Shortterm Financing

1
Chapter 6,78

• Short-term Financing

2
Introduction

• Long-term financing is normally used to fund
  plant and equipment acquisition or other
  long-term investments.
• Short-term financing is required because we need
  working capital
• An efficient current asset management helps to
  reduce the amount of working capital and thus the
  reliance on short-term financing

3
Todays Agenda

• Working Capital
• Current Asset Management
• Sources of Short-term Financing

4
Working Capital

• What is working capital ?
• Example - a manufacturing company
• When the production plant (factory) and the
  necessary equipment (machine) are ready, the firm
  has to order raw materials, hire employees,
  manufacture goods, finished goods transferred to
  inventory and eventually sold

5
Working Capital cont

• The amount of capital involved in the above
  process (excluding plant and equipment
  investments) is called working capital
• Once the goods are sold, the working capital will
  be recovered
• (In addition, a small portion of the plant and
  equipment investment may be recovered)

6
(No Transcript)
7
Need for Financing

• Time lag between receipt of payment from
  customers and the need to pay suppliers and
  employees
• For manufacturing firms, they have to pay their
  suppliers and employees before they receive
  payment from their customers
• Hence, there is a need for short-term
  financing(proceed of sales are coming)

8
Need for Financing cont

• If financing is not available, suppliers will
  stop supplying raw material and employees will
  leave
• The longer the time lag, the greater the need for
  short-term financing
• The larger the amount of working capital, the
  greater the need for short-term financing

9
Need for Financing cont

• Excess financing occurs when we fund the
  short-term needs with long-term funds
• Long-term funds are normally more expensive
• - term structure of interest rates
• - the longer the period, the higher the rate e.g.
  home mortgage

10
Figure 6-11(2) A Normal yield curve
11
Short-Term vs. Long-Term Financing

• Short-term financing is less expensive but
  riskier
• lower interest rates
• short-term rates are volatile
• risk of default if sales slow down
• risk that bank may not extend / renew loans
• Long-term financing is more expensive but less
  risky
• usually higher interest rates,
• you may pay interest on funds you dont always
  need
• you have capital at all times
• Firm must decide the appropriate mix

12
Working Capital Current Asset

• As firms grow, sales increase leads to the need
  for more working capital which in turn will also
  increase the demand for current assets
• - higher cash to pay employees wages
• - higher inventories
• - higher levels of A/R

13
Current Asset (CA) Management

• Efficient CA management helps to reduce the
  required amount of working capital
• Current assets include cash, marketable
  securities, accounts receivable and inventory
• CA management management of cash, marketable
  securities, A/R and inventory

14
Principle in managing CA

• The lower the level of current assets, the lower
  the firms liquidity, the greater the risk of
  being caught short of cash and inventories
• To increase liquidity (reduce risk), the firm may
  invest additional capital in current assets
• However, current assets earn no or low returns
• Hence, investment in current assets is a balance
  between risk and return

15
Cash Management

• Cash is a necessary but low earning asset
• Minimize cash balance, yet keep sufficient amount
  to meet obligations
• Invest excess cash
• Cash flow is determined by customers payment
  pattern, amount of credit sales, credit terms,
  checks clearing time, inventory turnover and
  production cycle

16
Cash Management cont

• To minimize cash balance, speed up cash receipts
  (e.g. debit cards and preauthorized payments) and
  slow down payments
• Use electronic transfer of funds and/or lock-box
  system (both are serviced by banks), checks can
  be cleared immediately
• Remote disbursement (longer mailing time) to slow
  down payments to suppliers, etc

17
Cost and Benefit

• The primary benefit of speeding up inflows or
  slowing outflows is the earnings generated from
  the freed up balances
• The benefit must be weighed against the cost of
  installing the collection and payment systems

18
Invest Excess Cash in Marketable Securities

• Play the Float
• The Float is the difference between bank book and
  the firms accounting book
• By investing the float for a day or two, the firm
  may generate a higher return
• Example on the next slide shows a float of
  300,000

19
Play the Float
20
(No Transcript)
21
Account Receivable Management

• Account receivable is the result of credit sales.
  Credit policy has 4 components
• credit period, cash discounts, credit standards
  and collection policies
• Credit period time customers can take to pay
  for goods without penalty
• - involves a trade-off longer periods better
  for customers but worse for the selling firm
  (raise financing needs and bad debt risk)

22
A/R Management cont

• Cash discount encourage early payment by
  customers e.g. 2/10 net 30 means customers get 2
  discount if paid within 10 days, else full amount
  is due within 30 days
• Credit standards refer to the credit assessment
  standards usually done by a third party e.g. Dun
  Bradstreet

23
A/R Management cont

• Collection policy with regard to average
  collection days, ratio of bad debts to credit
  sales and aging of accounts receivables
• Inventory management SKIP - DONE IN 42.230 (p
  243-249)

24
Short-Term Financing

• Sources
• Trade credits,
• bank financing,
• Commercial paper,
• Banker's acceptance,
• pledging or factoring of A/R,
• inventory financing,
• Other types of collateral financing (personal,
  chattel mortgage)
• In all cases, the issues are the cost of
  financing (effective interest rate), time
  horizon, collateral, and availability

25
Trade Credit

• Costs We can forego the discount and pay on the
  final date due.
• Costs are high 2/10 net 30
• 2/98 365/(30-10) (simple)
• or
• (12/98)365/(30-10) - 1 (compounding)
• effective rate of 37.2 (simple) or
  44.6(compound)
• usually, the cost of foregoing the discount is
  high

26
Bank Loans

• many choices and terms and types
• Operating loan or Line of credit,
• bridge loan,
• unconfirmed or stand by LOC,
• Promissory note (transaction loan)
• Term Loans
• Fees
• commitment fee,
• stand-by fee,
• compensating balances (rare in Canada)
• usually total of fees is about 1 percent of loan
• can be negotiated and waived
• - discount interest loan pay interest upfront

27
Bank Loan cont

• A bank offers you a 10 discount interest loan of
  1,000,000 for a year
• The effective annual rate (EAR)
  (1100000/900000)1-1 11.1
• If the bank also requires a 15 compensating
  balance, the EAR (1100000/750000)1-1 13.3

28
Commercial Paper

• Unsecured promissory notes sold by large
  companies e.g. GM
• generally short term
• interest slightly higher than the t-bill rate,
  depends upon the supply and demand
• Canadian market intentionally created by Bank of
  Canada and some large Canadian firms

29
Banker's Acceptances

• Bank guarantees payment when due to the seller of
  the goods.
• The seller of the goods may then sell the bank
  acceptances to his bank
• His bank then pays a discounted value to him less
  a fee (handling charge interest).

30
A/R and Inventory Financing

• Accounts Receivable
• once pledged, up to 75 of the face value of A/R
  can be the borrowed amount
• Inventories
• Used inventories as collateral to borrow money

31
Summary

• Short-term financing is required for the
  provision of Working Capital
• Current Asset Management as a mean to reduce the
  reliance on short-term financing
• Sources of Short-term Financing