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Flashcards in Financing Options: Short term Financing Deck (19):
1

Short-term (Working Capital) Financing Defined:

Short-term (Working Capital) Financing:

  • The funding provided by obligations which become due within one year (current liabilities).
  • Items considered current liab are also considered forms of short-term financing.
  • The use of current assets to obtain funding.

Forms of Short-term Financing:

  1. Trade Accounts Payable
  2. Accrued notes receivable
  3. Short-term notes
  4. Lines of credit, revolving credit, or letter of credit
  5. Commercial paper
  6. Pledging accounts receivable
  7. Factoring accounts receivable
  8. Inventory secured loans

2

Payables Defined:

Payables: Occurs through acquiring of goods or services financed by incurring an obligation to pay in the future.

  • Trade payables are widely used in normal course of business
  • Financing of certain assets - like supplies and inventory - is highly flexible; the liability occurs concurrent w the acquisition of goods and services
  • Discounts offered on trade AP have favorable effective interest rates and should be taken when possible. 

3

Trade Accounts Payable:

Trade Accounts Payable: Deferred payment for goods or services in the normal course of business. May carry the offer of cash discount for early pymt of obligation.

Advantages:

  • Easy to use; little documentation required
  • Flexible; they expand and contract w needs (i.e. purchases)
  • Interest normally not charged
  • Discounts often are offered for early payment

Disadvantages:

  • Require pymt in the short term
  • Effective cost is higher if discounts not taken
  • Financing they provide is specific
    • Their use finances only the assets acquired through trade accounts

 

4

Accrued Accounts Payable:

Accrued Accounts Payable: result from acquiring cash and other benefits financed by an obligation to be satisfied in the future.

  • Examples:
    • Salaries and wages payable
    • Taxes payable
    • Unearned revenue, including gift and other prepaid cards
  • The time between when the benefit or cash is received and the obligation satisfied provides short-term financing. 

Advantages:

  • Easy to use; occur in normal course of business
  • Flexible; they expand and contract w activity
  • Collateral normally not required, though some creditors may have specific legal claims. 

Disadvantages:

  • Require pymt in short term
  • Some financing is use specific ; many things cannot be financed through accrued accounts. 

5

Short-term Notes Payable:

Short-term Notes Payable: Result from acquiring cash through borrowing w repayment due in one yr or less.

  • Typically a promissory note is required
  • Interest rate charged based on credit rating of borrower
  • A compensating balance may be required:
    • An amount that must be maintained in a demand deposit account w lender.
    • It increases effective cost of borrowing

Advantages:

  • Commonly available for creditworthy firms
  • Flexible; amounts and periods can be varied w need
  • Collateral normally not required; they are unsecured
  • Provides cash for various purposes

Disadvantages:

  • Poor credit rating will mean higher int rate and possibly require collateral
  • Require pymt in short term
  • Compensating balance increase effective cost of borrowing and reduce funds available
  • Refinancing would be necessary, if the note cannot be paid when due. 

6

 

Which one of the following provides a source of spontaneous financing for a firm?

A. Accounts receivable.

B. Accounts payable.

C. Bonds.

D. Common stock.

B. Accounts payable.

Accounts payable are a source of spontaneous financing. Spontaneous financing occurs when credit is provided in the course of day-to-day operations; In general, the level of financing goes up concurrent with the purchase of goods or services or the carrying out of other day-to-day activities.

7

Which one of the following forms of short-term financing is least likely to be considered a spontaneous source of funding?

A.  Short-term notes payable.
B.  Accrued taxes payable.
C.  Accrued salaries payable.
D.  Trade accounts payable.

A.  Short-term notes payable.

Spontaneous financing occurs automatically in the carrying out of day-to-day operations. Financing through the use of short-term notes payable does not occur automatically as a result of carrying out day-to-day operations, but rather requires negotiation with a lending institution, usually a commercial bank, and the execution of a promissory note. The other forms of payable occur spontaneously as a result of normal business operations.

8

"Stand-by" Credit Arrangements

"Stand-by" Credit: An arrangement to have financing available for a specific purpose or period of time.

Three forms of "Stand-by Credit":

  1. Line of Credit
  2. Revolving Credit
  3. Letter of Credit

9

"Stand-by" Credit Arrangement: Line of Credit

Line of Credit: An informal agreement whereby a financial institution agrees to a maximum amount of credit that will be extended at any one time. 

  • Not legally binding on financial institution, but provides reasonable assurance of funds.
  • Available funds generally can be used for any purpose.

10

"Stand-by" Credit Arrangement: Revolving Credit

Revolving Credit: Formal agreement whereby a financial institution or other lender agrees to a maximum amount of credit that will be extended. 

  • Revolving credit is like a line of credit, but with a legally binding agreement.

11

"Stand-by" Credit Arrangement: Letter of Credit

Letter of Credit: A conditional commitment by a financial institution to pay a third party in accordance w specified terms and conditions. 

  • Example: Pymt to 3rd party upon proof of shipment of goods
  • Provides 3rd party assurance of pymt without the buyer (who is also the borrower) having to pay in advance.
  • Often used in connection w foreign transactions.

12

"Stand-by" Credit Advantages and Disadvantages:

Stand-by Credit Advantages:

  • Commonly available for creditworthy firms
  • Highly flexible; credit used, and debt incurred, only when needed
  • Usually no collateral required; it is unsecured
  • Both line of credit and revolving credit provide cash for general use.

Stand-by Credit Disadvantages:

  • Poor credit rating will mean higher int rates and possibly require security 
  • Typically involves a fee
  • Requires satisfaction in the short term
  • Required compensation balance increases effective cost of borrowing and reduces funds available for use
  • Line of credit not legally binding on financial institution.

13

Commercial Paper:

Commercial Paper: A short-term, unsecured promissory note sold by largely, highly-creditworthy firms.

  • Most are for 180 days or less
  • If more than 270 days SEC registration is required
  • May be sold directly to investors or through dealers
  • May be sold on discounted bases or with interest paid over short life of the note.

Advantages:

  • Interest rates are generally lower than other short-term sources
  • Large amounts can be obtained
  • Compensating balances are not required
  • No assets need to be pledged as collateral; unsecured
  • Provides cash for general use

Disadvantages:

  • Only available to most creditworthy firms
  • Requires satisfaction in the short term, usually of a large amount
  • Lacks flexibility of extension or other accomodations (as compared w bank loans)

14

Which one of the following typically is not a characteristic of commercial paper?

A. Matures in the short-term.

B. Loans are secured.

C. Users have high credit ratings.

D. Provide cash for operating use.

B. Loans are secured.​

Commercial paper is short-term unsecured promissory notes. Typically, use of commercial paper does not involve security from the borrower.

15

Pledging Accounts Receivable:

Pledging Accounts Receivable: Using AR as security (collateral) for short-term borrowings

  • A level of borrowing available for a set of AR depends on:
    • Creditworthiness of the AR
    • Level of lender's recourse against borrower
  • A fee based on the value of AR pledged is usually charged.

Advantages:

  • Commonly available
  • Flexible, as new AR occur, they can be used as security
  • Compensating balances not required
  • Provides cash for general use
  • Lender may provide billing and collection services, usually for a fee

Disadvantages:

  • AR are commited to lender as security
  • Cost of pledging AR may be greater than other sources of short term financing
  • Requires repayment in short term

16

Factoring Accounts Receivable:

Factoring Accounts Receivable: The sale of AR.

  • Buyer is called a "Factor"
  • Terms of sale may be:
    • Without recourse: The factor (buyer) bears the risk of uncollectibility, except in case of fraud.
    • With recourse: The factor has recourse against the seller for some or all of the risk associated w uncollectibility of the receivables. 
  • Factor charges a fee, known as "factor's fee", based on: 
    • Creditworthiness and length of maturity of receivables
    • Extent to which the factor assumes risk of uncollectibility 
  • Advantages:
    • ​Commonly Available
    • Flexible, as new AR occur they can be sold
    • Compensating balance not required
    • Provides cash for general use
    • Buyer generally assumes billing and collection responsibilities
  • Disadvantages:
    • ​Cost may be greater than certain other sources of short-term financing
    • If sold with recourse, selling firm may have on-going risk
    • Sale of AR may alienate customers.

17

Inventory Secured Loans:

Inventory Secured Loans: Occur when a firm pledges all or part of its inventory as collateral for a short-term loan.

  • Amount that can be borrowed usually depends on value and marketability of the inventory.
  • Several alternative inventory security arrangements are used:
    1. Floating Lien Agreement: Borrower gives a lien on all of its inventory, but retains control of it and can continuously sell and replace it.
    2. Chattel Mortgage Agreement: Lender has a lien against specifically identified inventory, borrower retains control of that inventory, but cannot sell it without lender approval.
    3. Field Warehouse Agreement: Inventory remains at borrower's warehouse, but under the control of an independent 3rd party.
    4. Terminal Warehouse Agreement: Inventory is moved to a public warehouse and placed under the control of an independent 3rd party. 
  • Cost of Inventory Secured Loans depends on:
    • Nature of inventory
    • Credit standing of the borrower
    • Specific type of security agreement used

Advantages:

  • Commonly available for certain inventories, including commodities, automobiles, etc.
  • Flexible, as new inventories become available they can become security
  • May provide cash for general use

Disadvantages:

  • Pledged inventory may not be available when needed
  • Cost of using inventory secured loans may be greater than other short term financing
  • May require repayment in the short term
  • Not available for certain inventories

18

Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days:

  • Value of receivables to be held in reserve for contingencies 10%
  • Following costs are deducted at time accounts are factored:
    • Interest rate on amounts provided (annual rate) 12%
    • Factor fee on total receivables factored 2%

If Nexco plans to factor $200,000 of accounts receivable due in 30 days, which one of the following is the amount it will receive from Factorco at the time the accounts are factored?

A.  $154,880
B.  $174,240
C.  $176,000
D.  $196,000

B.  $174,240

  • Reserve for contingencies= $200,000x.10 = $20,000
  • Factor fee on total AR factored:n $200,000x.02 =$4,000
  • $200,000 - (20,000+4,000)= $176,000 (for which interest would be charged)
  • $176,000 x .12 (annual rate) $21,120 / 12 mos = $1,760
  • $176,000-$1,760 = $174,240

19

Nexco, Inc. is considering factoring its accounts receivable. Factorco, Inc. has offered the following terms for accounts receivable due in 30 days:

  • Value of receivables to be held in reserve for contingencies 10%
  • Following costs are deducted at time accounts are factored:
    • Interest rate on amounts provided (annual rate) 12%
    • Factor fee on total receivables factored 2%

If Nexco factors $200,000 of its accounts receivable due in 30 days with Factorco and, during that 30 days, $10,000 of those accounts receivable are reversed because the related goods were return or allowances were granted, which one of the following is the amount that Nexco will receive from Factorco at the end of the 30 day period?

A.  $ -0- (no amount)
B.  $ 9,800
C.  $10,000
D.  $19,600

C.  $10,000

  • The amount held in reserve was .10 x $200,000, or $20,000.
  • During the 30-day period of the factor agreement, $10,000 of the accounts receivable factored had to be reversed because of sales returns and allowances. 
  • Therefore, at the end of the 30-day period, Factorco would pay Nexco the remaining $10,000 ($20,000 reserve - $10,000 reversed = $10,000).