Short Term Financing-Lin Wen

Short Term FinancingShort Term Financing

InstructorLin Wen

2006

OutlineOutlineShort Term v. Long Term FinancingNeed For Short Term (S-T) FinancingTypes of S-T Financing

Business LoansTrade CreditCommercial PaperFactoring

Calculation Methods for S-T FinancingCollateral AnalysisDebt Service Analysis in S-T Financing

Short Term v. Long Term Short Term v. Long Term FinancingFinancing

Short Term Financing:Less than one (1) year period

Long Term Financing:More than one (1) year period

Short Term v. Long Term Financing Short Term v. Long Term Financing (Example)(Example)

Short Term Long Term

Seasonal purchases (Inventory, supplies,

etc..)Business Expansion

(e.g. Open a second store)

Receivables from salesPurchasing Commercial Real

Estate

Payroll Expenses Purchasing Business

Advertising Expenses Establish business

Purchasing new or used business equipment

Purchasing Vehicles

Why Short Term (S-T) Financing?

Profits may not be sufficient to keep up with growth-related financing needs.Firms may prefer to borrow now for their needs rather than wait until they have saved enough.Short-term financing instead of long-term sources of financing due to:

easier availabilityusually lower cost

Types of S-T Financing

Business Loans

Trade Credit

Commercial Paper

Factoring

Business LoansConcept: Borrowing from banks or other financial institutions for short and long term financing.

Use of FundsMonthly Payment

Line of Credit Short Term Working

CapitalSeasonal

PurchasesBusiness Supplies

Capital LoanLong Term working

CapitalBusiness

ExpansionRefinance Existing

Debt

Equipment Loan

Purchase or refinance new/used business equipment

Principal and interest monthly

Vehicle Loan

Purchase or refinance new/used business vehicles


Interest Monthly, principal at maturity.

In some cases: Principal +

Interest monthly


Trade CreditConcept: Borrowing from suppliers

Trade credit is the act of obtaining funds by delaying payment to suppliers.

Even though it is obtained by simply delaying payment, it is not always free.

The cost of trade credit may be some interest charge that the supplier charges on the unpaid balance. More often, it is in the form of a lost discount that would be given to firms who pay earlier.

Credit has a cost. That cost may be passed along to the customer as higher prices, absorbed by the seller as lower profits, or some of both.

Concept: Available to large credit- worthy businesses.

Business issues notes to the public and finances its short term needs

Notes can be issued between 30 days and 360 days

Principal and interest is due by the end of maturity

Commercial Paper

FactoringConcept: Borrowing from factoring companies by selling Accounts Receivables arising from sales

Factoring companies collect the interest in advanceFlat fee is paid in advanceFlat fee covers administrative expenses for A/RsFactoring agreements can be “With-Recourse” or “Without-Recourse”Without-Recourse agreements are costly than With-Recourse ones (High risk, High premium)

Factoring

“With Recourse”Factoring company is not responsible to

collect delinquent receivables

“Without Recourse”Factoring company has to collect

delinquent accounts

Interest Rate Calculations

$Net Amount $ Final Payment of Financing

I---------------------t days-----------------------------------------

$ Interest for t days = Final Payment – Net Amount of Financing

Final Payment- Net Amount of Financing% Interest for t days = ---------------------------------------------------

Net Amount of Financing

Interest Rate Calculations (Example)

$ 1,000 $1,010

I---------------------30 days---------------------------------------

$ Interest for 30 days = $1,010 – $1,000 = $10

$1,010 – $1,000% Interest for 30 days = ---------------------

$1,000 = 1% (for 30 days only!!!)

Simple Interest v. Compound Interest

Simple Annual Interest =

(Final Payment- Net Amount of Financing) 360 --------------------------------------------------- X -------- (Net Amount of Financing) t

($1,010 – 1,000) 360Example = ------------------- X --------- = 12% $1,000 30

Effective (Compound) Annual Interest =

Final Payment ---------------------------------- - 1 Net Amount of Financing

$1,010 Example = ------------------- - 1 = 1.1268 - 1 $1,000

= 0.1268 or 12.68%

Simple Interest v. Compound Interest

360t

36030

Concept: Effective Interest Rate is used to determine the cost of the credit to be able to compare differing terms.

Coffee Time…

Interest Calculation Methods S-T Financing

Business LoansIn terms of payment method, business loans are classified as

Term Loans: Principal and Interest monthly (Usually for long term financing, however, in some

cases, it can be used for short term financing)

Line of Credits : Interest monthly(Common use is for short term financing and sometimes lenders require that a minimum amount, called a compensating balance be kept in the bank account.)

Term Loan Interest Calculation:First Step: Monthly Payment Calculation

Loan AmountMonthly Pmt = ________________________ 1

1- ________________ Interest Rate n OR EXCEL FUNCTION1 + ____________

12___________________ Interest Rate _____________ n= Number of months

12


Business Loans

Term Loan Monthly Payment Calculation

Name of the Excel Function: PMT

Rate (Annual rate / # of payments in one year)Total # of payments for the loan (Nper)Loan Amount (PV)Future Value (FV)Type 1 if the payment is at the beginning of period

0 if the payment is at the end of period

Illustration:

Rate 5% / 12 = 0.00417Total # of payments 60 months ( 5 years)Loan Amount $10,000Future Value $0Type 0

Solution with Excel Function

=PMT(0.05/12,60,10000,0,0)

-$188.71 Monthly Payment

TERM LOAN PAYMENT CALCULATION BY USING EXCEL FUNCTION

Interest Calculation Methods S-T FinancingBusiness Loans

Second Step: $ Interest paid

$ Interest Paid = (Monthly Pmt X Number of Months) – (Loan Amount)

Third Step: % Interest Paid (Annual)

(Monthly Pmt X Number of Months) – (Loan Amount)Loan Amount_______________

Number of Years

Interest Calculation Methods S-T FinancingIllustration

Purchasing CNC Equipment of $10,000 with business term loan. 5%-interest & 5-year term (60 months)

First: Monthly Payment CalculationBy using the formula, monthly payment is calculated at $188.71 Second: Interest calculation$ Interest Paid ($188.71 X 60 months) – ($10,000) = $1,322.60

% Interest Paid (Annual) ($188.71 X 60 months) – ($10,000) = 2.64%

$10,000 ____________ 5 years


Business Loans

Line of Credit Interest Calculation:Since some lenders require borrowers to keep a minimum amount in the bank account, called compensating balance, interest rate calculation

should take into consideration this balance. Formula for

the effective cost is shown as follows:

$ Interest Paid / (Loan Amount – Comp. Balance)

Example: Annual simple real cost for a line of credit of

$30,000 with simple interest of 5% and a $5,000

compensating balance is

$1,500* /($30,000-$5,000) = 6% (real cost)

* Assumed the line is fully utilized.


Business Loans

Mechanism of Trade Credit

Typically receive a discount accounts payable early.

Stated as: 2/10, net 60 Purchaser receives a 2% discount if pay within 10 days of receiving invoice, otherwise due within 60 days.

The cost is in the form of the lost discount.

Mechanism of Trade Credit

Assume your purchase is $100 list.

If you take the discount, you pay $98.

If you don’t take the discount, you pay $100.

Therefore, you are paying $2 for the privilege of borrowing $98 for the additional 50 days.

(Note: the first 10 days are free in this example).

Interest Calculation Methods S-T FinancingTrade Credit

The exponent is the number of times per year the firm can take 50 days of credit. The cost of trade credit for 2/10 net 60 :[1 +(2/98)])7.2 -1 = 15.66%.

Day 0 Day 10 Day 60

360days to pay - disc. pd.

Cost =of Credit

Discount %1-Discount%( 1 + ) -1

$98 $98 + $2

Interest Calculation Methods S-T FinancingFactoring (Discount Loan)

Must pay the interest up front so that reduces the dollars available to use.Illustration: 9 % Discount $ 20 Flat Fee $10,000 x 9% x 90days + $20

360 days $ 225+ $20 = $ 245[$ 245/($10,000-$245)]*4 10.04 % ( Real Cost)

Case Analysis

Debt Service Coverage Analysis in S-T Financing

(Eligibility Criteria for business loans)

Lenders also calculates debt service coverage ratio before they give loan to businesses. Since each lender has different minimum requirements for this ratio, the calculation methods are identical. If the business cash flow is eligible under lender’s debt service coverage criteria, the lender usually grants the loan.


(Example)

Statement Type Year Year 1Date 12/31/2003

BUSINESS:Net Profit $12,000Add:(+)Depreciation $1,500(+)Interest Expense $2,000Total (+) Adjustments $3,500

Cash Flow before Debt Service $15,500 (Net Profit + Total (+) Adjustments)Loan Annual Payment for Loan (6% interest payment) $6,000 ($100,000 X 6%)Total Debt Service $6,000

Net Cash Flow $9,500 (Cash Flow Before Debt Service - Total Debt Service) Business Debt Coverage Ratio 2.58 ( Cash Flow before Debt service / Total Debt Service)

Debt Service Coverage


(Example)

If the lender requires minimum debt service coverage ratio of 1.2x from

the borrower, Neptune Inc. is eligible to

get the loan with a higher debt servicecoverage ratio, 2.58x.

Mini Case

CONGRATS !!!

Documents

Short Term Financing-Lin Wen