Source

of
Short-Term
Financing

Term paper
By: Group C

Class Term Paper : By group C 1

 CONTENT

I. Short Term Financing………………………...3

Account payable management………..…4
Accruals……………………………………………...5
Bank loan…………………………………………...7
Commercial paper……………………….…….11

Reference/Bibliography …………………………..12

Short Term Financing

Class Term Paper : By group C 2

The ultimate source of capital is, of course, the investor, but there are
a number of ways by which a business may endeavor to obtain the
finance it requires with the maximum of certainty and the minimum of
expense. When seeking to capitalize a business, it is essential to know
the amount of finance required, and the type of undertaking and its
relevant circumstances. However, it is equally important that the
search for funds should be made when the appeal is likely to have the
desired effect. It is necessary, therefore, to consider the various
methods of raising capital together with the conditions in which a
business finds it expedient to apply them.

The repayment term of short term financing is usually shorter than

one year. Creditworthiness is an important aspect which the
entrepreneur or the venture must satisfy before any short term
financing will be granted. The following aspects are considered when
assessing creditworthiness.

Character: The reputation of honesty and reliability.

Capacity: The business sense of the borrower, the level of experience

and business history.

Circumstances: The general business circumstances in the industry

and the economy.

Insurance Cover: The extent of the cover of insurable risks taken out
by the borrower.

Guarantees: The lender may require the borrower to use assets to

guarantee the loan.

Different Aspects of Short Term Finance

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Important sources

• Trade cycle
• Accrual
• Bank loan
• Commercial paper

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Account payable management.

Accounts payable are the major source of unsecured shot-term

financing for business firms. They result from transaction in which
merchandise is purchased but no formal note is signed to show the
purchaser's liability to the seller. The purchaser in effect agrees to pay
the supplier the amount required in accordance with credit terms
normally stated on the supplier’s voice.

Role in the cash conversion cycle:

Cash conversion cycle is the period between the payment to its

creditors and receipts from its suppliers. But here we discuss the
management by the firm of the time that elapse between its purchase
of raw material and its mailing payment to the supplier. This activity is
account payable management.

The firm's goal is to pay as slowly as possible without damaging its

credit rating. This means that accounts should be paid on the last day
possible, given the suppliers stated credit terms. For example, if the
terms are net 30, than the account should be paid 30 days from the
beginning of the credit period, which is typically either the date of
invoice or the end of the month (EOM), in which the purchase was
made. This allows for the maximum use of an interest-free loan from
the supplier and will not damage the firm's credit rating (because the
account is paid within the stated credit terms).

Analyzing Credit Terms:

The credit terms that a firm is offered by its suppliers enable it to

delay payments for its purchase. Because the suppliers cost of having
its money tied up in merchandise after it is sold is probably reflected in
purchase price, the purchaser is already indirectly paying for this
benefit. The purchaser should therefore carefully analyze credit terms
that include a cash discount; it has two options- to take the cash
discount or to give it up.

Taking the cash discount: If a firm intends to make a cash discount, it

should pay on the last day of the discount period. There is no cost
associated with taking a cash discount.

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Give Up the Cash Discount: - If the firm choose to give up the cash
discount, it should pay on the final day of the credit period. There is an
implicit cost associated with giving up a cash discount. The cost of
giving up a cash discount is the implied rate of interest paid to delay
payment of an account payable for an additional number of days. In
other words, the amount is the interest being paid by the firm to keep
its money for a number of days.

Effects of Stretching Accounts Payable:

A strategy that is often employed by a firm is stretching accounts

payable- that is, paying bills as late as possible without damaging its
credit rating. Such a strategy can reduced the cost of giving up a cash
discount.

Source: Suppliers of merchandise

Cost or condition: No stated cost except when a cash discount is

offered for early payment.

Characteristics: Credit extended on open account for 0 to 120 days. It

is largest source of short term financing.

Formula:

Cost of giving up cash discount = CD 360

100-CD N

Approximate cost of giving up cash discount = CD 360

N

Class Term Paper : By group C 6

Accruals

A spontaneous source of short term business financing is accruals.

Accruals are liabilities for service received for which payment has yet
to be made. The most common items accrued by a firm are tax and
wages. Because taxes are paid to the government, their accrual cannot
be manipulated by the firm. However the accruals of the wages can be
manipulated to some extent. These is accomplished by delaying
payment of wages, there by receiving the interest free loan from the
employees who are paid after some time.

Source: The main sources of the accruals are employees and

government.

Cost and condition: It is a cost free, interest free, & non conditional
loan

Characteristics: it is a result of wages and taxes which are paid at

discrete point of time. Hard to manipulate this kind of source.

Formula:

Annual saving = (cost of fund (in %) payroll amount)

Class Term Paper : By group C 7

Bank loan

Banks are the major source of unsecured short term loans to business.
The major types of loan made by the banks to the business are the
short term, self-liquidating loan. That is an unsecured short term loan
in which the use to which the borrowed money is put provides the
mechanism through which the loan is repaid. Banks lends unsecured,
short-term funds in three basic ways: through single- payment notes,
lines of credit, and revolving credit agreements.

1. Single- payment notes: A short-term, one-time loan made to

a borrower who needs funds for a specific purpose for a short
period. The instruction is the note, signed by the borrower, that
state terms of the loan, including the length of the loan and the
interest rate.

Source: It can be obtained from a commercial bank by a creditworthy

business borrower.

Cost and condition: prime plus 0% to 4% risk premium – fixed or

floating rate.

Characteristics: A single- payment loan used to meet a fund shortage

expected to last only a short period of time.

Formula:

Annual percentage cost= interest cost + commitment fee 365 .

Net amount used no. of days fund used

Effective annual rate = Interest amount . 100%

For a discount loan amount borrowed- interest

360/no. of days
Effective annual rate= 1 + interest cost + commitment fee 1
Net amount used

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 2. Lines of credit: an agreement between a commercial bank and a
business specifying the amount of unsecured short term
borrowing the bank will make available to the firm over the given
period of time. It is not guaranteed loan but indicates that if the
bank has a sufficient fund available, it will allow the credit is the
maximum amount the firm can owe the bank at any point of time.

Sources: It can be obtained from a commercial bank by a

creditworthy business borrower.

Cost and condition: prime plus 0% to 4% risk premium – fixed or

floating rate. Often must maintain 10% and 20% compensating
balance and clean up the line annually.

Characteristics: A prearranging borrowing limited under which funds,

if available, will lend to allow the borrowing to the seasonal needs.

Formula:

Annual percentage cost= interest cost + commitment fee 365 .

Net amount used no. of days fund used

360/no. of days
Effective annual rate = 1 + interest cost + commitment fee 1
Net amount used

3. Revolving credit agreements: A line of credit guaranteed to a

borrower by a commercial bank regards less of the scarcity of
money. the interest rate and other requirement are similar to
those for the line of credit.

Source: It can be obtained from a commercial bank by a creditworthy

business borrower.

Cost and condition: Prime plus 0% to 4% risk premium – fixed or

floating rate. Often must maintain 10% and 20% compensating
balance and pay a commitment fee approximately 0.5% of the
average unused balance.

Class Term Paper : By group C 9

 Characteristics: A line of credit agreement under which the
availability of the fund is guaranteed. Often period greater than one
year.

Formula:

Annual percentage cost= interest cost + commitment fee 365 .

Net amount used no. of days fund used

360/no. of days
Effective annual rate= 1 + interest cost + commitment fee 1
Net amount used

Class Term Paper : By group C 10

COMMERICAL PAPER

Large, well-established companies sometimes borrow on a short-term

basis through commercial paper & other money market instruments.
Commercial paper represents an unsecured, short-term, negotiable
promissory note sold in the money market. Because these notes are a
money instruments, only the most creditworthy companies are able to
use commercial paper as a source of short-term financing.

The commercial paper market is composed of two parts: the dealer

market and the direct-placement market. Industrial firms, utilities, and
medium sized finance company all the commercial paper through
dealers. The dealer organization is composed of a half dozen major
dealers who purchase commercial paper from the issues and, in turn,
sell it to investors. The typical commission a dealer earns is 1\8
percent, and maturities on dealer-placed paper generally range from
30 to 90 days. Although the dealer market has been characterized in
the past by significant number of issues who borrowed on a seasonal
basis, the trend is definitely toward financing on a revolving or more
permanent basis.

Source: business firm both non financial and non-financial.

Cost and condition: Generally 2% to 4% below the prime rate of

interest.

Characteristics: An unsecured short term promissory note issued by

the most financially sound firm.

Formula:

Annual percentage cost= Interest cost + placement cost 360 .

Net amount used maturity date

360/no. of days
Effective annual rate= 1 + interest cost + placement cost 1
Net amount used

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Reference/Bibliography

A. “Financial management” – L. J. Gitman

B. Internet search
C. four write book
D. others

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Class Term Paper : By group C 12