What is Short-Term Financing?
Short-term financing is like borrowing money to cover immediate needs, usually for
less than a year. Businesses often use this to pay for everyday expenses, like buying
supplies or covering salaries, when cash is tight.
Understanding Interest Rates in Short-Term Financing
When businesses borrow money, they need to understand the interest rate, which is
the cost of using someone else's funds. Let's break this down:
The Nominal Rate is the basic interest rate, often used as a reference. It tells you
how much interest you'll pay on the principal amount (the loaned money).
Think of it as the "official price" for borrowing, without considering extra costs like
fees or conditions.
Nominal Rate = Interest /Principal x Time
Example:
Imagine you borrow ₱10,000 for 1 year, with an interest payment of ₱500:
Nominal Rate = 500/(10,000 x 1) = 5%
The Effective Rate gives the true cost of borrowing. It includes additional factors
like fees, discounts, or the actual money you receive (net proceeds). This is a better
measure for comparing loans.
Effective Rate=(Financing Cost/Net Proceeds)×(365 or 360/Credit Period)
Financing Cost: Total cost of the loan (e.g., interest, fees).
Net Proceeds: The amount you actually receive after deductions (e.g., fees,
required balances).
Example:
You borrow ₱10,000 for 60 days but receive only ₱9,500 because of deductions. Your
financing cost is ₱500.
Effective Rate=(500/₱9,500)×(360/60)
Effective Rate=0.0526×6=0.3156 or 31.56%
Why Does This Matter?
The Nominal Rate is simple but may not reflect the true cost.
The Effective Rate helps you compare loans with different terms, fees, or
payment schedules.
When evaluating short-term loans, always check the Effective Rate to understand
how much you're really paying!
Sources of Short-term Financing
Trade Credit
This is an agreement between two parties: the buyer and the seller. The term of
purchase is the cheapest way of obtaining short-term loan and is considered to be
the largest source of short-term funds. The term offered may or may not consist of a
discount.
The cost of discount forgone
The cost of discount forgone is essentially the opportunity cost of not utilizing an
available discount. Businesses should compare this cost to other financing options
(like bank loans) to decide whether to pay early or use the full credit period.
Discount % 360
Cost of Discount Forgone = x
100 %−Discount % Final due date−Discount period
CBA Corporation considers availing of the discount on the credit term offered by the
supplier. The terms are 4/10, n/60. At the time the term is offered, the borrowing
rate in the market is 12% per annum. Should CBA corporation take advantage of the
discount offered?
4% 360
Cost of Discount Forgone = x = 30%
100 %−4 % 60−10
Conclusion:
CBA Corporation should take the discount because:
1. The 4% discount is equivalent to a 30% annualized savings.
2. Borrowing at 12% to pay within the discount period is far cheaper than
effectively "paying" 30% by using the full credit period.
3. Taking advantage of the discount saves money for the corporation.
Stretching of Payables
It refers to delaying payment to suppliers beyond the agreed credit terms without
formally renegotiating those terms. This strategy allows businesses to hold onto
their cash longer, potentially improving short-term liquidity. However, it also comes
with risks and trade-offs.
Example Scenario
Suppose CBA Corporation has credit terms of n/60 (no discount). If they stretch their
payables to 90 days:
Benefit: Retains cash for an additional 30 days.
Risk: Supplier may impose late fees or refuse future credit.
If the supplier charges a 1% late fee on overdue payments:
The annualized cost of stretching payables is:
Late Fee % 360
Cost (%) = x
100 %−Late Fee % Stretch Period
1% 360
Cost (%) = x = 12.12%
100 %−1% 30
This 12.12% is close to typical borrowing rates, so stretching payables in this case is
only beneficial if no penalties apply.
Commercial Bank Loan
Interest (Financing Cost ) days∈a year
Cost of Term Loan = x
Principal −Interest−Compensating Balance days loan outstanding
Amount needed
Principal/Amount to be Borrowed =
1−Interest %−Compensating Balance %
Notes to remember:
1. Interest is deducted to the principal only when the loan is discounted.
2. If there’s any, the compensating balance is deducted to the principal.
3. If the problem is silent, assume simple interest.
Types of Bank Financing
1. Unsecured loans
2. Secured loans
3. Credit line
4. Installment loans
Unsecured loans
An unsecured loan is a type of loan where no collateral (assets like property or
equipment) is required.
Notes to remember:
1. No Collateral Needed: Borrowers don’t need to pledge assets as security.
2. Preferred Borrowers: Banks usually offer these loans to large, financially
stable companies (like the top 500 corporations) with strong credit histories
and steady cash flows.
3. Prime Rate Advantage: Sometimes, these loans are offered at low interest
rates, like the prime rate.
Disadvantages:
1. Higher Risk for Banks: Since there’s no collateral, the bank cannot seize
assets if the borrower fails to pay.
2. Restructuring Cost: If the borrower struggles to pay, the bank may
renegotiate the loan but with a higher interest rate.
3. Demand for Immediate Payment: If the bank notices financial trouble in the
company, it can demand full repayment quickly.
Advantages:
1. No need to pledge assets.
2. Easier to qualify for if the company has good credit.
3. Potential access to lower interest rates.
Secured loans
A secured loan is a type of loan where the borrower pledges an asset (called
collateral) to guarantee repayment. If the borrower fails to repay, the lender has the
legal right to seize and sell the collateral to recover the loan amount.
Notes to remember:
1. Collateral Requirement: The value of the collateral often determines the loan
amount.
2. Lower Interest Rates: Since the loan is less risky for the lender (due to
collateral), secured loans usually have lower interest rates compared to
unsecured loans.
3. Higher Loan Amounts: Secured loans allow borrowers to access larger loan
amounts because of the added security provided by the collateral.
4. Risk of Asset Seizure: If the borrower defaults, the lender can take possession
of the pledged asset to recover the loan.
Advantages
1. Lower Interest Costs: Less risk for the lender often translates to lower rates
for borrowers.
2. Larger Borrowing Capacity: Collateral allows access to more funds.
3. Easier Approval: Having collateral increases the chances of loan approval,
even for borrowers with lower credit scores.
Disadvantages
1. Asset Risk: Borrowers risk losing their pledged asset if they fail to repay.
2. Longer Process: Evaluating the value of collateral can make the approval
process slower.
3. Restrictive Terms: Lenders may place restrictions on the use of collateral or
impose additional fees.
Credit line
This is the type of loan granted by banks to a firm on a periodic basis, normally for
one year, and up to a specific amount. If the borrowing firm has stablished a good
credit standing with a bank, the credit line can be renewed after a year.
Revolving credit agreement versus credit line
Revolving Credit Agreement
A flexible funding option where the lender sets aside a credit limit for the borrower
to use as needed. The borrower can draw and repay repeatedly within the
agreement period.
Flexible Usage: Borrow, repay, and borrow again within the credit limit.
Interest Charged on Borrowed Amount: Interest is only applied to the funds
you use.
Commitment Fee on Unused Funds: A small fee is charged on the portion of
the credit limit that remains unused.
Note: commitment fee is part of financing cost.
Credit line
A one-time credit arrangement where the borrower accesses funds up to a limit.
Once the credit is used and paid off, the account is closed.
One-Time Use: Borrow up to the limit, and after repayment, the agreement
ends.
Interest Charged on Borrowed Amount: Like revolving credit, interest applies
only to the amount used.
No Commitment Fee: Unlike revolving credit, there's no fee for unused funds.
Sample problem:
XYZ Corporation arranges a ₱5,000,000 revolving credit agreement with a bank.
The bank charges an annual commitment fee of 0.75% on the unused
balance of the loan.
On the borrowed portion, the company pays interest at 2% above the prime
rate, where the prime rate is 6%.
XYZ Corporation immediately borrows ₱3,000,000 and repays it after one
year.
Requirement:
1. Calculate the total cost of the revolving credit agreement for one year.
2. Determine the effective interest rate.
3. If the company repays the loan after 90 days, adjust the calculations to
account for the shorter borrowing period.
Interest on borrowed amount = 3,000,000 x .08 = P240,000
Commitment fee = 2,000,000 x 0.0075 = 15,000
Total financing cost = 240,000 + 15,000 = P255,000
Total Financing Cost
Effective interest rate = x 100
Amount borrowed
255,000
Effective interest rate = x 100
3,000,000
Effective interest rate = 8.5%
Installment loans
An installment loan is a type of loan where the borrower repays the loan amount
(principal) and interest in fixed, regular payments over a set period of time. Each
payment typically covers part of the principal and the interest, and the loan is fully
paid off by the end of the term.
¿
Cost of Installment Loan = 2 x ¿ of installments x interest
(1+ ¿ of installments ) x principal
Example:
Concon borrowed P15,000 on a 12-month installment basis with total monthly
payments applicable to interest and principal. The interest rate charged by the
lending institution is 12% per annum. Thus, the interest will be P1,800 for one year
period since this is an add-on interest, then the total payment will have a face value
of P16,800 for one year with a monthly payment of P1,400. The interest has been
computed in advance and added to the principal in order to arrive at the monthly
payment. The principal amount of loan could have been used for only a month but
the interest computation is based on the principal amount of loan and not on the
diminishing balance. A P1,400 payment per month inclusive of interest and
principal, and without actually using P15,000 for one year, gives an approximate
outstanding loan balance of only P7,500. Thus, the effective interest rate will be:
2 x 12 x 1,800
Cost of Installment Loan = = 22.15%
( 1+ 12 ) x 15,000
Commercial Paper
Commercial paper (CP) is a short-term, unsecured debt instrument issued by large,
financially stable corporations to meet short-term financing needs such as payroll,
inventory, or accounts payable. It is typically used as an alternative to bank loans
and is issued at a discount to its face value.
Discount+ Floatation cost 360
Cost of Term Loan = x
Issue Price credit period
Example:
Conan corporation, having a high credit rating, is given an opportunity to issue a
commercial paper worth P100,000 at 15% for 120 days. The first obtained from the
issuance will be needed for 90 days only. The excess funds on hand can be invested
in securities with a rate of return equivalent to 12%. The brokerage fee of the
marketable security transactions is 2%. What is the cost of issuing the commercial
paper?
Discount=100,000×0.15×(120/360) = 100,000 × 0.05 = P5,000
Brokerage fee = 100,000 x .02 = 2,000
Return on marketable securities = 100,000 x .12 x (30/360) = 1,000 *120days –
90 days = 30 days
5,000+2000−1000 360
Cost of Term Loan = x brokerage fee is a
95,000−2,000 120
floatation cost
Cost of Term Loan = 19.35%
Receivable Financing
Receivable financing is a way for companies to get cash quickly by using their
accounts receivable (money owed to them by customers) as collateral. In simple
terms, when a company sells products or services, they usually give their customers
some time to pay. However, the company might need cash right away, so they can
borrow money using their unpaid invoices (receivables) as security.
The advantage of receivable financing is that it helps companies maintain cash flow
without waiting for customers to pay. The downside is that it can be expensive due
to interest rates or service charges.
Example:
CBA company assigned P500,000 of its accounts receivable to RCBC under a
notification arrangement. RCBC loans 80% less 4% service charge and 3%
Commission on the gross amount assigned. CBA signed a promissory note that
provides for 12% interest on the advances the final payment will take place after six
months. What is the amount of the loan and the effective interest rate?
Amount Loan = 500,000 x 80% = 400,000
Interest = 400,000 x 12% x 180/360 = 24,000 Note: Interest is based on
amount loan
Service Charge = 500,000 x 4% = 20,000
Commission = 500,000 x 3% = 15,000 SC and Commission are based on the
assigned amount
24,000+20,000+5,000 360
EIR = x
400,000−25,000 180
49,000 360
EIR = x
375,000 180
EIR = 26.13 %
Inventory Financing
Inventory financing is when a company borrows money using its inventory (products
or goods it holds for sale) as collateral. If a company has products ready to sell but
needs cash to pay for bills, employees, or other expenses, it can use its inventory to
secure a loan.
In this case, the lender agrees to provide funds based on the value of the inventory.
If the company doesn't pay back the loan, the lender can take the inventory and sell
it to recover the money.
This is useful for businesses that have a lot of products but aren't able to sell them
immediately. Inventory financing allows them to keep running their operations and
not be stuck waiting for sales to happen. The risk for the lender is that inventory
might not sell for as much as expected, so they may not get all their money back.