Business Finance

Chapter : Three
Short-term Financing
Prepared by: Anindita Tasneem
Department of Finance
University of Dhaka

1. What is short-term financing?

Short-term Financing:
Required amount of fund collected by a business enterprise for running day to day
operations and meeting up emergencies from different available sources for less than
one year time period is known as short term financing.

2. Describe the features/characteristics of short-term financing.

The features of short-term financing are described below:

1. Time:

Short-term funds are raised for one year or less than one year. The sources, from
which the funds are collected, are repaid within one year. Example: A firm can
purchase raw material by cash or on trade credit. In case of cash payment, firm
can borrow cash from bank for 6 months and pay with the cash. On the other hand,
it can purchase a portion of the raw material on trade credit of 3 month and pay
the credit amount after 3 months. Both are the types of short-term financing.

2. Purpose:

Short-term funds are generally raised to fulfill the need of working capital or to
meet the daily expenditures. Example: For purchasing raw materials, paying the
salaries of the workers or meeting other daily needs.

3. Costly and Risky:

As short term loans are borrowed for a short time, they are generally risky to be
repaid. So, the lender charges higher interest against these loans. As a result,
these loans become costly too.

4. Security:

Short-term loans are generally small in amount. So, they can be easily repaid by
selling or producing goods. As a result, no security is demanded by the lender. But
in some cases, bank can demand security observing the solvency of the borrower.

5. Recycling:
A major advantage of short-term financing is that funds can be raised continuously
and regularly from these types of sources. If the loan is repaid regularly within the
credit period lender becomes satisfied and gets encourage to lend more.

6. Renewal:
If the borrower repays the loans accordingly and willingly within the time period,
he has chances to get loan easily in future. Lender can renew the loan agreement if
the borrower is trustworthy.
7. Size and Nature of the firm:
Generally every firm has to raise short-term funds. But traders need these types
of fund more than the manufacturers. On the other hand, small firms use shortterm funds more than the large firms.

3. Describe the major classifications of short-term financing.

There are 4 major types of short-term financing. They are:

1. Spontaneous Financing:
a. Trade Credit:
i. Open Account
ii. Notes Payable/ Promissory Notes
iii. Trade Acceptance
b. Advances from Customers and Deferred Income
c. Accrued Expenses

2. Money Market Credit:

a. Commercial Credit
b. Bankers Acceptance

3. Short-term Unsecured Bank Loan:

a. Single Payment Credit/ Transaction Loan
b. Revolving Credit
c. Line of Credit

4. Secured Short-term Bank Credit

a. Financing by accounts receivable:

i. Assigning/ Pledging the Accounts Receivable
ii. Financing by Factoring Accounts Receivable
b. Financing against inventory as security:
i. Floating Lien / Blanket Inventory Lien
ii. Chattel Mortgage
iii. Trust Receipt Loan
iv. Warehouse Receipt Loan

4. Describe the spontaneous sources of financing.

Spontaneous Financing:
Financing which flows with the volume of sales activity during normal business
operations and requires no additional assistance from lenders or creditors is called
spontaneous financing.
The major sources of spontaneous financing are:
1. Trade Credit:
a. Open Account
b. Notes Payable/ Promissory Notes
c. Trade Acceptance
2. Advances from Customers and Deferred Income
3. Accrued Expenses

1. Trade Credit:
Trade credit is a loan advantage by which the seller sells products to his customer on
credit and allows them to pay the credit amount after a certain period. It is also
called accounts payable. Trade credit allows the buyer to pay the cost after a certain
period and use the payable money as a short-term source of financing.
This credit is a spontaneous source of financing in the sense that it arises
spontaneously from ordinary business transactions. For example, suppose a firm makes
a purchase of 1,000 on terms of net 30, meaning that it must pay for goods 30 days

after the invoice date. This instantly and spontaneously provides it with 1,000 of
credit for 30 days. If it purchases 1,000 of goods each day, then on average, it will
be receiving 30 times 1,000, or 30,000, of credit from its suppliers.

Types of trade credit:

There are generally three basic types of trade credit. They are:
a. Open Account
b. Notes Payable/ Promissory Notes
c. Trade Acceptance
a. Open Account:
Of the three types of trade credit the open-account arrangement is by far the most
common kind. With this arrangement the seller ships goods to the buyer and sends an
invoice that specifies the goods shipped the total amount due, and the terms of the
sale. Open-account credit derives its name from the fact that the buyer does not sign
a formal debt instrument evidencing the amount owed the seller. The seller generally
extends credit based on a credit investigation of the buyer. Open-account credit
appears on the buyers balance sheet as accounts payable.

b. Notes Payable / Promissory Notes:

In some situations promissory notes are employed instead of open-account credit. The
buyer signs a note that evidences a debt to the seller. The note calls for the payment
of the obligation at some specified future date. This arrangement is employed when
the seller wants the buyer to acknowledge the debt formally. For example, a seller
might request a promissory note from a buyer if the buyers open account became past
due.
c. Trade Acceptance
A trade acceptance is another arrangement by which the indebtedness of the buyer is
formally recognized. Under this arrangement, the seller draws a draft on the buyer,
ordering the buyer to pay the draft at some future date. The seller will not release
the goods until the buyer accepts the draft.
Accepting the draft, the buyer designates a bank at which the draft will be paid when
it comes due. At that time, the draft becomes a trade acceptance, and, depending on
the creditworthiness of the buyer, it may possess some degree of marketability. If
the trade acceptance is marketable, the seller of the goods can sell it at a discount
and receive immediate payment for the goods. At final maturity, the holder of the
acceptance presents it to the designated bank for collection.

Features of Trade Credit:

1. Credit Sale or Purchase: Arises from credit sale.
2. Fewer Formalities: Fewer formalities are needed to be performed. Arise easily
from daily transactions.
3. Timing: Generally provided for three months or less. Depending on the
creditworthiness of the buyer seller can also provide for more than three
months.
4. Financing Volume: This credit is a spontaneous source of financing in the sense
that it arises spontaneously from ordinary business transactions. For example,
suppose a firm makes a purchase of 1,000 on terms of net 30, meaning that it
must pay for goods 30 days after the invoice date. This instantly and
spontaneously provides it with 1,000 of credit for 30 days. If it purchases

1,000 of goods each day, then on average, it will be receiving 30 times 1,000,
or 30,000, of credit from its suppliers. If sales, and consequently purchases,

double, then its accounts payable would also double, to 60,000. So, simply by
growing, the firm spontaneously generates another 30,000 of financing.
Similarly, if the terms under which it bought were extended from 30 to 40
days, its accounts payable would expand from 30,000 to 40,000. Thus, both
expanding sales and lengthening the credit period generate additional financing.

5. Cost

of Financing: If no cash discount is offered, there is no cost for the use

of credit during the net period. On the other hand, if a firm takes a discount,
there is no cost for the use of trade credit during the discount period. If a
cash discount is offered but not taken, however, there is a definite opportunity
cost.

6.

Purpose and Nature: Trade credit is generally used to buy raw materials

and products. So, it is an important source of meeting up the need of working

capital.
7. Security: Generally no security is demanded by the seller while providing this
type of credit. Mutual trust, goodwill and good relation between the seller and
the buyer acts as the security from buyer.
8. Continuing Credit: This credit is a spontaneous source of financing in the sense
that it arises spontaneously from ordinary business transactions. Repaying the

previous loan the buyer can purchase more and more goods on credit from the
seller.

Terms of Sale:
Because the use of promissory notes and trade acceptances is rather limited, the
subsequent discussion will be confined to open-account trade credit. The terms of the
sale make a great deal of difference in this type of credit. These terms, specified in
the invoice, may be placed in several broad categories according to the net period
within which payment is expected and according to the terms of the cash discount, if
any.
1. COD and CBD: No Trade Credit. COD means cash on delivery of goods. The only
risk the seller undertakes is that the buyer may refuse the shipment. Under such
circumstances, the seller will be stuck with the shipping costs. Occasionally a seller
might ask for cash before delivery (CBD) to avoid all risk. Under either COD or CBD
terms, the seller does not extend credit.
2. Net Period-No Cash Discount: When credit is extended, the seller specifies the
period of time allowed for payment. For example, the terms net 30 indicate that the
invoice or bill must be paid within 30 days. If the seller bills on a monthly basis, it
might require such terms as net 15, EOM, which means that all goods shipped before
the end of the month must be paid for by the 15th of the following month.
3. Net Period Cash Discount: In addition to extending credit, the seller may offer
a cash discount if the bill is paid during the early part of the net period. The terms
2/10, net 30 indicate that the seller offers a 2 percent discount if the bill is paid
within 10 days; otherwise, the buyer must pay the full amount within 30 days. Usually,
a cash discount is offered as an incentive to the buyer to pay early. A cash discount
differs from a trade discount and from a quantity discount. A trade discount is
greater for one class of customers (wholesalers) than for others (retailers). A
quantity discount is offered on large shipments.
4. Seasonal Datings: In a seasonal business, sellers frequently use datings to
encourage customers to place their orders before a heavy selling period. A
manufacturer of lawn mowers, for example, may give seasonal datings specifying that
any shipment to a dealer in the winter or spring does not have to be paid for until
summer. Earlier orders benefit the seller, who can now estimate demand more
realistically and schedule production more efficiently. Also, the seller can reduce or
avoid the carrying costs associated with maintaining a finished goods inventory. The
buyer has the advantage of knowing that stock will be on hand when the selling season
begins, and of not having to pay for the goods until well into the selling period. Under
this arrangement, credit is extended for a longer than normal period of time.

Cost of Trade Credit:

Generally, we cannot detect any cost of trade credit. But according to the principles
of finance the analysts do not recognize the trade credit as a non-cost borrowing. But
the cost of trade credit is different from the others. In case of other credits, the
interest rate and additional costs are stated particularly. But the cost of trade credit
depends on the following factors:
1. Cash Discount Rate
2. Variation of the duration of discount period
3. Variation of the duration of net period
If no cash discount is offered by the terms of sale, there is no cost for the use of
credit during the net period. Hence,
No cash discount offered = No cost of credit
But in most of the cases firms offer cash discounts. If the buyer pays the credit
amount within the discount period he receives a cash discount on the money borrowed
by trade credit. If a firm takes a discount, there is no cost for the use of trade
credit during the discount period.
Cash discount offered + Taken by the buyer = No Cost of Trade Credit
If the buyer does not pay the credit amount within the discount period, he has to pay
the whole amount stated in the bill after the credit/net period ends. In this case, a
cash discount is offered but not taken. So, there is a definite opportunity cost which
is called the cost of trade credit.
Cash discount offered + Not taken by the buyer = Cost of Trade Credit

So, if the seller offers cash discount the buyer can be benefitted in two ways:
1. Paying within the discount period, he can have a discount on the whole amount.
In this case, he doesnt have to pay the full credit amount.
2. Without paying within the discount period, he can ignore the discount amount
and pay the credit money after the net period. In this case, he can use the
credit amount as a source of financing from the date the discount period ends
to the date the net period ends.

Calculating cost of credit:

If the terms of sale are 2/10, net 30, the firm has the use of funds for an
additional 20 days if it does not take the cash discount but pays on the final day of
the net period. For a $100 invoice, it would have the use of $98 for 20 days, and for
this privilege it pays $2. (This is the result of paying $100 thirty days after the sale,
rather than $98 ten days after the sale.) Treating this situation as equivalent to a
loan of $98 for 20 days at a $2 interest cost, we can solve for the approximate annual
interest rate (X%) as follows:
Cost of credit, 2 = 98 X% (20 days/360 days)
Therefore, X% = (2/98) (360/20) = 36.73%
Thus we see that trade credit can be a very expensive form of short-term financing
when a cash discount is offered but not accepted. The cost, on an annual percentage
basis, of not taking a cash discount can be generalized as:
EIR =

Cash Discount Rate

100- Cash Discount Rate

360
Credit Period- Discount Period

100

Making use of equation we can see that the cost of not taking a discount declines as
the payment date becomes longer in relation to the discount period.
Had the terms in our example been 2/10, net 60, the approximate annual percentage
cost of not taking the discount, but rather paying at the end of the credit period,
would have been
(2/98) (360/50) = 14.69%
The approximate interest cost over a variety of payment decisions for 2/10, net __.
Payment Date
11
20
30
60
90

Annual Rate of Interest

744.9%
73.47%
36.73%
14.69%
9.18%

We see that the cost of trade credit decreases at a decreasing rate as the net period
increases. The point is that, if a firm does not take a cash discount, its cost of trade
credit declines with the length of time it is able to postpone payment.

2. Advances from customers / Deferred Income:

Advances taken from the customers are another source of short-term spontaneous
financing. Sometimes businessmen insist on their customers to make some advance
payment. It is generally asked when the value of order is quite large or things ordered
are very costly. Customers' advance represents a part of the payment towards price
on the products which will be delivered at a later date. Customers generally agree to
make advances when such goods are not easily available in the market or there is an
urgent need of goods. A firm can meet its short-term requirements with the help of
customers' advances.
This has become an increasingly popular source of short-term finance among the small
business enterprises mainly due to two reasons. First, the enterprises do not pay any
interest on advances from their customers. Second, if any company pays interest on
advances, that too at a nominal rate. Thus, advances from customers become one of
the cheapest sources of raising funds for meeting working capital requirements of
companies.

3. Accrued Expenses:
Perhaps even more than accounts payable, accrued expenses represent a spontaneous
source of financing. The most common accrued expenses are for wages and taxes. For
both accounts, the expense is incurred, or accrued, but not yet paid. Usually a date is
specified when the accrued expense must be paid.
Generally, there is a certain amount of time gap between incomes is earned and is
actually received or expenditure becomes due and is actually paid. Salaries, wages and
taxes, for example, become due at the end of the month but are usually paid in the
first week of the next month. Thus, the outstanding salaries and wages as expenses
for a week help the enterprise in meeting their working capital requirements. This
source of raising funds does not involve any cost.
For example, a firm has 10,000 workers and their daily salary is 100 taka per person.
If the firm gives their payment after the end of 15 days payment period, they will
have this outstanding expense of (10,00010015) or 15,000,000 taka as an internal
spontaneous source of financing for these 15 days.
Like accounts payable, accrued expenses tend to rise and fall with the level of the
firms operations. For example, as sales increase, labor costs usually increase and, with
them, accrued wages also increase. In a sense, accrued expenses represent costless

financing. Services are rendered for wages, but employees are not paid and do not
expect to be paid until the end of the pay period. Thus accrued expenses represent an
interest-free source of financing.

5. Describe the Money Market Credits.

Money Market Credit:
As money became a commodity, the money market became a component of the financial
markets for assets involved in short-term borrowing, lending, buying and selling. The money

market consists of financial institutions and dealers in money or credit who wish to
either borrow or lend. Participants borrow and lend for short periods, typically up to one
year.

Money market trades in short-term financial instruments commonly called "paper".

This contrasts with the capital market for longer-term funding, which is supplied
by bonds and equity. Money markets, which provide liquidity for the global financial
system and capital markets, make up the financial market. Large, well-established
companies sometimes borrow on a short-term basis through Commercial paper and
other money market instruments like Bankers Acceptance.

Commercial Paper:
Commercial paper represents an unsecured, short-term, negotiable promissory note
sold in the money market. Because these notes are a money market instrument, only
the most creditworthy companies are able to use commercial paper as a source of
short-term financing. Besides, industrial firms, utilities, and medium-sized finance
companies sell commercial paper through dealers.
Generally commercial papers have a face value. But they are sold at a price which is 1
to 5 percent less than the face value. For example, Beximco Group wants to sell
commercial papers with a face value of 100 taka each. The sales value of each
commercial paper is 95 taka and the buyer of the commercial paper will be repaid
after 6 months. The floatation cost (selling cost) of each commercial paper is 4 taka.
It means, if a commercial paper is sold for 6 month (January 1 to June 30) on January
1, the buyer will give 95 taka (sell value) to the firm. In return, on June 30 the seller
will repay the buyer 100 taka (face value). Then the cost of commercial paper will be:
5 = (95-4) x%
Therefore, X% =

5
91

180
360

360
180 100 = 10.99%

Effective Interest Rate (EIR) =

Face Value- Sale Value

Net Sale Value

360 days
Repayment Period in Days

100

How Commercial Papers are sold:

Generally commercial papers are issued in two methods:
1. Direct Selling:
In this method, the issuer firm directly sells commercial papers to the buyer.
This type of market is called directly placed market. Besides, in this method,
the issuer firm does not have not pay any fee to the dealers for selling
commercial paper.
2. Through dealer or open market sale:
Generally, in this method, the manufacturers, service providers and trading
companies sell their commercial papers to dealers. The dealers resell them to
investors and for this the get commission from the issuing firms at a fixed rate.
Any person, commercial bank, insurance company, pension fund and mutual fund
can purchase these commercial papers and provide short-term loans to the
firms.
Unlike many industrial issuers, finance companies use the commercial paper market as
a permanent source of funds. Both dealer-placed and directly placed paper is rated
according to its quality.
Advantages of Commercial Paper:
1. Lower Cost: The principal advantage of commercial paper as a source of shortterm financing is that it is generally cheaper than a short-term business loan
from a commercial bank. Depending on the interest-rate cycle, the rate on
commercial paper may be as much as several percent lower than the prime rate
for bank loans to the highest-quality borrowers.
2. Easily handy: For most companies, commercial paper is a supplement to bank
credit. When there is scarcity of short-term bank loans, at that time the firm
can easily meet their need of working capital by selling the commercial papers.
3. No necessity of compensating balances: In addition to charging interest on
loans, commercial banks may require the borrower to maintain demand deposit
balances at the bank in direct proportion to the amount of funds borrowed. This

amount is called compensating balance. This is not required in case of

commercial paper.

4. Bank Supported: Instead of issuing stand-alone paper, some corporations

issue what is known as bank-supported commercial paper. A bank-supported

arrangement makes sense for companies that are not well known. The banks give
assurance that if the company fails to repay the money the bank will repay it.
Thus the buyers feel safe.

Bankers Acceptances:
For a company engaged in foreign trade or the domestic shipment of certain
marketable goods, bankers acceptances can be a meaningful source of financing.
When a Bangladeshi company wishes to import 100,000 worth of electronic
components from a company in Japan, the two companies agree that a 90-day time
draft will be used in settlement of the trade. The Bangladeshi company arranges a
letter of credit with its bank, whereby the bank agrees to honor drafts drawn on the
company as presented through a Japanese bank. The Japanese company ships the
goods and at the same time draws a draft ordering the Bangladeshi company to pay in
90 days. It then takes the draft to its Japanese bank.
By prearrangement, the draft is sent to the Bangladeshi bank and is accepted by
that bank. At that time it becomes a bankers acceptance. In essence, the bank
accepts responsibility for payment, thereby substituting its creditworthiness for that
of the drawee, the Bangladeshi company.
If the bank is large and well known and most banks accepting drafts are the
instrument becomes highly marketable upon acceptance. As a result, the drawer (the
Japanese company) does not have to hold the draft until the final due date; it can sell
the draft in the market for less than its face value. The discount involved represents
the interest payment to the investor.
At the end of 90 days the investor presents the acceptance to the accepting bank for
payment and receives 100,000. At this time the Bangladeshi company is obligated to
have funds on deposit to cover the draft. Thus it has financed its import for a 90-day
period. Presumably, the Japanese exporter would have charged a lower price if
payment were to be made on shipment. In this sense the Bangladeshi company is the
borrower. The presence of an active and viable bankers acceptance market makes
possible the financing of foreign trade at interest rates approximating those on
commercial paper. Although the principles by which the acceptance is created are the
same for foreign and domestic trade, a smaller portion of the total bankers
acceptances outstanding is domestic. In addition to trade, domestic acceptance
financing is used in connection with the storage of such things as grain.

6. Describe the Short-term Unsecured Bank Loans.

Short-term Unsecured Bank Loans:
Almost without exception, finance companies do not offer unsecured loans, simply
because a borrower who deserves unsecured credit can borrow at a lower cost from a
commercial bank.
Short-term, unsecured bank loans are typically regarded as self-liquidating in that
the assets purchased with the proceeds generate sufficient cash flows to pay off the
loan. The short-term, self-liquidating loan is a popular source of business financing,
particularly in financing seasonal buildups in accounts receivable and inventories.
Unsecured short-term loans itself is formally evidenced by a promissory note signed
by the borrower, stating the interest to be paid along with how and when the loan will
be repaid.
Types of Short-term Unsecured Bank Loans:
There are three types of short-term unsecured bank loans. They are:
1. Transaction Loans:
Borrowing under transaction loans is appropriate when the firm needs short-term
funds for only one specific purpose. A contractor may borrow from a bank in order to
complete a job. When the contractor receives payment for the job, the loan is paid
off. For this type of loan, a bank evaluates each request by the borrower as a
separate transaction. In these evaluations, the cash-flow ability of the borrower to
pay the loan is usually of paramount importance.
This is a loan agreement of very small period
Loan is granted for a very particular purpose. Once the purpose is served,
the loan will be cancelled.
The Effective Interest Rate for transaction loan is =
Where,
R= Interest Rate
M= Frequency of taking loan in the year

(1+

R M
) -1
M

} 100

2. Revolving Credit Agreement:

A revolving credit agreement is a formal, legal commitment by a bank to extend
credit up to a maximum amount. While the commitment is in force, the bank must
provide credit whenever the borrower wishes to borrow, on condition that total
borrowings do not exceed the maximum amount specified.
If the revolving credit is for 1 million and 700,000 is already owed, the borrower
can borrow up to an additional 300,000 at any time. For the privilege of having this

formal commitment, the borrower is usually required to pay a commitment fee on the
unused portion of the revolving credit, in addition to interest on any loaned amount.
For example, if the revolving credit is for 1 million on 12% interest and borrowing for
the year averages 400,000, the borrower could be required to pay a commitment fee

on the 600,000 unused (but available) portion. If the commitment fee is 0.5 %, the
cost of this privilege (commitment fee) will be 3,000 (600,000.5%). In addition the
interest amount will be 48000 (400,000 12%) for the year. So the borrower must
keep total 51000 (48000+3000) in his bank account as security.
Revolving credit agreements frequently extend beyond one year. Because lending
agreements of more than a year must be regarded as intermediate-term credit.
3. Line of Credit:
A line of credit is an informal arrangement between a bank and its customer
specifying the maximum amount of credit the bank will permit the firm to owe at any
one time. Usually, credit lines are established for a one-year period and are set for
renewal after the bank receives the latest annual report and has had a chance to
review the progress of the borrower. If the borrowers year-end statement date is
December 31, a bank may set its line to expire sometime in March.
At that time, the bank and the company would meet to discuss the credit needs of the
firm for the coming year in light of its past years performance. The amount of the
line is based on the banks assessment of the creditworthiness and the credit needs of
the borrower. Depending on changes in these conditions, a line of credit may be
adjusted at the renewal date or before, if conditions necessitate a change.
Despite its many advantages to the borrower, it is important to note that a line of
credit does not constitute a legal commitment on the part of the bank to extend
credit. The borrower is usually informed of the line by means of a letter indicating
that the bank is willing to extend credit up to a certain amount.

Two main features of this type of loans are:

1. This letter is not a legal obligation of the bank to extend credit. If the
creditworthiness of the borrower should deteriorate over the year, the bank
might not want to extend credit and would not be required to do so.
2. The amount of the loan are withdrawn and repaid at a time. But if the bank
agrees the repayment can be made in installments.

Difference between Line of Credit and Revolving Credit:

No

Features

Line of Credit

Revolving Credit

.
1.

Installments

The loan amount is disbursed

The borrower can collect and

and repaid at a time.

repay the money in multiple

After disbursing the credit

installments.
Any party just cannot cancel its

any party can withdraw this

agreement. Here legal bindings

agreement if they want. So

are strict.

2.

Legal Issue

there is no legal commitment

3.

Commitment

here.
As the loan amount is

As the borrower has the

Fee

withdrawn at a time the

impendence to withdraw the

borrower doesnt have to pay

loan amount in multiple

any commitment fees.

installments he has to pay a

commitment fee on the unused

4.
5.

Cost of

The cost of credit doesnt

portion of the loan.

The cost of credit includes

Credit

include commitment fees

commitment fees

Obligation of

Bank lends the maximum

Bank is obliged to pay any

lending

amount at only one time.

amount of loan demanded buy

After the disbursement

the borrower up to the

there is no chance to have

maximum amount stated.

loan without the renewal of

the agreement.

Cost of Short-term Unsecured Bank Loans:

A number of important factors affect the cost of borrowing on a short-term basis.
These factors help determine the effective rate of interest on short-term
borrowing which include Interest Rates, Compensating Balances and Commitment Fees.
1. Interest Rates:
The stated (nominal) interest rates on most business loans are determined through
negotiation between the borrower and the lender. In some measure, banks try to vary
the interest rate charged according to the creditworthiness of the borrower the
lower the creditworthiness, the higher the interest rate. Interest rates charged also
vary in keeping with money market conditions.
One measure that changes with underlying market conditions is the prime rate. The
prime rate is the rate charged on short-term business loans to financially sound
companies. The rate itself is usually set by large money market banks and is relatively
uniform throughout the country. For the unsecured loans, the interest rate is
generally 1 or 2 percent greater than the prime rate.
Methods of Computing Interest Rates:
Three common ways in which interest on a short-term business loan may be paid are:
a. Collect Basis:
When paid on a collect basis, the interest is paid at the maturity of the note. On a
10,000 loan at 12 percent stated interest for one year, the effective rate of
interest on a collect note is simply the stated rate:
Effective Interest Rate (EIR) =

1,200 in interest
10,000 in usable funds

100 = 12.00%

b. Discount Basis:
When paid on a discount basis, interest is deducted from the initial loan. On a discount
basis, however, the effective rate of interest is higher than 12 percent:
Effective Interest Rate (EIR) =

Total Interest
Loan Utilized
13.64%

1,200
8,800 in usable funds 100 =

[When we pay on a discount basis, we have the use of only

8,800 for the year but must pay back

10,000 at the end of that time. Thus the effective rate of interest is higher on a discount note than
on a collect note. We should point out that most bank loans are paid on a collect basis.]

c. Installment Basis:
When loans are repaid by installments then the interest is calculated by dividing the
whole year into a certain number of installments. The interest amount is added with
the loan amount and the total amount is repaid by installments.
For example, we have to calculate the effective interest rate of a loan of

200,000 at 12% interest to be repaid by 12 installments. Then the amount to be repaid

by each installment is:
200,000 + (200,00012%)
12

200,000 + 24000
12

= 18,667

As the total loan amount with interest is to be repaid within 12 installments the
effective interest rate will be:

Effective Interest Rate (EIR) =

2PC
A (N+1)

100

P = Number of annual installments

C = Interest to be paid
A = Total amount of loan
N= Total Number of Installments

Effective Interest Rate (EIR) =

2 12 24000
200,000 (12+1)

100

=22.15%

Compensating Balances:
In addition to charging interest on loans, commercial banks may require the borrower
to maintain demand deposit balances at the bank in direct proportion to either the
amount of funds borrowed or the amount of the commitment. These minimum balances
are known as compensating balances.

The amount required in the compensating balance varies according to competitive

conditions in the market for loans and specific negotiations between the borrower and
the lender.
Banks generally would like to obtain balances equal to at least 10 percent of a line of
credit. If the line is 2 million, the borrower would be required to maintain average
balances of at least 200,000 during the year.

The result of compensating balance requirements is to raise the effective cost of

borrowing (Effective Interest RateEIR) if the borrower is required to maintain cash
balances above the amount the firm would ordinarily maintain. If we borrow 1 million
at 8% and are required to maintain 20% more in balances than we would ordinarily, we
will then have the use of only 800,000 of the 1 million loan. The effective annual
interest cost is then not equal to the stated rate of 8%, but rather:

Effective Interest Rate (EIR) =

80,000 in interest
800,000 in usable funds

100 = 10%

With the rapid and significant fluctuations in the cost of funds to banks in recent
years, as well as the accelerated competition among financial institutions, banks are
increasingly making loans without compensating balance requirements. The interest
rate charged, however, is more in line with the banks incremental cost of obtaining
funds. The movement toward sophisticated profitability analyses has driven banks to
direct compensation for loans through interest rates and fees as opposed to indirect
compensation through deposit balances.

Ex: $1 million revolving credit at 10% stated interest rate for 1 year; borrowing for
the year was $600,000; a required 5% compensating balance on borrowed funds; and
a .5% commitment fee on $400,000 of unused credit. What is the cost of borrowing?
Interest:
Commitment Fee:
Compensating Balance:
Usable Funds:

($600,000) x (10%)
($400,000) x (0.5%)
($600,000) x (5%)
$600,000 - $30,000

= $ 60,000
= $ 2,000
= $ 30,000
= $570,000

$60,000 in interest + $2,000 in commitment fees

$570,000 in usable funds

= 10.88%

7. Describe the Secured Short-term Bank Credits.

Many firms cannot obtain credit on an unsecured basis, either because they are new
and unproven or because bankers do not have high regard for the firms ability to
service the amount of debt required. To make loans to such firms, lenders may require
security (collateral) that will reduce their risk of loss.
With security, lenders have two sources of loan repayment:
1. The cash-flow ability of the firm to service the debt and
2. If that source fails for some reason, the collateral value of the security.
Most lenders will not make a loan unless the firm has sufficient expected cash flows
to make proper servicing of debt highly probable. To reduce their risk, however, they
may require security.
Technically, a secured (or asset-based) loan is any loan secured by any of the
borrowers assets. However, when the loan involved is short-term, the assets most
commonly used as security are accounts receivables and inventories.

1. Financing by Accounts Receivables:

Accounts receivables are quick assets that can be quickly converted into cash. So the
banks and the financial institutions give loans against accounts receivables.
When a bank assigns a loan against accounts receivables, he has to consider these
factors:
1.
2.
3.
4.
5.
6.

The goodwill, financial condition, repaying habit of the drawer

The duration of relationship the bank and the borrower with the drawer.
The usage and output of the loan
The solvency, goodwill, creditworthiness, profitability, liquidity of the
borrower.
The duration of the bill must be less than the duration of the loan.
Otherwise, there is a big risk for the lender.
The quality rating of the bill. If the bill has higher credit rating, the
borrower has the chance to more amount of credit.

Two methods of using accounts receivables as short term loans security are:
a.
b.

Assigning or pledging accounts receivables

Factoring accounts receivables

a. Assigning or pledging accounts receivables:

Any firm can borrow short-term fund from bank or other financial institutions by
assigning or pledging accounts receivables. A firm which wants to borrow loan gives
application to the bank along with the accounts receivables as security. If the
bank becomes satisfied after analyzing the accounts receivables it lends the
borrower about 70%-80% of the total value of the accounts receivables. After the
maturity of accounts receivables, borrower has to pay repay the bank from the
amount he got from the customer/drawer of the bill.
On the basis of repayment method there are two ways of pledging accounts
receivables. They are:
i.

Notification basis: In this method, when the borrower assigns accounts

receivables as security to the bank, he notifies the customer that his payable
bills have been used as security to a particular bank. As a result, the day when
the bill becomes matured, the customer/drawer of the bill makes the payment
directly to the borrowers account.
Bank keeps the principal and interest
amount from the money and the gives the rest money back to the borrower. In
this method the bank has to face less risk.

ii.

Non-notification basis: In this method, when the borrower assigns accounts

receivables as security to the bank, he does not notify the customer that his
payable bills have been used as security. When the borrower gets payment from
the drawer of the bill on the maturity date, he repays the total amount
(principal and the interest). Otherwise, after maturity the bank notifies both
the borrower and the drawer of the bill to repay the money. In that case, bank
orders the drawer to make the payment of his payable bill in the borrowers
account. After the payment, bank collects the total principal and interest
amount from the money and credits the rest amount to the borrowers account.
On the basis of the amount of security pledged there are two ways of pledging
accounts receivables:

i.

Continuous Basis: In this method, there is a contract between the bank and the
borrower by which the borrower can borrow loan by pledging one bill or more
than one bills. After the maturity of the bills, the borrower adjusts the bill
amount with the loan amount and again pledges other accounts receivables as
security against the loan. That means after the maturity of one account

receivable he can pledge another account receivable. Thus, by means of a longterm contract borrower can borrow a maximum fixed amount of loan. The lender
does not require a compensating balance against this type of loan. So, the
interest rate is generally 2-4% above the prime rate.
ii.

Seasonal Basis: In this method, there is a contract between the bank and the
borrower by which the borrower can borrow only one loan at a time by pledging
his bills receivables. After the maturity of the bills, the borrower has to sign a
new contract with the bank by pledging new bills as securities.

Cost of loans by assigning or pledging accounts receivables:

The cost of loans by assigning or pledging accounts receivables are generally higher
than other loans. Because:
1. If the credit rating of the bill which is pledged against the loan, is lower, then
the banks charges more interest on the loan.
2. By assigning loan against accounts receivables, the overall cost of credit
administration of the bank increases. So, the bank imposes higher service
charge for this purpose.
3.

The risk against this type of loan is generally higher. So, the bank charges
interest at a high rate.

We can calculate the effective interest rate against loans by assigning or pledging
accounts receivables by the following formula:

Effective Interest Rate, EIR =

1
1
1
R
N

R = Nominal / Stated Interest Rate

N = Accounts Receivables Turnover

b. Factoring Accounts receivables:

Under this method, before maturity, the borrower directly sells the accounts
receivables to bank or other financial institutions at discount for quick cash
earning. This process is called factoring accounts receivables. Generally, bank and
other financial institutions perform as the factor. So, the institutions which
accomplish the factoring of the accounts receivables are called factors.

While factoring, the borrower and the factor both inform the drawee in advance
and orders him to pay directly to the factor at maturity date. The factor retains
10% of the face value of the accounts receivables and gives the rest 90% as loan to
the seller (borrower). The factor also retains some additional amount as factoring
commission from the borrower.
Cost of factoring accounts receivables: As a factor the bank performs the following:
1.
2.
3.
4.

Evaluating the bills

Collecting the amount of the bills
Taking the risk of the failure of the repayment
Giving the loan in cash

For doing these tasks the collects fees from the borrower which is identified as the
cost of the borrowing. This cost includes:
a. The rate of factoring commission
b. The amount of cash given
c. Reserve for the bad debt loss etc.

2. Financing against inventory as security:

Basic raw-material and finished-goods inventories represent reasonably liquid assets
and are therefore suitable as security for short-term loans. As with a receivable loan,
the lender determines a percentage advance against the market value of the
collateral. This percentage varies according to the quality and type of inventory.
Certain inventories, such as grains, are very marketable and, when properly stored,
resist physical deterioration.
The margin of safety required by the lender on a loan of this sort is fairly small, and
the advance may be as high as 90 percent. On the other hand, the market for a highly
specialized piece of equipment may be so narrow that a lender is unwilling to make any
advance against its reported market value.
Thus not every kind of inventory can be pledged as security for a loan. The best
collateral is inventory that is relatively standard and for which a ready market exists
apart from the marketing organization of the borrower. Lenders determine the
percentage that they are willing to advance by considering:
1.
2.
3.
4.
5.

Market Value
Marketability
Perishability
Market price stability
The difficulty and expense of selling the inventory to satisfy the loan. The cost
of selling some inventory may be very high. Lenders do not want to be in the

business of liquidating collateral, but they do want to assure themselves that

collateral has adequate value in case the borrower defaults in the payment of
principal or interest.
6. As is true with most secured, short-term loans, however, the actual decision to
make the loan will primarily depend on the cash-flow ability of the borrower to
service debt.
Methods of Inventory Mortgage Loan:
There are a number of different ways in which a lender can obtain a secured interest
in inventories. They are:
1.
2.
3.
4.

Floating lien / Blanket Lien

Chattel mortgage
Trust receipt loan
Ware house Receipt loan

1. Floating lien:
Under the Uniform Commercial Code the borrower may pledge inventories in general
without specifying the specific property involved. Under this arrangement the lender
obtains a floating lien on the borrowers entire inventory. This lien allows for the legal
seizure of the pledged assets in the event of loan default. By its very nature, the
floating lien is a loose arrangement, and the lender may find it difficult to police.
Frequently, a floating lien is requested only as additional protection and does not play
a major role in determining whether or not the loan will be made. Even if the collateral
is valuable, the lender is usually willing to make only a moderate advance because of
the difficulty in exercising tight control over the collateral. The floating lien can be
made to cover receivables and inventories, as well as the collection of receivables. This
modification gives the lender a lien on a major portion of a firms current assets. In
addition, the lien can be made to encompass almost any length of time so that it
includes future as well as present inventory as security.
2. Chattel mortgage:
With a chattel mortgage, inventories are identified by serial number or some other
means. While the borrower holds title to the goods, the lender has a lien on inventory.
This inventory cannot be sold unless the lender consents. Because of the rigorous
identification requirements, chattel mortgages are ill-suited for inventory with rapid
turnover or inventory that is not easy to identify specifically. Chattel mortgages are
well suited, however, for certain finished-goods inventories of capital goods such as
machine tools.
3. Trust receipt:

Under a trust receipt arrangement, the borrower holds the inventory and the
proceeds from its sale in trust for the lender. This type of lending arrangement, also
known as floor planning, has been used extensively by automobile dealers, equipment
dealers, and consumer durable goods dealers. An automobile manufacturer will ship
cars to a dealer, who, in turn, may finance the payment for these cars through a
finance company. The finance company pays the manufacturer for the cars shipped.
The dealer signs a trust receipt security agreement, which specifies what can be done
with the inventory. The car dealer is allowed to sell the cars but must turn the
proceeds of the sale over to the lender in payment of the loan. Inventory in trust,
unlike inventory under a floating lien, is specifically identified by serial number or
other means. In our example, the finance company periodically audits the cars the
dealer has on hand. The serial numbers of these cars are checked against those shown
in the security agreement. The purpose of the audit is to see whether the dealer has
sold cars without remitting the proceeds of the sale to the finance company. As the
dealer buys new cars from the automobile manufacturer, a new trust receipt security
agreement is signed, reflecting the new inventory. The dealer then borrows against
this new collateral, holding it in trust. Although there is tighter control over collateral
with a trust receipt agreement than with a floating lien, there is still the risk of
inventory being sold without the proceeds being turned over to the lender.
Consequently, the lender must exercise judgment in deciding to lend under this
arrangement. A dishonest dealer can devise numerous ways to fool the lender.
Many durable goods manufacturers finance the inventories of their distributors or
dealers. Their purpose is to encourage dealers or distributors to carry reasonable
stocks of goods. It is reasoned that the greater the stock, the more likely the dealer
or distributor is to make a sale. Because the manufacturer is interested in selling its
product, financing terms are often more attractive than they would be with an
outside lender.
In these first three methods (floating lien, chattel mortgage, and trust receipt), the
inventory remains in the possession of the borrower.

4. Warehouse Receipt Loan:

In the warehouse receipts loan the inventory is in the possession of the lender. So,
this type of loan is more secured. As the inventory is in the possession of the lender,
he can easily sell it in case the borrower fails to repay the loan. Two types of loans are
provided under this method. They are:
a. Terminal Warehouse Receipt Loan
b. Field Warehouse Receipt Loan

a. Terminal warehouse receipt:

A borrower secures a terminal warehouse receipt loan by storing inventory with a
public, or terminal, warehousing company. The warehouse company issues a warehouse
receipt, which evidences title to specific goods that are located in the warehouse. The
warehouse receipt gives the lender a security interest in the goods, against which a
loan can be made to the borrower. Under such an arrangement, the warehouse can
release the collateral to the borrower only when authorized to do so by the lender.
Consequently, the lender is able to maintain strict control over the collateral and will
release collateral only when the borrower pays a portion of the loan. For protection,
the lender usually requires the borrower to take out an insurance policy with a losspayable clause in favor of the lender.
Warehouse receipts may be either nonnegotiable or negotiable. A nonnegotiable
warehouse receipt is issued in favor of a specific party in this case, the lender who
is given title to the goods and has sole authority to release them. A negotiable
warehouse receipt can be transferred by endorsement. Before goods can be released,
the negotiable receipt must be presented to the warehouse operator. A negotiable
receipt is useful when title to the goods is transferred from one party to another
while the goods are in storage. With a nonnegotiable receipt, the release of goods can
be authorized only in writing. Most lending arrangements are based on nonnegotiable
receipts.
b. Field warehouse receipt:
In a terminal warehouse receipt loan, the pledged goods are located in a public
warehouse. In a field warehouse receipt loan, the pledged inventory is located on the
borrowers premises. Under this arrangement, a field warehousing company (an
independent company that operates a borrowers warehouse) reserves a designated
area on the borrowers premises for the inventory pledged as collateral. The field
warehousing company has sole access to this area and is supposed to maintain strict
control over it. (The goods that serve as collateral are segregated from the
borrowers other inventory.) The field warehouse company issues a warehouse receipt
as described in the previous section, and the lender extends a loan based on the
collateral value of the inventory. The field warehouse arrangement is a useful means
of financing when it is not desirable to place the inventory in a public warehouse
either because of the expense or because of the inconvenience. Field warehouse
receipt lending is particularly appropriate when a borrower must make frequent use of
inventory. Because of the need to pay the field warehouse companys expenses, the
cost of this method of financing can be relatively high.

The warehouse receipt, as evidence of collateral, is only as good as the issuing

warehousing company. When administered properly, a warehouse receipt loan affords
the lender a high degree of control over the collateral. However, sufficient examples
of fraud show that the warehouse receipt does not always provide concrete evidence
of value.