Chapter 4

Short-term Debt

9-1

Learning Objectives
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations: Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

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4.1 Trade Credit
• Short-term debt is a financing arrangement for a
period of less than one year with various
characteristics to suit borrowers’ particular needs
– Timing of repayment, risk, interest rate structures
(variable or fixed) and the source of funds
• Matching principle
– Short-term assets should be funded with short-term
liabilities

9-3

4.1 Trade Credit (cont.)

• A supplier provides goods or services to a
purchaser with an arrangement for payment at a
later date

• Often includes a discount for early payment (e.g.

2/10, n/30, i.e. 2% discount if paid within 10 days,
otherwise the full amount is due within 30 days)

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4.1 Trade Credit (cont.)
• The opportunity cost of the purchaser foregoing
the discount on an invoice (2/10, n/30) is

% discount 365
Opportunity cost = 
1− % discount days difference between
early and late settlement
(4.1)
2% 365
= 
1- 2% (30 - 10)
= 37.2%

Earning after tax 30% -> option early payment

9-5

Chapter Organisation
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations; Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

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4.2 Bank Overdrafts
• Major source of short-term finance
• Allows a firm to place its cheque (operating)
account into deficit, to an agreed limit
• Generally operated on a fully fluctuating basis
• Lender also imposes an establishment fee,
monthly account service fee and a fee on the
unused overdraft limit

9-7

4.2 Bank Overdrafts (cont.)

• Interest rates negotiated with bank at a margin
above an indicator rate, reflecting the borrower’s
credit risk
▪ Financial performance and future cash flows
▪ Length of mismatch between cash inflows and outflows
▪ Adequacy of collateral
• Indicator rate typically a floating rate based on a
published market rate, e.g. BBSW

9-8

4
Chapter Organisation
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations: Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

9-9

4.3 Commercial Bills

• A bill of exchange is a discount security issued
with a face value payable at a future date
• A commercial bill is a bill of exchange issued to
raise funds for general business purposes
• A bank-accepted bill is a bill that is issued by a
corporation and incorporates the name of a bank
as acceptor

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5
4.3 Commercial Bills (cont.)
• Features of commercial bills—parties involved (bank-
accepted bill)

9-11

4.3 Commercial Bills (cont.)

• Features of commercial bills—parties involved
(bank-accepted bill) (cont.)
– Drawer
▪ Issuer of the bill
▪ Secondary liability for repayment of the bill (after the
acceptor)
– Acceptor
▪ Undertakes to repay the face value to the holder of the bill
at maturity
▪ Acceptor is usually a bank or merchant bank

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4.3 Commercial Bills (cont.)
• Features of commercial bills—parties involved
(bank-accepted bill) (cont.)
– Payee
▪ The party to whom the bill is specified to be paid, i.e. the
party who receives the funds
▪ Usually the drawer, but the drawer can specify some other
party as payee
– Discounter
▪ The party that discounts the face value and purchases the
bill
▪ The provider or lender of the funds
▪ May also be the acceptor of the bill

9-13

4.3 Commercial Bills (cont.)

• Features of commercial bills—parties involved
(bank-accepted bill) (cont.)
– Endorser
▪ The party that was previously a holder of the bill
▪ Signs the reverse side of the bill when selling, or
discounting, the bill
▪ Order of liability for payment of the bill runs from acceptor to
drawer and then to endorser

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4.3 Commercial Bills (cont.)
• The flow of funds (bank-accepted bills)

9-15

4.3 Commercial Bills (cont.)

• The flow of funds (non-bank bills)
– Alternatively, a bill can be drawn by the bank and
accepted by the borrower
– The bank is both drawer and discounter of the bill
– Funds are lent to borrower as payee
– At maturity date the borrower, as acceptor of the bill, is
liable to pay face value to the holder of the bill

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4.3 Commercial Bills (cont.)
• Establishing a bill financing facility
– Borrower approaches bank or merchant bank
– Assessment made of borrower’s credit risk
– Credit rating of borrower affects size of discount
– Maturity usually 30, 60, 90, 120 or 180 days
– Minimum face value usually $100 000

9-17

4.3 Commercial Bills (cont.)

• Advantages of commercial bill financing
– Lower cost than other short-term borrowing forms, i.e.
overdraft, fully-drawn advances
– Borrowing cost (yield) determined at issue date (not
affected by subsequent changes in interest rates)
– A bill line
▪ Arrangement with a bank where it agrees to progressively
discount bills up to an agreed amount
– Term of loan may be extended by ‘rollover’ at maturity

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9
Chapter Organisation
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations: Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

9-19

4.4 Calculations: Discount Securities

• Calculations considered
– Calculating price—yield known
– Calculating face value—issue price and yield known
– Calculating yield
– Calculating price—discount rate known
– Calculating discount rate

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Calculating price—yield known

9-21

Calculating price—yield known (cont.)

• Example 3: A company decides to fund its short-term
inventory needs by issuing a 30-day bank-accepted bill with
a face value of $500 000. Having approached two
prospective discounters, the company has been quoted
yields of 9.52% per annum and 9.48% per annum. Which
quote should the company accept, and what amount will the
company raise?

$500 000  365

= $496 118.04
365 + (0.0952  30)
or
$500 000  365
= $496 134.23
365 + (0.0948  30

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Calculating price—yield known (cont.)
• An alternative formulae for calculating price

9-23

Calculating face value—issue price and

yield known

yield
365 + (  days to maturity)
Face value = price[ 100 ]
365

(4.4)

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Calculating face value—issue price and
yield known (cont.)
– Example 4: A company needs to raise additional funding
of $500 000 to purchase inventory. The company has
decided to raise the funds through the issue of a 60-day
bank-accepted bill rollover facility. The bank has agreed
to discount the bill at a yield of 8.75%. At what face value
will the initial bill be drawn?

365 + (0.0875  60)

Face value = $500 000[ ]
365
= $507 191.75

9-25

Calculating yield

(sell price - buy price) (days in year  100)

Yield = 
buy price days to maturity

(4.5)

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 Calculating yield (cont.)
– Example 7: In Example 3, a company issued a 30-day bank-
accepted bill with a face value of $500 000. The bill was
discounted at a yield of 4.48% per annum, representing a price
of $496 134.23. After seven days the discounter sells the bill in
the short-term money market for $497 057.36. The bill is not
traded again in the market. Calculate the yield to the original
discounter and to the holder at maturity.
Yield to original discounter:
(497 057.36 − 496 134.23) 36 500
 = 9.70%
496 134.23 7
Yield to holder at maturity:

(500 000.00 − 497 057.36) 36 500

 = 9.39%
497 057.36 23

9-27

Calculating price—discount rate known

days to maturity discount rate

Price = face value = [1 −  ]
days in year 100

(4.6)

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Calculating price—discount rate known
(cont.)
– Example 8: The price of a 180-day bill, with a face value
of $100 000, selling at a discount of 14.75%, would be:

180
Price = $100 000[1 -  0.1475]
365
= $100 000(1 - 0.0727)
= $92 726.03

– The discount in this formula is effectively the rate of

return to the buyer of the bill (or the cost of funds to the
drawer of the bill), expressed as a percentage per
annum, in relation to the face value of the bill.

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Calculating discount rate

face value - current price days in year  100

Discount rate = 
face value days to maturity

(4.7)

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Calculating discount rate (cont.)
– Example 9: A 180-day bill with a face value of $100 000
and selling currently at $92 000, with a full 180 days to
run to maturity, has a discount rate of:

(100 000 - 92 00 0 ) 36 500

Discount rate = 
100 000 180
= 0.08  202.778
= 16.22%

9-31

Chapter Organisation
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations: Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

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4.5 Promissory Notes
• Also called P-notes or commercial paper, they are
discount securities, issued in the money market
with a face value payable at maturity but sold
today by the issuer for less than face value
• Typically available to companies with an excellent
credit reputation because
– There is no acceptor or endorser
– They are unsecured instruments

9-33

4.5 Promissory Notes (cont.)

• Calculations—use discount securities formulae
• Issue programs
– Usually arranged by major commercial banks and money
market corporations
– Standardised documentation
– Revolving facility
– Most P-notes are issued for 90 days
▪ By tender, tap issuance or dealer bids

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Chapter Organisation
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations: Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

9-35

4.6 Negotiable Certificates of Deposit

• Short term discount security issued by banks to
manage their liabilities and liquidity
• Maturities range up to 180 days
• Issued to institutional investors in the wholesale
money market
• The short-term money market has an active
secondary market in CDs

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Chapter Organisation
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations: Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

9-37

4.7 Inventory Finance, Accounts

Receivable Financing and Factoring
• Inventory finance
– Most common form is ‘floor plan finance’
– Particularly designed for the needs of motor vehicle
dealers to finance their inventory of vehicles
▪ Bailment common—finance company holds title to
dealership’s stock
– Dealer is expected to promote financier’s financial
products

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4.7 Inventory Finance, Accounts
Receivable Financing and Factoring (cont.)
• Accounts receivable finance
– A loan to a business secured against its accounts
receivable (debtors)
– Mainly supplied by finance companies
– Lending company takes charge over a company’s
accounts receivable; however, the borrowing company is
still responsible for the debtor book and bad debts

9-39

4.7 Inventory Finance, Accounts

Receivable Financing and Factoring (cont.)
• Factoring
– Company sells its accounts receivable to a factoring
company and in doing so
▪ In doing so it converts a future cash flow (receivables) into a
current cash flow
– Factoring provides immediate cash to the vendor; plus it
removes administration costs of accounts receivable

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4.7 Inventory Finance, Accounts
Receivable Financing and Factoring (cont.)
• Factoring (cont.)
– Main providers of factor finance are the finance
companies
– Factor is responsible for collection of receivables
– Notification basis: vendor is required to notify its
(accounts receivables) customers that payment is to be
made to the factor
– Recourse arrangement
▪ Factor has a claim against the vendor if a receivable is not
paid
– Non-recourse arrangement
▪ Factor has no claim against vendor company

9-41

Chapter Organisation
4.1 Trade Credit
4.2 Bank Overdrafts
4.3 Commercial Bills
4.4 Calculations: Discount Securities
4.5 Promissory Notes
4.6 Negotiable Certificates of Deposit
4.7 Inventory Finance, Accounts Receivable
Financing and Factoring
4.8 Summary

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4.8 Summary
• Short-term debt is appropriate for funding short-
term assets (matching principle)
• Trade credit—simple and common
• Bank overdraft—common
• Discount securities
– Bill financing—important source of funds
– Promissory-notes (P-notes)—good credit rating required
– Certificates of deposit (CDs)—issued by banks to
manage liabilities and liquidity
• Inventory loans, accounts receivable finance and
factoring—alternative sources of finance for small
and medium-sized businesses (SMEs)

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