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UNIVERSITY OF SANTO TOMAS
AMV College of Accountancy
ACC 7 – Management Consultancy
Short-Term Credit Financing
Reasons for short-term financing:
1. Short-term financing (or current liabilities) is intended to primarily sustain short-term investment (or
current assets) operations.
2. Inasmuch as current assets are expected to be recovered within a short period of time, normally not
exceeding a year, the current liabilities are likewise expected to be paid within a year.
3. Short-term financing is tapped to lessen the equity exposure and risk of the firm to finance its operating
activities.
4. Since, operating suppliers benefit significantly from the enterprise’s operations, they are inherently willing
to equitably share in financing and sustaining the operating activities of the firm.
WC Financing Policies
1. Aggressive Financing Strategy – operations are conducted with a minimum amount of working capital.
This is also known as restricted policy.
2. Conservative Financing Strategy – a company seeks to minimize liquidity risk by increasing working
capital. This is also known as relaxed policy.
3. Moderate Financing Strategy – also known as semi-aggressive or semi-conservative financing strategy.
Under this strategy, working capital maintained is relatively not too high (conservative) nor too low
(aggressive). This is also known as balanced policy.
4. Matching Policy – This is achieved by matching the maturity of financing source with an asset’s useful life.
This is also known as self-liquidating policy or hedging policy.
Short-term assets are financed with short-term liabilities.
Long-term assets are funded by long-term financing sources.
Hedging – financing assets with liabilities of similar maturity.
Illustration: Aggressive vs. Conservative Financing Strategies
Venom Corporation’s permanent financing requirement is P300,000 per quarter, composed of P200,000 for
fixed assets, and P100,000 for current assets. However, the financing requirements for current assets are
expected to increase by P30,000 in the first quarter, P20,000 in the second quarter, P40,000 in the third and
P10,000 in the fourth.
Required: Determine the amount of working capital to maintain under:
1. Aggressive financing strategy P100,000
2. Conservative financing strategy P140,000.
3. Moderate financing strategy P125,000 – approx.
Exercises:
1. Amazing Company’s total assets fluctuate between P320,000 and P410,000, while its fixed assets remain
constant at P260,000. If the firm follows a maturity matching or moderate working capital financing policy,
what is the likely level of its long-term financing? P320,000
2. Great Company has P8,000,000 in current assets, P3,500,000 of which are considered permanent current assets.
In addition, the firm has P6,000,000 invested in fixed assets. Great Company wishes to finance all fixed assets
and permanent current assets plus half of its temporary current assets with long-term financing costing 15%.
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Short-term financing currently costs 10%. Great Company’s earnings before interest and taxes are P2,200,000.
Income tax rate is 40%.
How much would Real Company’s earnings after taxes be under this financing plan? P127,500
3. Normal Company has total fixed assets of P100,000 and no current liabilities. The table below displays its wide
variation in current asset components:
1st Qtr
2nd Qtr
3rd Qtr
4th Qtr
Cash
P 20,000
P 10,000
P 15,000
P 20,000
Accounts receivable
66,000
25,000
47,000
88,000
Inventory
20,000
65,000
59,000
10,000
Total
P106,000
P100,000
P121,000
P118,000
If Normal’s policy is to finance all fixed assets and half the permanent current assets with long-term financing
and the rest with short-term financing, what is the level of long-term financing? P150,000
Cost of Bank Loans:
Without compensating balance:
i. If not discounted (cash proceeds normally equal face value):
Cost = Interest / Amount Received (Face)
ii. If discounted (cash proceeds is net of interest deducted in advance):
Cost = Interest / Face Value – Interest
With compensating balance:
i. If not discounted:
Cost = Interest / (Face Value – CB)
ii. If discounted:
Cost = Interest / (Face Value – Interest – CB)
Illustration:
Eddie Trading Co. was granted a P200,000 bank loan with 12% stated interest.
Required: The effective annual rate, under the following cases:
1. Eddie receives the entire amount of P200,000. 12%
2. Eddie was granted a discounted loan.
3. Eddie is required to maintain a CB of P10,000 under the non-discounted loan.
4. Eddie is required to maintain a CB of 10% under a discounted loan.
5. Assuming the same data in No. 4 but in addition, the compensating balance bears interest equivalent to
4% annually.
6. Assuming the same data in No. 5 but the term of the loan is only for 60 days.
Compound Interest
Illustration: Peter borrowed P100,000 from a bank on a one-year 8% term loan, with interest compounded
quarterly. What is the effective annual interest on the loan?
Add-on Interest
What is an ‘Add-On Interest’?
A method of calculating interest whereby the interest payable is determined at the beginning of a loan and
added onto the principal. The sum of the interest and principal is the amount repayable upon maturity.
EIR, Add-on = Interest expense / Average principal
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Where: Average principal = Principal + (Principal/12*)
2
* assuming the loan is payable in 12 equal monthly installments.
Illustration:
Stark Company borrowed from a bank an amount of P1,000,000. The bank charged a 12% stated rate in an add-
on arrangement, payable in 12 equal monthly installments.
Required:
1. Compute for the effective interest rate.
2. Compute for the effective interest rate assuming the loan is payable for 9 months only.
Costs of Short-Term Trade Credit – is the cost of not availing the purchase discounts.
Cost of Trade Credit with supplier*:
Cost = [Discount rate / (100% – Discount rate)] x [360 days / (Credit period – Discount period)]
Illustration:
PROBLEM 1
Clark Trading Co. purchases merchandise for P200,000, 2/10, n/30.
Required: Determine:
1. The annual cost of trade credit 36.73%
2. The annual cost of trade credit if term is changed to 1/15, n/20 72.73%
3. Free trade credit P5,444
4. Costly trade credit P10,889
5. Total trade credit P16,333
PROBLEM 2
An invoice of a P100,000 purchase has credit terms of 1/10, n/40. A bank loan for 8% can be arranged at any
time. When should the customer pay the invoice?
a. Pay on the 1st b. Pay on the 10th c. Pay on the 40th d. Pay on the 60th
Cost of Commercial Papers:
Commercial paper – is an unsecured, short-term debt instrument issued by a corporation, typically for the
financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper
rarely range any longer than 270 days. Commercial paper is usually issued at a discount from face value and
reflects prevailing market interest rates.
Cost = [(Interest + Issue Costs) / (Face Value – Interest – Issue Costs)] x (360 days / Term)
Illustration:
PROBLEM 1
Bruce Co. plans to sell P100,000,000 in 180-day maturity paper, which it expects to pay discounted interest at an
annual rate of 12%. Due to this commercial paper, Bruce expects to incur P100,000 in dealer placement fees and
paper issuance costs. What is the effective cost of the commercial paper?
PROBLEM 2
A firm issued P2 million worth of commercial paper that has a 90-day maturity and sells for P1,900,000. The
annual interest rate on the issue of commercial paper is 21%
Cost of Factoring
EIR = Costs (e.g., Factor’s Fee, Interest) / Net proceeds
Illustration:
PROBLEM 1
Groot Company provided the following data regarding its factoring of receivables for the year 2018:
Face of the receivables factored P 200,000
Credit term 30 days
Factor’s fee 1%
Factor’s holdback (reserve) 6%
Interest rate 12%
Compute for the effective annual financing cost. 26.09%
PROBLEM 2
Star Lord Company has just acquired a large account and needs to increase its working capital by P100,000.
The controller of the company has identified the source of funds given below.
Pay a factor to buy the company’s receivables, which average P125,000 per month and have an average
collection period of 30 days. The factor will advance up to 80% of the face value of receivables at 10% and