?

Answer 47

* Commonly available for certain inventors, including commodities, automobiles, etc * Flexible; as new inventories become available they can become security * May provide cash for general use

Question 48

Receivables/Inventory: Inventory secured loan: Disadvantages?

Answer 48

* Pledged inventory may not be available when needed * Cost of using the loan may be greater than other ST financing * May require repayment in the short term * Not available for certain inventories