Short-term financing is crucial for managing a company's working capital. It includes options like trade credit, bank loans, and commercial paper. Each has unique costs and benefits that impact a company's financial health and performance.

Choosing the right short-term financing option depends on factors like creditworthiness and funding needs. Companies must carefully evaluate these options to maintain healthy cash flow, manage liquidity, and align with their overall financial strategy.

Short-Term Financing Options

Evaluating Costs and Benefits

• Short-term financing options include trade credit, bank loans, lines of credit, commercial paper, and factoring, each with unique characteristics, costs, and benefits that must be carefully evaluated
• The cost of short-term financing is typically expressed as an annual percentage rate (APR) or effective annual rate (EAR), which takes into account interest charges, fees, and other associated costs
• The benefits of short-term financing include flexibility, quick access to funds, and the ability to manage working capital needs
• The choice of short-term financing depends on factors such as the company's creditworthiness, the amount of funding needed, the duration of the financing, and the purpose of the funds
  • Companies should compare the costs and benefits of various options to determine the most suitable financing solution

Impact on Financial Performance

• The use of short-term financing can impact a company's cash flow, liquidity, and financial ratios
  • It is essential to monitor and manage short-term financing to ensure that it aligns with the company's overall financial strategy and objectives
• Companies should carefully assess their ability to repay short-term financing and monitor their debt-to-equity ratio and interest coverage ratio to ensure they are not overextended
• Overreliance on short-term financing can strain relationships with suppliers, customers, and investors, and may indicate financial distress

Trade Credit as Financing

Mechanics of Trade Credit

• Trade credit is a form of short-term financing provided by suppliers, allowing companies to purchase goods or services on credit and pay for them at a later date
  • It is a common source of financing for many businesses, particularly small and medium-sized enterprises
• The terms of trade credit vary depending on the supplier and industry practices
  • Common terms include net 30, net 60, or net 90, which indicate the number of days a company has to pay the invoice
  • Some suppliers may offer discounts for early payment, such as a 2/10 net 30 term, which means a 2% discount if paid within 10 days, or the full amount is due within 30 days

Costs and Benefits of Trade Credit

• The cost of trade credit is often embedded in the price of goods or services
  • If a company fails to take advantage of early payment discounts, the effective cost of trade credit can be high
    • For example, if a supplier offers a 2/10 net 30 term and the company does not pay within 10 days, it effectively forgoes a 2% discount, which translates to an annualized cost of 36.7%
• The use of trade credit can help companies manage their working capital by delaying cash outflows
• However, overreliance on trade credit can strain relationships with suppliers and may indicate financial distress
  • Companies should monitor their accounts payable turnover ratio and days payable outstanding (DPO) to ensure they are managing trade credit effectively

Bank Loans for Working Capital

Types of Bank Financing

• Bank loans and lines of credit are common sources of short-term financing for companies
  • A bank loan is a lump sum borrowed from a bank, typically with a fixed repayment schedule and interest rate
  • A line of credit is a pre-approved borrowing limit that a company can draw upon as needed, with interest charged only on the amount borrowed

Terms and Conditions

• The terms of bank loans and lines of credit depend on the company's creditworthiness, financial performance, and relationship with the bank
  • Interest rates may be fixed or variable, and the loan may require collateral or personal guarantees from the company's owners or managers
• Bank loans and lines of credit can provide flexible funding for working capital needs, such as inventory purchases, accounts receivable financing, or seasonal fluctuations in cash flow
  • However, the cost of borrowing can be high, particularly for companies with weak credit profiles or limited borrowing history
• Companies should maintain good relationships with their banks and provide regular financial updates to ensure continued access to financing

Commercial Paper vs Factoring

Commercial Paper

• Commercial paper is an unsecured, short-term debt instrument issued by large, creditworthy companies to finance short-term liabilities or working capital needs
  • It typically has a maturity of less than 270 days and is sold at a discount to face value, with the difference representing the interest earned by the investor
• The cost of commercial paper is generally lower than other forms of short-term financing, as it is available only to companies with strong credit ratings
  • The interest rate on commercial paper is typically linked to a benchmark rate, such as LIBOR or the Fed Funds rate, plus a spread based on the company's credit risk

Factoring

• Factoring is a financial transaction in which a company sells its accounts receivable to a third party (the factor) at a discount in exchange for immediate cash
  • The factor assumes the credit risk of the company's customers and is responsible for collecting the receivables
• Factoring can provide quick access to cash for companies with limited borrowing capacity or weak credit profiles
  • The cost of factoring includes the discount rate applied to the receivables and any fees charged by the factor
  • Factoring can be done on a recourse or non-recourse basis, depending on whether the company or the factor assumes the risk of non-payment by customers
• The use of commercial paper and factoring can help companies manage their short-term financing needs, but they should be evaluated in the context of the company's overall financial strategy and risk profile