Short-Term Financing: Trade Credit, Accounts Payable, and Negotiated Financing, Lecture notes of Finance

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Chapter 11 Chapter 11

Short-Term Short-Term

Financing Financing

After studying Chapter 11, After studying Chapter 11,

you should be able to: you should be able to:

 (^) Understand the sources and types of spontaneous financing.  (^) Calculate the annual cost of trade credit when trade discounts are forgone.  (^) Explain what is meant by "stretching payables" and understand its potential drawbacks.  (^) Describe various types of negotiated (or external) short-term borrowing.  (^) Secured and unsecured loans  (^) Understand what is meant by factoring accounts receivable.

Spontaneous Financing Spontaneous Financing  Accounts Payable (Trade Credit from Suppliers)  (^) Accrued Expenses Types of spontaneous Types of spontaneous financing financing

Spontaneous Financing Spontaneous Financing  (^) Open Accounts : the seller ships goods to the buyer with an invoice specifying goods shipped, total amount due, and terms of the sale.  (^) Notes Payable : the buyer signs a note that evidences a debt to the seller. Trade Credit Trade Credit -- credit granted from one business to another. Examples of trade credittrade credit are:

Terms of the Sale Terms of the Sale  Net Period - No Cash DiscountNet Period - No Cash Discount -- when credit is extended, the seller specifies the period of time allowed for payment. “Net 30” implies full payment in 30 days from the invoice date.  CODCOD andand CBDCBD - No Trade Credit : the buyer pays cash on deliverycash on delivery or cash before deliverycash before delivery. This reduces the seller’s risk under CODCOD to the buyer refusing the shipment or eliminates it completely for CBD.

Terms of the Sale Terms of the Sale  Seasonal DatingSeasonal Dating -- credit terms that encourage the buyer of seasonal products to take delivery before the peak sales period and to defer payment until after the peak sales period.  Net Period - Cash DiscountNet Period - Cash Discount -- when credit is extended, the seller specifies the period of time allowed for payment and offers a cash discount if paid in the early part of the period. “2/10, net 30” implies full payment within 30 days from the invoice date less a 2% discount if paid within 10 days.

Cost to Forgo a Discount Cost to Forgo a Discount Approximate annual interest cost = % discount 365 days (100% - % discount) (payment date - discount period) What is the approximate annual cost What is the approximate annual cost to forgo the cash discount of “2/10, to forgo the cash discount of “2/10, net 30” after the first ten days? net 30” after the first ten days? X

Cost to Forgo a Discount Cost to Forgo a Discount Approximate annual interest cost = 2% 365 days (100% - 2%) (30 days - 10 days) = (2/98) x (365/20) = 37.2% What is the approximate annual cost to What is the approximate annual cost to forgo the cash discount of “2/10, net 30,” forgo the cash discount of “2/10, net 30,” and pay at the end of the credit period? and pay at the end of the credit period? X

Advantages of Advantages of Trade Credit Trade Credit  (^) Convenience and availability of trade credit  (^) Greater flexibility as a means of financing Compare costs of forgoing a possible Compare costs of forgoing a possible cash discount against the advantages cash discount against the advantages of trade credit. of trade credit.

Who Bears the Cost of Who Bears the Cost of Funds for Trade Credit? Funds for Trade Credit?  BuyersBuyers -- when costs can be fully passed on through higher prices to the buyer by the seller.  SuppliersSuppliers -- when trade costs cannot be passed on to buyers because of price competition and demand.

Negotiated Financing Negotiated Financing  Money Market CreditMoney Market Credit  (^) Commercial Paper  (^) Bankers’ Acceptances  Unsecured LoansUnsecured Loans  (^) Line of Credit  (^) Revolving Credit Agreement  (^) Transaction Loan Types of negotiated financing Types of negotiated financing:

Commercial Paper Commercial Paper  Commercial paper market is composed of theCommercial paper market is composed of the (1) dealer and (2) direct-placement markets.  (^) AdvantageAdvantage: Cheaper than a short-term business loan from a commercial bank.  (^) Dealers require a line of creditline of credit to ensure that the commercial paper is paid off. Commercial Paper Commercial Paper -- Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs).

Bankers’ Acceptances Bankers’ Acceptances  (^) Used to facilitate foreign trade or the shipment of certain marketable goods.  (^) Liquid market provides rates similar to commercial paper rates. Bankers’ Acceptances Bankers’ Acceptances -- Short-term promissory trade notes for which a bank (by having “accepted” them) promises to pay the holder the face amount at maturity.

Short-Term Short-Term Business Loans Business Loans  Secured LoansSecured Loans -- A form of debt for money borrowed in which specific assets have been pledged to guarantee payment.  Unsecured LoansUnsecured Loans -- A form of debt for money borrowed that is not backed by the pledge of specific assets.