Short-Term Financing Flashcards
What are the types of short-term financing sources?
Types of sources include the following:
- Spontaneous sources (those that arise in the normal course of business)
- Commercial banks
- Market-based instruments
How is trade credit a source of spontaneous form of financing for a firm?
Trade credit resulting in accounts payable is the largest source of credit for small firms. It is created when a firm is offered credit terms
Example: A vendor has delivered goods at a price of $160K on terms of net 30. The firm has effectively received a 30-day interest-free loan
The advantages of trade credit are that it is widely available and is free during the discount period
Another advantage is that not taking the discount sometimes is less costly than alternative sources of financing
How are accrued expenses a source of spontaneous form of financing for a firm?
Accrued expenses (i.e. salaries, wages, interest, dividends and taxes payable) are other sources of (interest-free) spontaneous financing
For instance, employees work 5, 6 or 7 days a week but are paid only every 2 weeks. A firm carries on operations constantly but must only remit federal income taxes every quarter
Accruals have the additional advantage of fluctuating directly with operating activity, satisfying the matching principle
What are the advantages of bank loans as a source of short-term financing?
Commercial banks offer term loans and lines of credit. These loans are second only to spontaneous credit as a source of short-term financing
The advantage is that bank loans provide financing not available from trade credit, etc. Thus, a firm can benefit from growth opportunities
What are the disadvantages of bank loans as a source of short-term financing?
The disadvantages are:
a. Increased risk of insolvency
b. Risk that short-term loans may not be renewed
c. Imposition of contractual restrictions (such as a compensating balance requirement)
A term loan (such as a note) must be repaid by a certain date
What is a Line of credit?
A line of credit is an informal borrowing arrangement (generally for a 1-year period). It allows the debtor to re-borrow amounts up to a maximum, as long as certain minimum payments are made each month (similar to a customer’s credit card)
A line of credit is the right to draw cash at any time up to a specified maximum. A line of credit may have a definite term (or it may be revolving) that is the borrower can continuously pay off and re-borrow from it. Sometimes a bank charges a borrower a commitment fee on the unused portion
What is an advantages of using a line of credit as a source of short-term financing?
An advantage of a line of credit is that it is often an unsecured loan that is self-liquidating, that is the assets acquired (i.e. inventory) provide the cash to pay the loan
What is a disadvantage of using a line of credit as a source of short-term financing?
One disadvantage of a line of credit is that it is NOT a legal commitment to give credit. Accordingly, it might not be renewed
A second is that a bank might require the borrower to “clean up” its debt for a certain period during the year (i.e. for 1 or 2 months)
What is the Prime interest rate?
The prime interest rate is the rate charged by commercial banks to their best (the largest and financially strongest) business customers
It is traditionally the lowest rate charged by banks
What is a Simple interest loan?
A simple interest loan is one in which the interest is paid at the end of the loan term. The effective rate on the loan is the same as the nominal (state) rate. The relevant formulas are as follows:
Amount needed = Invoice amount x (1.0 - Discount %)
Interest expense (annualized) = Amount needed x Stated rate
What is the Effective rate on a loan?
The effective rate on any financing arrangement is the ratio of the amount the firm must pay to the amount the firm can use. The most basic statement of this ratio uses the dollar amounts generated by the equations for a simple interest loan:
Effective interest rate = Net interest expense (annualized) / Usable funds
Note: The effective rate and the nominal rate on a simple interest loan are the same
What is Discounted loan?
A discounted loan requires the interest to be paid at the beginning of the loan term
Total borrowings = Amount needed / (1.0 - Stated rate)
Note: Since the borrower has the use of a smaller amount, the effective rate on a discounted loan is higher than its nominal rate
How do you calculate the effective rate on a discounted loan?
As with all financing arrangements, the effective rate can be calculated without reference to dollar amounts:
Effective rate on discounted loan = Stated rate / (1.0 - Stated rate)
Effective rate = Net interest expense (annualized) / Usable funds
What is the formula for calculating total borrowing for loans with compensating balances?
Rather than charge cash interest, banks sometimes require borrowers to maintain a compensating balance during the term of a financing arrangement:
Total borrowings = Amount needed / (1.0 - Compensating balance %)
As with a discounted loan, the borrower has access to a smaller amount than the face amount of the loan and so pays an effective rate higher than the nominal rate
How do you calculate the effective rate on a loan with a compensating balance?
As with all financing arrangements, the effective rate can be calculated without reference to dollar amounts:
Effective rate with comp. balance = Stated rate / (1.0 - Compensating balance %)
Effective rate = Net interest expense (annualized) / Usable funds
