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Subject 5. Managing Short-Term Financing

There are two sources of short-term financing:

Bank Sources

Unsecured Loans: A form of debt for money borrowed that is not backed by the pledge of specific assets.

  • Line of credit (L/C).

    • A bank provides a letter of credit, for a fee, guaranteeing the investor that the company's obligation will be paid. It is a promise from a bank for payment in the event that certain conditions are met.
    • It is frequently used to guarantee payment of an obligation.
    • Committed lines of credit are stronger than those that are uncommitted because of the bank's formal commitment.

  • Revolving credit agreement: A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.
  • Banker's acceptance.

    • These are short-term promissory trade notes for which a bank (by having "accepted them") promises to pay the holder the face amount at maturity.
    • They are used to facilitate foreign trade or the shipment of certain marketable goods.

Secured Loans: A form of debt for money borrowed in which specific assets have been pledged to guarantee payment.

  • Factoring accounts receivable. Factoring is the selling of receivables to a financial institution, the factor, usually "without recourse."

    • A factor is often a subsidiary of a bank holding company.
    • A factor maintains a credit department and performs credit checks on accounts.
    • This type of loans allows a firm to eliminate its credit department and the associated costs.
    • Contracts are usually for 1 year, but are renewable.

  • Inventory-backed loans. Loan evaluations are made on the basis of marketability, price stability, perishability, and difficulty and expense of selling for loan satisfaction.
  • Floating Lien: A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified.
  • Trust Receipt: A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender.
  • Terminal Warehouse Receipt: A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan.

Nonbank Sources

  • Commercial paper.

    • Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs).
    • Cheaper than a short-term business loan from a commercial bank.
    • Dealers often require a line of credit to ensure that the commercial paper is paid off.

  • Nonbank finance companies.

The best mix of short-term financing depends on:

  • Cost of the financing method;
  • Availability of funds;
  • Timing;
  • Flexibility;
  • Degree to which the assets are encumbered.

Cost of Borrowing

The fundamental rule is to compute the total cost of borrowing and divide that by the net proceeds.

  • Collect basis: interest is paid at maturity of the note.

    • Example: $100,000 loan at 10% stated interest rate for 1 year.
    • $10,000 in interest / $100,000 in usable funds = 10.00%.

  • Discount basis: interest is deducted from the initial loan.

    • Example: $100,000 loan at 10% stated interest rate for 1 year.
    • $10,000 in interest / $90,000 in usable funds = 11.11%.

  • Compensating balances: demand deposits maintained by a firm to compensate a bank for services provided, credit lines, or loans.

    • Example: $1,000,000 loan at 10% stated interest rate for 1 year with a required $150,000 compensating balance.
    • $100,000 in interest / $850,000 in usable funds = 11.76%.

  • Commitment fees: The fee charged by the lender for agreeing to hold credit available on the unused portions of credit.


$1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was $600,000; a required 5% compensating balance on borrowed funds; and a .5% commitment fee on $400,000 of unused credit. What is the cost of borrowing?

Interest: ($600,000) x (10%) = $60,000
Commitment Fee: ($400,000) x (0.5%) = $2,000
Compensating Balance: ($600,000) x (5%) = $30,000
Usable Funds: $600,000 - $30,000 = $570,000

Cost = ($60,000 in interest + $2,000 in commitment fees) / $570,000 in usable funds = 10.88%

Practice Question 1

What is the interest rate that banks in London pay each other for Euro-dollars?

A. London interbank offered rate (LIBOR)
B. London Euro rate (LER)
C. London Eurobond rate (LER)

Correct Answer: A

The LIBOR is the rate between banks in London.

Practice Question 2

What is the difference between interest being paid on a discount basis versus a collect basis?

A. Interest is deducted from a loan on a discount basis while interest is paid at maturity on a collect basis.
B. The present value of all interest payments are paid up front on a discount basis while the future value of all interest payments are paid at maturity on a collect basis.
C. The interest rate is below prime, or at a discount, when paid on a discount basis; the collect basis occurs when additional interest is charged for excessive loan risk and collected at the maturity of the loan.

Correct Answer: A

Interest is deducted from the loan on a discount basis while interest is paid at maturity on a collect basis.

Practice Question 3

Inventory is in the possession of a third party under which of the following methods?

A. Inventory blanket lien
B. Trust receipt arrangement
C. Warehouse receipt arrangement
D. Inventory factoring

Correct Answer: C

Study notes from a previous year's CFA exam:

5. Managing Short-Term Financing