Short-term financing is crucial for businesses to manage cash flow and meet immediate financial needs. From trade credit to secured loans, companies have various options to access funds quickly, each with its own costs and benefits.

Calculating effective annual rates helps businesses compare financing options accurately. By optimizing their mix of short-term financing sources, companies can balance costs, flexibility, and risk to support their operations and growth strategies effectively.

Sources and Considerations for Short-term Financing

Sources of short-term financing

• Trade credit
  • Accounts payable involve purchasing goods or services on credit and paying suppliers at a later date
  • Delaying payments to suppliers provides additional working capital by extending the payment period (net 30, net 60)
• Short-term loans
  • Bank loans are direct borrowings from financial institutions for a specific term and interest rate
  • Commercial paper is an unsecured promissory note issued by large corporations to raise short-term funds (maturity less than 270 days)
  • Factoring involves selling accounts receivable to a third party at a discount to receive immediate cash
• Lines of credit
  • Revolving credit allows borrowers to draw funds, repay, and redraw up to a predetermined limit (credit cards)
  • Non-revolving credit provides a fixed amount of funds that cannot be redrawn once repaid (term loans)
• Secured financing
  • Inventory financing uses a company's inventory as collateral to secure a loan
  • Accounts receivable financing involves borrowing against outstanding invoices or using them as collateral (invoice discounting)

Costs vs benefits of financing options

• Trade credit
  • Cost: Forgoing early payment discounts offered by suppliers for prompt payment (2/10 net 30)
  • Benefit: Flexibility in payment timing allows companies to manage cash flow and working capital needs
• Short-term loans
  • Cost: Interest expenses paid on borrowed funds increase the overall cost of financing
  • Benefit: Quick access to funds helps companies meet immediate cash flow needs or take advantage of opportunities
• Lines of credit
  • Cost: Commitment fees charged for maintaining the credit line and interest expenses on borrowed funds
  • Benefit: Flexibility in borrowing and repayment allows companies to manage fluctuations in cash flow (seasonal businesses)
• Secured financing
  • Cost: Collateral requirements tie up assets and higher interest rates compared to unsecured financing
  • Benefit: Access to funds for companies with limited credit history or lower credit scores

Calculating and Optimizing Short-term Financing

Calculation of effective annual rates

• EAR formula: $EAR = (1 + \frac{r}{m})^m - 1$
  • $r$: Nominal annual interest rate represents the stated interest rate before considering compounding
  • $m$: Number of compounding periods per year reflects how often interest is calculated and added to the principal
• Example: A loan with a 6% nominal annual interest rate compounded monthly
  1. Plug in the values: $EAR = (1 + \frac{0.06}{12})^{12} - 1$
  2. Calculate: $EAR = 1.005^{12} - 1 = 0.0616$
  3. Express as a percentage: $EAR = 0.0616 = 6.16%$

Optimal mix of financing sources

• Assess the company's cash flow requirements
  • Seasonal or cyclical needs arise from fluctuations in business activity (retail during holidays, agriculture during harvest)
  • Working capital management involves optimizing the balance between current assets and liabilities
• Consider the costs and benefits of each financing option
  • Interest rates and fees directly impact the cost of borrowing and should be minimized
  • Flexibility and repayment terms affect a company's ability to manage cash flow and adapt to changing circumstances
• Evaluate the company's credit profile and collateral availability
  • Credit history and score determine a company's access to financing and the terms offered by lenders
  • Assets available for secured financing, such as inventory or accounts receivable, can expand borrowing options
• Determine the optimal mix based on cost, flexibility, and risk
  • Diversify funding sources to manage risk by not relying too heavily on a single financing option (bank loans, commercial paper)
  • Prioritize lower-cost options while maintaining flexibility to ensure the company can meet its obligations and grow