1. Chapter 16 Short-Term Business Financing © 2011 John Wiley and Sons

2. 2 Chapter Outcomes n Identify and describe strategies for financing working capital. n Identify and briefly explain the factors that affect short-term financing requirements. n Identify the types of unsecured loans made by commercial banks to business borrowers. n Describe the use of accounts receivable, inventory, and other sources of security for bank loans.

3. 3 n Explain the characteristics, terms, and costs of trade credit. n Explain the role of commercial finance companies, factors, Small Business Administration, and commercial paper in providing short-term business financing. Chapter Outcomes, continued

4. 4 Strategies for Financing Working Capital n Working capital n Net working capital (NWC) n NWC and financing strategy –If NWC>0, NWC represents the dollar amount of current assets financed with long-term funds –If NWC<0, NWC represents the dollar amount of fixed assets financed with current liabilities

5. 5 Another way to look at a firm’s assets... n Fixed Assets n Permanent current assets n Temporary current assets n Asset levels fluctuate over time for a firm

6. 6 Asset Trends for a Growing Firm Assets ($) Time Fixed Assets Permanent Current Assets Temporary or Fluctuating Current Assets

7. 7 Asset Trends for a Growing Firm: Maturity Matching Assets ($) Time Fixed Assets Permanent Current Assets Temporary or Fluctuating Current Assets Long-term financing Short-term financing

8. 8 Asset Trends for a Growing Firm: Aggressive Financing Assets ($) Time Fixed Assets Permanent Current Assets Temporary or Fluctuating Current Assets Long-term financing Short-term financing

9. 9 Asset Trends for a Growing Firm: Conservative Financing Assets ($) Time Fixed Assets Permanent Current Assets Temporary or Fluctuating Current Assets Long-term financing Short-term financing

10. 10 Basic Financing Strategies n Maturity matching n Aggressive n Conservative

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12. 12 Financing Strategy Problems n Over-reliance on short-term debt –Exposure to increases in short- term rates –Difficulties in rolling over debt –Forced to acquire long-term financing at inopportune times

13. 13 Problems Not Caused by Financing Strategy n Dot coms –Market ignored cash flow generation—or lack thereof! n Ethical lapses

14. 14 Influences on the short-term/ long-term financing decision n Industry and Company Factors –Ratios of short-term financing to assets (2008) AT&T15.9 Consolidated Edison 9.6 Dell67.2 ExxonMobil21.5 Microsoft41.1 Sears33.6 Walgreens29.6 Walmart33.9

15. 15 Influences on the short-term/ long-term financing decision n Current assets/total assets relationship n Growth n Seasonal variation n Firm life cycle/sales trends

16. 16 Patterns of Short-Term and Long-Term Financing over Time Pattern of Short-Term Financing Pattern of Long-Term Financing Time $ 0 $ 0

17. 17 Influences on the short-term/ long-term financing decision n Cyclical variation n Other influences –Flexibility –Relationship with short-term lenders –Concern over constant debt rollover, exposure to interest rate spikes

18. 18 Sources of Short-Term Financing n Commercial Banks n Trade Credit (Accounts Payable) n Commercial Finance Companies n Commercial Paper n Accounts Receivable Financing n Inventory Financing n Loans secured by stocks, bonds, life insurance, co-signed loans, acceptances

19. 19 Commercial Bank Lending n Prime Rate n Line of Credit n Revolving Credit Agreement

20. 20 Line of Credit n Clean up period n Periodic re-approval n Compensating balance versus fees

21. 21 Revolving Credit Agreement n Commitment by bank n Charge on unused funds in addition to interest charge on borrowed funds

22. 22 Small Business Administration Loan Guarantees n The SBA does not give loans, it guarantees them n SBA’s 7(a) loan program: the SBA guarantees 85% of loans of $150,000 or less (bank exposure is only 15%) n It guarantees 75% of loans of $150,000 - $2 million n Loan guarantees available only if firm is unable to obtain financing elsewhere

23. 23 Computing interest rates n EAR = (1 + APR/m) m - 1 n $10,000 loan, 6 months, 8%APR n EAR = (1 +.08/2) 2 - 1 = 8.16%

24. 24 Discounted Loans n Discounted loan $ received = loan amount - interest = $10,000 - $400 = $9600 Periodic rate = $400/9600 APR = 8.51% n Loan request = funds needed 1 - discount %

25. 25 Trade Credit From Suppliers n Net date n Trade discounts 2/10 net 30 n Cost of trade credit Pay $98 within 10 days or pay $100 within 30 days Cost: extra $2 for delaying 20 days

26. 26 Cost of Trade Credit n Cost: extra $2 on a $98 charge for delaying 20 days n Approx. effective cost = 2/98 x 365/20 = 37.2% General formula: Percent discount x 3 6 5 days 100%-discount % net days-discount days

27. 27 True Effective Cost of Trade Credit Using effective annual rate: (1+ 0.02 / (1-0.02) ) 365/(30-10) - 1 =(1 + 0.02/0.98) 365/20 - 1 = 44.6%

28. 28 Commercial Finance Companies n Organization without a bank charter that advances funds to businesses –discounts receivables –secured machinery loans –inventory loans –leases n Higher cost than bank loans

29. 29 Commercial Paper n Short-term, unsecured promissory note n Financing source available only to large, high-credit-quality issuers n Sold via broker, dealer, electronic trading system n Maturity: 270 days or less

30. 30 Commercial Paper n proceeds = issue size less interest less placement fees n Cost is less than bank loans n Global market n Issuer typically has line of credit available to repay paper if it cannot roll it over

31. 31 Accounts Receivable Financing n Pledging receivables –Uses accounts receivable as collateral; as receivables are collected, the loan is repaid –<80 percent of AR value n Interest rate + fees

32. 32 Factors n Purchases receivables and assumes credit risk n Can supplement or replace a firm’s credit department n Two types of factoring: –maturity factoring –advance factoring n Cost: interest plus charges

33. 33 Factors n Pro: –Factor does credit checks, assumes collection risk –Management can focus on sales, production –Easier than managing credit of exports n Con: –Higher cost –Implications of financial weakness

34. 34 Inventory Loans n Percent of value lent depends on inventory characteristics n Blanket inventory loan n Trust receipt n Warehouse receipt n Field warehouse n Higher cost than bank loans –Cost of warehousing operations –Used by borrowers with weak credit rating

35. 35 Inventory Valuation n Digital writing/recording devices (e.g., digital cameras) can photograph inventory, record serial numbers for later recall n Business-to-Business and eBay-like auction sites can be used to estimate value (or to sell surplus inventory)

36. 36 Other Types of Loan Security... n Stock and bonds n Cash value of life insurance policy n Co-signer n Acceptances

37. 37 Determining the Cost of Short-Term Financing: A 5-Step Process 1. Determine the amount to be borrowed (consider discounting, compensating balances) 2. Interest expense = interest rate x amount borrowed 3. Estimate fees, other expenses of loan 4. Estimate net loan proceeds 5. Financing cost = (interest expenses + fees)/net proceeds Annualize, if necessary

38. 38 Example Fluoridated Manufacturing is considering short-term financing choices. A factor is willing to advance FM 80 percent of its receivables and charge it a 2 percent fee to compensate it for analysis the receivables and determining which it will purchase. FM estimates they will pay 12 percent APR in order to receive cash an average of 45 days earlier. The current receivables balance is $10,000.

39. 39 Following the Steps… 1. Determine the amount to be received. With receivables of $10,000 and an advance rate of 80 percent, FM will receive $10,000 x 0.80 = $8,000. 2. Determine the interest expense. With a 12 percent APR the daily interest charge is 0.12/365. Factoring allows FM to receive its funds an average of 45 days sooner, so the interest expense is $8,000 x (0.12/365) x 45 = $118.36.

40. 40 Following the Steps n 3. Determine the fees and other expenses. The factor’s fee is 2 percent for basing a loan on a receivables balance of $10,000. The fees are 0.02 x $10,000 = $200. n 4. Estimate the net proceeds. There is no discounting, so in this case the net proceeds will be $8,000. We assume FM will pay the fees out-of-pocket. The net proceeds will be smaller if the $200 in fees are deducted by the factor from the loan amount.

41. 41 Following the Steps n 5. The financing cost is $118.36 + $200 = $318.36 with net proceeds of $8,000. The percentage cost is: $318.36/$8,000 = 0.0398 or 3.98% for 45 days of financing. The annualized rate is (1 + 0.0398) 365/45 – 1 = 0.3724 or 37.24 percent.

42. 42 Web Links www.jpmorganchase.com www.bankofamerica.com www.sba.gov www.cfa.com www.bloomberg.com www.platinumfundinggroup.com www.cit.com www.gecapital.com www.gecfo.com www.textronfinancial.com www.citicapital.com www.celticcapital.com www.ebay.com www.salvagesale.com