FINANCIAL

MANAGEMENT
CHAPTER 6: SHORT TERM FINANCING
INTRODUCTION

❖ Short term financing is a short term obligation that is expected to mature in one year or less
and is required to support a large portion of the firm’s current asset.

❖ Short-term financing may be used to meet seasonal and temporary fluctuations in funds
position as well as to meet long-term needs. Most firms use short term financing to some extend
to support its assets especially current assets.

❖ The use of short term financing due to its short maturity and volatile interest costs (EAR%
effective annual rate @ cost of financing) .
❑ The pro and cons of financing with short term debt are;
❑ Flexibility – If the needs for funds are seasonal or cyclical, the use of short term debt is more appropriate as the firm
did not want to commit itself to long term debt.
❑ Lower cost of short- term debt. If the yield curve is sloping as it often is the interest will be lower on the long term rate
than on long term rates.
❑ Relative riskiness of long term and short-term debt. In general the use of short term debt by the firms tend to be
riskier due to the short term interest tend to fluctuate widely while long term interest can lock in the given rate.
❑ Short term financing is helpful to business that are seasonal in nature such as retail businesses who has to build up
inventory for the holiday season.
❑ Other uses of short term financing are to raise working capital /fund to cover temporary deficiencies/ shortage in
funds so company can meet payroll and other expenses.
SHORT TERM
FINANCING

SECURED LOAN
UNSECURED
LOAN ACCOUNT
BANK CREDIT RECEIVABLE
FINANCING

TRADE CREDIT OVERDRAFT

COMMERCIAL BANKER
PAPER ACCEPTANCE
Sources of Short-Term Financing (a)
Unsecured sources
Unsecured sources is fund raised by the firm without pledging an asset as collateral. Several sources of
unsecured financing are:
(1) Bank Credit / Line of credit
✓ It is an agreement between a commercial bank and a business firm that states the amount of
unsecured short term borrowing the bank will make available to the borrower. Typically, it is made for a
period of one year.
✓ Rate of interest are based on risk and creditworthiness of the borrowers and the interest rate levels
prevailing in the economy as a whole. The borrower will be required to maintain a minimum balance in
the bank throughout the period of the loan referred as the compensating balance. (10 – 20%).
✓Interest rate may be calculated as simple interest or discount interest. The type of interest rate charged
will be determining the effective cost of bank loan.
1. Bank Credit (Simple Interest)
Interest are charged on the basis of the amount borrowed and it is paid when the loan end.
Simple interest without compensating balance

Sharina wishes to borrow RM20,000 for one year. The bank offer a simple interest loan at 14 per
cent interest. Calculate the effective annual interest cost of the loan.

Interest charge = 14% x RM20,000

= RM2,800
Total amount to be paid to bank = RM20,000 + RM2,800
= RM22,800
EAR = Interest (RM) / amount received
= RM20,000 x 0.14 / RM20,000
= 2,800 /20,000
= 14% cost of financing
Simple interest with compensating balance

Sharina wishes to borrow RM20,000 for one year. The bank offer a simple interest loan at 14
percent interest and requires Sharina to maintain a compensating balance of 20 percent of the
loan amount. Calculate the effective annual interest cost of the loan.

Interest =RM20,000 x 0.14

= RM2,800
Compensating balance = 0.20 x 20,000
= RM4,000
Amount received = RM20,000 – RM4,000
= RM16,000
EAR = Interest (RM) /amount received
= 2,800 / 16,000
= 17.5% cost of financing
Bank Credit ( Discount Interest)
Interest calculated on the amount borrowed but is paid when the loan begins. This interest is
deducted in the beginning, resulting that the borrowers receiving less than the face value of the loan.

Discount interest without compensating balance

Sharina wishes to borrow RM20,000 for one year. The bank offer loan at 14 percent discount
interest. Calculate the effective annual interest cost of the loan.

Interest = RM20,000 x 0.14

= RM2,800
Amount received = RM20,000 – RM2,800
= RM17,200
EAR = Interest/ amount received
= 2,800/17,200
= 16.28% cost of financing
Discount interest with compensating balance
Sharina wishes to borrow RM20,000 for one year. The bank loan at 14 percent discount interest
and requires Sharina to maintain a compensating balance of 20 percent of the loan amount. If she
has no money available for the compensating balance, calculate the effective annual interest cost
of the loan.

Interest = RM20,000 x 0.14

= RM2,800
Compensating balance = 0.20 x 20,000
= RM4,000
Amount received = 20,000 – 2,800- 4,000
= RM13,200

EAR = Interest/amount received

= 2,800 / 13,200
= 21.21% cost of financing
2. Account Receivables (Trade Credit)
❖ Most sales between companies are made on credit. The buying firm receives the goods
and is expected to pay for them at a specified later date. The selling company lends the
buyer the purchase price, without interest, from the time the goods are shipped until
payment is made.
❖ It is a very attractive source of financing because it’s free.
❖ Credit term – a supplier’s terms of sale specify the number of days after delivery that
payment is expected.
❖ Example - ABC company purchased RM1000 worth of merchandise on 1st December
2017 from supplier with a term 2/10, net 30.

2 = cash discount
10 = discount period
30 = credit period

The firm must pay in full amount within 30 days, but they will get 2%
cash discount if they made a payment in 10 days.
Account Receivables (Trade Credit) – Con’t

i. If the firm takes the cash discount. (pay within 10 days)

SP = RM1,000 – RM1,000(0.02)
= RM1,000 – RM20
= RM980
ii. If the firms forego the discount, it will have to pay full amount (RM1000) on 30th
December 2017
iii. Cost of not taking discount under credit term of 2/10, net 30
Formula;
EAR = ( Discount ) x ( 360 days )
100% – Discount Credit period – Discount Period

•
•
EAR = ( Discount ) x ( 360 days )
100% – Discount Credit period – Discount Period

= ( 2% ) x ( 360 )
100% – 2% 30 day – 10 day

= 0.0204 x 18

= 0.3672 x 100%

= 36%
3. Commercial Paper

❑ Commercial paper is a short-term, unsecured promissory note issued by a firm with a high credit
standing. Generally, only large firms in excellent financial condition can issue commercial paper.

❑ Most commercial paper has maturities ranging from 3 to 270 days, is issued in multiples of
RM100,000 or more, and is sold at a discount from par value.

❑ Commercial paper is traded in the money market and is commonly held as a marketable security
investment.
Commercial Paper (Con’t)
Bistro plans to issue RM100,000 commercial paper that can be sold at 94% of its par value. If maturity
is 6 month (6 x 30 days = 180 days) and issuing cost is 5%, compute the effective rate.

Interest = RM100,000 – RM100,000 (0.94)

= RM6,000
Cost = RM100,000 (0.05)
= RM5,000

Effective rate = Interest + other cost x (360 days / n)

value – interest – other cost
= 6,000 + 5,000 x (360/ 180)
100,000 – 6,000 – 5,000
= 11,000 x 2
89,000
= 0.247 x 100% = or 24.7%
Sources of Short-Term Financing (b)
Secured sources
Normally it is not easy to obtain short term funds from banks or other similar

1. Account receivable Financing

Involve either pledging of receivable or the selling of receivable (called factoring) to secure a loan. The lender
(bank) will evaluate the quality of the receivables to be pledge and the average size of the account pledge.
a) Pledging
Is characterized by the fact that the lender is not only claim against receivable but also has recourse to the
borrower or the seller that is if receivables are uncollectible, the selling firm will bear the loss. Pledging
receivable can be on:
- Notification basis: the borrower notifies its accounts that payments on the receivables are to be made directly
to the lender.
- Non-notification basis: The accounts are not informed of the financial agreements made between the
borrower and the lender.
b) Factoring
Involve purchase of account receivable by the lender and normally without recourse to the borrower. The factor
or the purchaser provides three services : credit checking, lending and risk bearing.
Sources of Short-Term Financing (b)
Secured sources
Normally it is not easy to obtain short term funds from banks or other similar

Inventory Financing
• Serve as collateral for the loan if the business does not sell its products and cannot repay the loan
• A lender securing loans by selling inventories at book value if the borrower default on its obligations
• Usually refer to types of inventory to cover short term loan which not perishable, readily marketable and have price
stability.
• Inventory financing occur through