COLLEGE OF BUSINESS AND ACCOUNTANCY

TOPIC: Short-Term Financing

LEARNING OBJECTIVES:
At the end of this module, the student should be able to:
1. Differentiate nominal rate, effective rate, and real interest rate.
2. Identify sources of short-term funds and their classification
3. Estimate the costs of short-term funds such as trade credit, bank loans, and commercial paper, as well as receivable
and inventory financing

BIBLICAL VALUES INTEGRATION:

“Each of you should give what you have decided in your heart to give, not reluctantly or under compulsion, for God loves a
cheerful giver. And God is able to bless you abundantly, so that in all things at all times, having all that you need, you will
abound in every good work.”
- 2 Corinthians 9:7-8

INTRODUCTION
Short-term financing refers to the financing of a business from short-term sources for a period of less than one year
and it assists the company in generating cash for working capital and operating expenses, which are typically for a smaller
amount, and it involves generating cash through online loans, lines of credit, and invoice financing.

Interest Rates:
Interest rate is the general term used for financing cost from borrowed funds. Different types of short-term interest
are Nominal rate, and Effective Rate.

Nominal rate - basis of cash payments on borrowings

Nominal Rate = Interest /Principal x Time

Effective rate - basis of determining the interest expense on borrowings

Effective Rate = (Financing cost/Net Proceeds) X (365/credit period).

*Financing cost depends on the source of financing. It usually includes interest payments, origination fees paid by
borrower, amortization of discount, etc.
*Net proceeds depend if the loan is discounted or with compensating balance requirement

Real interest rate - unlike the nominal rate, it takes inflation into account to provide investors with a more accurate measure
of their purchasing power after redeeming their positions.
Real rate = Nominal rate - Inflation factor.

Simple vs. Compounded Effective Interest

Simple interest is calculated on the loan or deposit's principal amount. Compound interest, on the other hand, is calculated
using the principal amount and the interest that accumulates on it over time. Simple interest is calculated using the following
formula:

Simple Interest = Principal x annual interest rate x term of loans

 COLLEGE OF BUSINESS AND ACCOUNTANCY
Illustration:
Jack Company borrows P500,000 for three years from the local bank, who agrees to charge Jack Co. simple interest at 5%
annually. How much would Jack Co. have to pay in interest charges every year, and what would its total interest charges be
after three years? (Assume the principal amount remains the same throughout the three years, le., the full loan amount is
repaid after three years.)

Compound interest accrues and is added to the accumulated interest of previous periods, it includes interest on Interest, in
other words. The formula for compound interest is
Compound Interest = P(1+r)t – P

Illustration:
Jack Company borrows P500,000 from the local bank at an interest rate of 5% per year compounded annually, with the full
loan amount and interest payable after three years. What would be the total interest paid by Jack Company?

SOURCES OF SHORT-TERM FINANCING

UNSECURED SOURCES

a) Trade credit
Financing that arises from the normal course of business, the two major short-term sources of such liabilities are accounts
payable and accruals. The effective interest is computed as:

Percentage Discount 360∨365 days

x
100 %−Percentage Discount Credit Period− Discount Period

Illustration:
Compute for the effective rate of terms 2/10. n/30, Assume 360 days

b) Commercial Bank Loan

Banks are major source of unsecured short-term loans to businesses. The major type of loan made by banks to businesses is
the short-term, self-liquidating loan.

Cost of Term Loans =

Interest (Financing Cost ) days∈ a year
x
Principal −Interest−Compensating Balance days loanis outstanding
Principal/Amount to be Borrowed =
Amount needed Net Proceeds ∈Peso
∨
1−Compensating balance%−Interest % Net Proceeds∈%
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Illustration
The Manila Commercial Bank and Bank Rap Corp signed a loan agreement subject to the following terms:
a. Stated interest rate of 18% for one-year, loan discounted in advance, and
b. 15% compensating non-interest-bearing checking account balance to be maintained by Bank Rap with Manila Commercial
Bank

The net proceeds of the loan were P1 million. How much was the principal amount of the loan? How much is the effective rate?

Illustration:
Principal P100,000
Nominal rate 12%
Period 120 days
Compensating balance 8%

1) Compute for the effective interest assuming

a. Discounted and with Compensating Balance requirement
b. Discounted but no Compensating Balance requirement
c. Simple interest with Compensating Balance requirement
d. Simple interest with no Compensating Balance requirement

2) Re-compute above assuming the company has 1) P5,000, 2) P10,000 deposited with the bank.

Revolving Credit Agreement vs Credit Line

Revolving credit and a line of credit are financing arrangements made between a lending institution and a business or an
individual. In Revolving credit agreement, the lender provides sets aside funds that the borrower can use at his discretion. The
borrowed portion is subject to interest, and the unborrowed portion is subject to Commitment fee. Commitment fee is part of
financing cost. A line of credit is a one-time arrangement, and when the credit line is paid off, the account is closed.

Illustration:
Highland Construction arranged a P10,000,000 revolving credit agreement with a group of small banks. The firm paid an
annual commitment fee of one-half of one percent of the unused balance of the loan commitment. On the used portion of the
loan, Highland paid 1.5 percent above prime for the funds actually borrowed on an annual, simple interest basis. The prime
rate was at 9 percent for the year. If Highland borrowed P6,000,000 immediately after the agreement was signed and repaid
the loan at the end of one year, what was the total cost of the loan agreement for one year?

Compute for the effective rate.

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Cost of Installment Loans

Installment loan/credit is another source of short-term financing, in which the borrowed amount is paid in equal installments
with interest. The effective interest on installment loan is computed as

2 x ¿ of installments x interest ¿
(1+ ¿ of installments ) x principal

Illustration
Ms. Smith borrowed P2,000 at an 8% stated rate of interest and was to pay back the loan in 24 monthly payments. What is her
effective rate of interest?

Illustration: Mrs. Smith entered a one-year loan with the following terms:
Principal P100,000
Nominal rate 12%
Term Installment loan

Compute for the effective interest assuming the following installment payments
a. Monthly
b. Quarterly
c. Semi-annual
d. Annual
e. Re-compute Monthly payments assume a 2-year loan
f. Re-compute the effective interest assuming the loan requires compensating balance of 8% of Principal.

c) Commercial Paper
Commercial paper is a form of financing that consists of short-term, unsecured promissory notes issued by firms with a high
credit standing. Generally, only quite large firms of unquestionable financial soundness can issue commercial paper. Most
commercial paper has maturities ranging from 1 days to 270 days. Commercial papers are often non-interest bearing and are
sold at a discount.

Features of CP:
1. The maturity period of CP ranges from 1day to 270 days
2. It is sold at a discount from its face value and redeemed at its face value.
3. Return on CP is the difference between par value and redeemable value.
4. It may be sold directly to investors or indirectly through dealers
5. There is no developed secondary market for CP.

Cost of commercial paper is computed as follows:

Discount+ Floatation cost 365 days

x
Issue Price credit period
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Illustration:
Face Value P1,000
Issue Price P920
Term 120 days
Compute for the effective interest.

Re-compute the effective interest assuming

a. Flotation cost of P10 is required
b. Paper carries 6% nominal rate,
c. Flotation cost of P10 is required and contains 6% nominal rate.

SECURED SOURCES OF FINANCING

a) Receivable Financing
Two commonly used means of obtaining short-term financing with accounts receivable are pledging accounts receivable and
factoring accounts receivable.

Pledging of Accounts Receivable

Accounts receivable pledging occurs when a business uses its accounts receivable asset as collateral on a loan, usually a line of
credit. Under a pledging agreement, the company retains title to and is responsible for collecting accounts receivable, not the
lender. Even though the lender now has a legal interest in the receivables, it is not necessary to notify customers of this
interest.

The cost of pledging of receivables is the same with commercial loans:

Financing cost 365 days

x
Net proceeds credit period
Illustration
ABC Company assigned P700,000 of accounts receivable to the PhilBank under a non-notification arrangement. PhilBank
advances 80% less a service charge 2%. ABC Company signed 120-day promissory note that provides for interest of 12% on
the unpaid loan balance.
Compute for the Amount of Loan and Effective rate.

b) Inventory Financing
Inventory financing is credit obtained by businesses to pay upfront for products that will not be sold immediately. The loan is
collaterized by the inventory it is used to purchase. Inventory financing is most often used by smaller privately-owned
businesses that do not have access to other options.

Illustration
The Advil Supply Company is considering obtaining a loan from a sales finance company secured by inventories under a field
warehousing arrangement. Advil would be permitted to borrow up to P500,000 under such an arrangement at an annual
interest rate of 10%. The additional cost of maintaining a field warehouse is P15,000 per year. Advil borrowed P400,000
during the year.
Compute for the financing cost and the effective rate.
 COLLEGE OF BUSINESS AND ACCOUNTANCY

Short-term Financing by Rhad Vic F. Estoque, CPA, MBA, RCA, MICB, CAT, CMA. REO CPA Review.