8-1
Sources of Short-Term Financing
Author’s Overview
The instructor has the opportunity to cover the various sources of short-term financing with an eye
toward the borrower’s size and the relative cost of doing business. Since banking is such a rapidly
changing area, the instructor may wish to highlight some of the changes that are taking place. The
student should also get some exposure to the various considerations in computing interest costs.
Throughout the chapter, there are ample opportunities to indicate the advantages and drawbacks of
trade credit, bank credit, commercial paper, foreign borrowing, and collateralized borrowing
arrangements.
Chapter Concepts
LO2. Bank loans are usually short term and should be paid off from funds from the normal
operations of the firm.
LO3. Commercial paper represents a short-term, unsecured promissory note issued by the firm.
LO4. By using accounts receivable and inventory as collateral for a loan, the firm may be able to
borrow larger amounts.
8
8-2
Annotated Outline and Strategy
I. Trade Credit
A. Usually the largest source of short-term financing
B. A spontaneous source of funds that changes as sales expand or contract
C. Credit period is set by terms of credit but firms may be able to “stretch” the payment
period.
D. Cash discount policy
1. Suppliers may provide a cash discount for early payment.
2. Foregoing discounts can be very expensive. The cost of failing to take a
discount is computed as follows:
3. Whether a firm should take a discount depends on the relative costs of
alternative sources of financing.
E. Net Credit Position
2. If the firm’s average accounts receivable exceeds average accounts payable,
it is a net provider of credit. If payables exceed receivables, the firm is a net
user of trade credit.
II. Bank Credit
Perspective 8-1: Discuss how financial institutions have changed over time. The Gramm-Leach-
Bliley Act in 1999 allowed banks and investment banks to merge and created a more competitive
marketplace but also created institutions that were “too big to fail.” The financial crisis of 2007–
2008 that resulted in the Dodd-Frank Act in 2011 impacted the way banks are regulated and is
changing the way banks are managing their risk assets.
A. Banks prefer short-term, self-liquidating loans
Cost of failing
to take a cashdiscount = Discount percent
100 percent–Discount percent ´ 360
Final due date–Discount period
8-3
B. Bank loan terms and concepts
1. Prime rate: The interest rate charged to the most creditworthy borrowers.
a. The prime rate serves as a base in determining the interest rate for
PPT The Prime Rate versus the London Interbank Offered Rate on U.S.
Dollar Deposits (Figure 8-1)
d. The London Interbank Offer Rate (LIBOR) on U.S. dollar deposits is
being used worldwide as a base lending rate on dollar loans.
Perspective 8-2: The Finance in Action box “LIBOR Price–Fixing Scandal” is a good lesson in
ethics. Many bank CEOs along with traders lost their jobs, and the scandal pointed out the
inadequacy of regulators.
2. Compensating balances
a. As a loan condition, a borrower may be required to maintain a
minimum average account balance in the bank equal to a percentage
3. Maturity provisions
4. Costs of commercial bank financing—The effective interest rate on a loan
8-4
Perspective 8-3: Review Formulas 8-2 through 8-6, including a comparison of the effective costs
of a loan under varying assumptions.
C. Annual percentage rate
1. The Truth in Lending Act enacted by Congress in 1968 requires that the
2. The APR requires the use of the actuarial method of compounded interest and
corresponds to the effective rate used throughout the text.
D. Bank credit availability tends to cycle
1. Credit crunches seem to appear every 3–5 years.
2. The pattern of the credit crunch has been as follows:
a. The Federal Reserve tightens the money supply to fight inflation.
b. Lendable funds shrink, interest rates rise.
III. Financing through Commercial Paper
A. Short-term, unsecured promissory notes issued to the public in minimum units of
$25,000.
B. Issuers
1. Finance companies such as General Motors Acceptance Corporation
2. Industrial or utility firms that issue paper indirectly through dealer. This type
of issue is called dealer paper.
8-5
C. There has been very rapid growth in the commercial paper market in the last few
PPT Total Commercial Paper Outstanding (Figure 8-2)
D. Traditionally, commercial paper has been a paper certificate issued to the lender to
signify the lender’s claim to be repaid. There is a growing trend among companies
E. Advantages
1. Commercial paper may be issued at below the prime interest rate at
commercial banks.
3. Prestige.
F. Limitations
1. The primary limitation is the possibility that the commercial paper market
2. A credit crisis like the one of 2007–2009 might cause the market to stop
functioning for a period of time.
PPT Comparison of Commercial Paper Rate to Prime Rate (annual rate*)
(Table 8-1)
IV. Foreign Borrowing
A. Loans from foreign banks are an increasing source of funds for U.S. firms.
8-6
currencies that are converted to dollars and forwarded to the U.S. parent company.
V. Use of Collateral in Short-Term Financing
A. The lending institution may require collateral to be pledged when granting a loan.
VI. Accounts Receivable Financing
1. Pledging accounts receivable as collateral
a. Convenient means of financing. Receivable levels are rising as the
need for financing is increasing.
PPT Receivables Loan Balance (Table 8-2)
2. Factoring Receivables
a. Receivables are sold, usually without recourse, to a factoring firm.
3. Asset-backed public offerings of receivables
a. Public offerings of securities backed by receivables as collateral are a
8-7
VII. Inventory Financing
A. The collateral value of inventory is based on several factors.
1. Marketability
a. Raw materials and finished goods are more marketable than goods–
in-process inventories.
b. Standardized products or widely traded commodities qualify for
higher percentage loans.
a. Blanket inventory liens: Lender has general claim against inventory
of borrower. No physical control.
(2) Field warehouse—independently controlled facility on the
premises of borrower.
B. Inventory financing and the associated control methods are standard procedures in
many industries.
Finance in Action: How About Going to the Internet to Borrow Money?
needed, and the interest rate they are willing to pay. Lenders register the amount they have to loan,
starting with as little as $50 and the rate they want to receive. Loans can then be consolidated from
several small lenders so the risk to any one lender is minimized.
VIII. Hedging to Reduce Borrowing Risk
A. Firms that continually borrow to finance operations are exposed to the risk of interest
rate changes.
Perspective 8-4: Hedging and the use of derivative products is one of the hottest topics in finance.
This example helps explain the general concept of hedging.
Other Chapter Supplements
Cases for Use with Foundations of Financial Management
Case 9, Pierce Control System (bank financing)