Chapter 16

Managing
Short-Term
Liabilities
(Financing)

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Short-Term Credit

Any liability originally scheduled for

repayment within one year.
 Sources of short-term credit:
• Accruals
• Accounts payable (trade credit)
• Bank loans, and
• Commercial paper.

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Sources of Short-Term Financing

Accruals
 Continually recurring short-term liabilities.
 Liabilities, such as wages and taxes, that
increase spontaneously with operations.
 Further, this type of debt generally is considered
‘‘free’’ in the sense that no explicit interest is paid
on funds generated by accruals.

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Sources of Short-Term Financing (Cont’d)

Accounts Payable (Trade Credit)

 Credit created when one firm buys on
credit from another firm.
 Trade credit is a spontaneous source of
financing in the sense that it arises from
ordinary business transactions.

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Components of Trade Credit: Free versus Costly
“Free” Trade Credit
 Credit received during the discount period.
Costly Trade Credit
 Credit taken in excess of “free” trade credit, the cost of
which is equal to the discount lost.
Financial managers always should use the free component,
but they should use the costly component only after
analyzing the cost of this source of financing to make sure
that it is less than the cost of funds that could be obtained
from other sources.
 Stretching accounts payable: The practice
of deliberately paying accounts payable late.
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Sources of Short-Term Financing (Cont’d)
Short-Term Bank Loans
 Commercial banks, whose loans generally appear on firms’
balance sheets as notes payable.

The key features of bank loans:

 Maturity typically 90 days.
 Promissory Notes specify terms and conditions of a loan:
• Amount, interest rate, repayment schedule, collateral,
and any other agreements.

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Sources of Short-Term Financing (Cont’d)
Short-Term Bank Loans
 Compensating Balance: A minimum checking
account balance that a firm must maintain with
a bank to borrow funds—generally 10 to 20
percent of the amount of loans outstanding.
 Line of Credit: A line of credit is an agreement
between a bank and a borrower indicating the
maximum credit the bank will extend to the
borrower.

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Sources of Short-Term Financing (Cont’d)
Short-Term Bank Loans
 Revolving (line of) credit agreement: When a
line of credit is guaranteed, it is called a revolving
credit agreement. A revolving credit agreement is similar
to a regular, or general, line of credit, except the bank has a
legal obligation to provide the funds when requested by the
borrower.
 Commitment Fee: Fee charged on the unused
balance of a revolving credit agreement. The fee
normally is about 1/4 percent (i.e., .25%) of the
unused balance.

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Sources of Short-Term Financing (Cont’d)
Commercial Paper
 Unsecured short-term promissory notes
issued by large, financially sound firms to
raise funds.
 It is sold primarily to other businesses,
insurance companies, pension funds, money
market mutual funds, and banks.

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Sources of Short-Term Financing (Cont’d)
Commercial Paper
 Maturity and Cost:
• Maturities of commercial paper vary from one to nine
months, with an average of about five months.
• The rate on commercial paper fluctuates with supply
and demand conditions.
• Generally, the rates on commercial paper are lower
than the stated prime rate of interest.
• Commercial paper is called a discount instrument
because it is sold at a price below its face, or
maturity, value.

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Computing the Cost of Short-Term Credit

 m = the number of borrowing (interest) periods in one

year—that is, if the loan is for one month, m = 12/1 = 12.

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Computing the Cost of Trade Credit (Accounts Payable)
Consider Microchip’s credit terms of 2/10, net 30, which allow its customers, such
as Personal Computer Company (PCC), to take a 2 percent discount from the
purchase price if payment is made on or before Day 10 of the billing cycle;
otherwise, the entire bill is due by Day 30. If the invoice price is $100 and the firm
does not take the discount, it effectively pays $2 to borrow $98 for a 20-day
period, so the cost of using the funds for the additional 20 days is:

According to this computation, if PCC chooses to pay its bill on Day 30, then it will
‘‘forgo’’ the 2 percent cash discount, which is equivalent to borrowing funds at a rate
of nearly 44 percent per year. PCC should forgo the cash discount to pay on Day 30
only if alternative financing, such as bank loans, has a cost greater than 43.9 percent.
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Computing the Cost of Trade Credit
(Accounts Payable) (Cont’d)
If a supplier offers terms of 3/20, net 60 to
its customers, what is the cost associated
with forgoing the cash discount and paying
the supplier on Day 60? Compute both the
APR and rEAR. (Answer: APR = 27.8%, rEAR =
31.5%)

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Computing the Cost of Bank Loans
Simple Interest Loan
 Both the amount borrowed and the interest
charged on that amount are paid at the maturity
of the loan.
 No payments made before maturity.
Face Value
 The amount of the loan (the amount borrowed)
 Also called the principal amount of the loan.

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Computing the Cost of Bank Loans (Cont’d)
Simple Interest Loan
 For example, with a simple interest loan of $10,000 at 12 percent
interest for nine months, the borrower receives the $10,000 upon
approval of the loan and pays back the $10,000 principal plus $900 =
$10,000[0.12 *(9/12)] in interest at maturity.

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Computing the Cost of Bank Loans
(Cont’d)
Discount Interest Loan
 A loan in which the interest, which is calculated
on the amount borrowed (principal), is paid at the
beginning of the loan period.
 Interest is paid in advance.

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Computing the Cost of Bank Loans (Cont’d)
Discount Interest Loan
 Assume Unilate Textiles receives a nine-month $10,000 discount interest loan
with a 12 percent quoted (simple) interest rate. The interest payment on this
loan is $900 = $10,000[0.12*(9/12)]. Because the interest is paid in advance,
Unilate has only $9,100 = $10,000 - $900 available for use. Thus, the nine-
month interest rate paid for the loan is:

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Computing the Cost of Bank Loans
(Cont’d)
Discount Interest Loan
 Suppose you apply for a $5,000 discount loan
with an 8 percent quoted interest rate. If this is a
six-month loan, what is its APR and rEAR? (Answer:
APR = 8.3%, rEAR = 8.5%)

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Computing the Cost of Bank Loans (Cont’d)

Discount Interest Loan

 What do you think the cost of the loan described here
would be if Unilate’s bank charged a $50 fee to cover the
cost of processing the loan?
• If Unilate uses the proceeds from the loan to pay the $50 fee,
both the numerator and the denominator are affected, and
the nine-month interest rate is:

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Computing the Cost of Commercial Paper
Suppose Unilate issues 270-day commercial paper with a
face value equal to $10,000. The simple annual interest rate
on the commercial paper is 12 percent, and the total
transactions fee, which includes the cost of a backup line of
credit, is 1/2 percent of the amount of the issue.

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