Short Term Financing Prof David S Allen Northern Arizona

Short Term Financingfin 340prof David S Allennorthern Arizona Univer

Short-term financing involves sources of funds that are typically repaid within one year or less. This document explores the various sources of short-term financing, including accruals, accounts payable, bank loans, and commercial paper, highlighting their characteristics, costs, and strategic considerations for firms seeking to optimize their short-term capital structure.

Paper For Above instruction

In the realm of corporate finance, effective management of short-term funding is crucial for maintaining liquidity, operational efficiency, and financial stability. Firms rely on a mix of spontaneous and non-spontaneous sources of short-term finance, each with distinct advantages, costs, and limitations. Understanding these sources allows firms to make informed decisions that align with their operational needs and cost minimization strategies.

Understanding Spontaneous Sources: Accruals and Accounts Payable

Accruals emerge naturally from a firm's operational cycle. They occur because firms do not typically pay their employees or taxes daily, but rather on weekly, biweekly, or monthly schedules, based on industry norms and legal requirements. Accruals are considered a 'free' source of financing since they do not involve explicit interest costs, but they do impact cash flow timing. Their control lies largely with the firm’s operational policies, and managing their levels involves optimizing payment schedules to avoid unnecessary liabilities.

Similarly, accounts payable, or trade credit, is a spontaneous source of financing that arises when firms purchase goods or services on credit from suppliers. This form of financing is particularly vital for small firms that may not qualify for formal borrowing options. Accounts payable is computed as:

Accounts payable = (average payment period) x (average daily purchases)

The cost associated with trade credit depends on the payment terms negotiated, especially whether the firm utilizes early payment discounts. For example, in terms such as 2/10 net 30, the firm can save interest costs by paying early to avail the discount.

Cost of Trade Credit and Strategic Use

The opportunity cost of foregoing discounts on trade credit can be significant if the firm has access to cheaper alternatives, such as bank loans or lines of credit. The decision criteria involve comparing the cost of using trade credit beyond the discount period versus the interest rate of alternative financing. Firms should prefer to use free trade credit during the discount window and only extend payments beyond the discount period if the cost of alternative financing exceeds the penalty of lost discounts.

The components of trade credit include free components (the period during which discounts are available) and costly components (credit used beyond discounts). Strategic management involves utilizing the free component efficiently and only extending credit if it’s economically justifiable.

Bank Loans: A Non-Spontaneous but Critical Source

Bank loans are a prevalent form of non-spontaneous, short-term financing. They are typically used when firms need funds beyond spontaneous sources. Bank loans can be structured as promissory notes, revolving lines of credit, or informal credit agreements, with terms varying according to the borrower’s creditworthiness and collateral offered.

Most short-term bank loans have maturities of less than a year, with a common duration of 90 days, but they can also be rolled over, creating a continuous cycle of short-term borrowing. The interest rate on these loans depends on the prime rate, the credit risk of the borrower, and whether the loan involves collateral or complicating features like compensating balances.

Compensating balances, where the borrower maintains a minimum balance in a checking account as collateral, effectively increase the interest cost, as these funds could have generated income elsewhere. Formal lines of credit involve commitment fees and can be pegged to short-term benchmark rates, such as the prime rate or T-bill rate. The interest rates and costs associated with bank loans can be expressed as nominal, effective annual rate (EAR), or annual percentage rate (APR), depending on the accounting and reporting standards.

Commercial Paper: An Unsecured, Cost-Effective Instrument

Commercial paper is a short-term, unsecured promissory note issued by large, creditworthy corporations. It provides a cost-effective means of financing for firms with high credit ratings. Its maturity is typically less than 270 days to avoid SEC registration requirements. The interest cost on commercial paper is usually below the prime rate but above the T-bill rate, reflecting the issuer’s creditworthiness.

Firms with substantial net worth and operating histories frequently issue commercial paper to meet their liquidity needs. The discounts offered on commercial paper are calculated based on the difference between face value and proceeds, with the effective interest rate computed accordingly. The use of commercial paper enables firms to access funds at lower costs compared to bank loans, especially if they have strong credit ratings and stable cash flows.

Strategic Implications and Cost Management

Effective management of short-term financing involves balancing the costs and risks associated with each source. Spontaneous sources such as accruals and trade credit are preferred due to their low or zero explicit costs, but they are limited by operational and supplier relationships. Non-spontaneous sources like bank loans and commercial paper provide additional funds but at varying costs depending on the firm's risk profile and market conditions.

Decisions regarding the use of these sources depend on interest rates, availability, flexibility, and the firm's overall liquidity position. For instance, firms may prefer trade credit for short-term working capital needs during periods of favorable discount terms and switch to bank borrowing when more flexible or larger amounts are required.

Furthermore, the strategic choice between fixed-rate and floating-rate debt, along with interest rate expectations and the firm’s financial health, influences the sequencing and proportion of short-term versus long-term financing.

Conclusion

In summary, short-term financing options encompass spontaneous sources such as accruals and accounts payable, and non-spontaneous sources including bank loans and commercial paper. Each source comes with its own set of costs, risks, and strategic considerations. An optimal short-term financing strategy aligns with operational needs, minimizes costs, maintains flexibility, and sustains financial stability.

References

• Brigham, E. F., & Ehrhardt, M. C. (2019). Financial Management: Theory & Practice (16th ed.). Cengage Learning.
• Ross, S. A., Westerfield, R. W., & Jaffe, J. (2021). Corporate Finance (12th ed.). McGraw-Hill Education.
• Fabozzi, F. J. (2020). Bond Markets, Analysis, and Strategies (10th ed.). Pearson.
• Damodaran, A. (2015). Applied Corporate Finance. Wiley Finance.
• Higgins, R. C. (2018). Analysis for Financial Management (11th ed.). McGraw-Hill Education.
• Levy, H. (2016). Money, Banking, and Financial Markets. Springer.
• Alan, M. (2020). The Use of Commercial Paper in Corporate Finance. Journal of Financial Markets.
• Jensen, M. C. (2018). Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers. American Economic Review.
• Stulz, R. M. (2019). Credit Risk Management Practices. Financial Analysts Journal.
• Corporate Finance Institute. (2020). Short-term Financing Options. https://corporatefinanceinstitute.com