Short Term Financing

Question 1

What are “Financing Options”?

Answer 1

The alternative ways that funding may be obtained to carry out capital projects and other undertakings of an entity.

Question 2

Which is more inclusive, capital structure or financial structure?

Answer 2

Financial Structure, which includes current and non-current liabilities, as well as owners’ equity. Capital Structure does not include current liabilities, only long-term debt and owners’ equity.

Question 3

Describe the components of a firm’s capital structure.

Answer 3

All elements of long-term debt and owners’ equity.

Question 4

Describe the components of a firm’s financial structure.

Answer 4

All elements of liabilities (current and non-current) and owners’ equity of a firm constitute its Financial Structure.

Question 5

Describe the concept of short-term financing.

Answer 5

Short-term financing involves:

1. Obtaining funding through obligations (debt) that must be repaid within one year (current liabilities), or
2. The use of current assets to obtain funding.

Question 6

Identify at least five forms of short-term financing.

Answer 6

1. Trade accounts payable.
2. Accrued accounts payable.
3. Short-term notes.
4. Lines of credit, revolving credit or letter of credit.
5. Commercial paper.
6. Pledging accounts receivable.
7. Factoring accounts receivable.
8. Inventory secured loans.

Question 7

Describe trade accounts payable (also called trade credit) as a means of short-term financing

Answer 7

Deferred payment for goods or services provided by suppliers in the normal course of business. May carry the offer of a cash discount for early payment of obligation.

Question 8

List the advantages of short-term notes (for financing purposes)

Answer 8

1. Commonly available for creditworthy firms;
2. Flexible - amounts and periods (within one year) can be varied;
3. Generally, no collateral required;
4. Provides cash.

Question 9

What are the disadvantages of using short-term notes for short-term financing purposes?

Answer 9

1. Poor credit rating = High interest rate;
2. Requires satisfaction in the short term;
3. May require compensating balance or security.

Question 10

List the advantages of using short-term payables (for financing purposes).

Answer 10

1. Ease of use;
2. Flexible;
3. Usually interest free;
4. Usually no security required;
5. Discounts may be offered for early payment.

Question 11

List the disadvantages of using short-term payables (for financing purposes).

Answer 11

1. Requires payment in the short-term;
2. Use specific;
3. Lost discounts increase cost.

Question 12

Why are cash discounts offered on trade accounts?

Answer 12

Cash discounts are offered to encourage early payment of amounts due on trade accounts.

Question 13

What is the meaning of cash discount terms of “2/10, n/30”?

Answer 13

The term 2/10, n/30 is a typical credit term and means the following:

1. The first digit (2) is the percent discount offered by the seller;
2. The second digit (10) is the number of days within which the discount is available;
3. n/30 indicates that if the buyer does not pay the (full) invoice amount within the 10 days to qualify for the discount, then the net amount is due within 30 days after the sales invoice date.

Question 14

Define “compensating balance”.

Answer 14

An amount that a borrower may be required to maintain in a demand deposit account with a lender as a condition of receiving a loan or other bank services. Increases effective cost of borrowing.

Question 15

Define “letter of credit”.

Answer 15

A conditional commitment by a bank to pay a third party in accordance with specified terms and commitments (e.g., bank payments to a supplier upon proof that goods have been shipped to bank client).

Question 16

Define “line of credit”.

Answer 16

An informal agreement between a borrower and a financial institution whereby the financial institution agrees to a maximum amount of credit that it will extend to the borrower at any one time, not legally binding on financial institution.

Question 17

Define a “revolving credit agreement”.

Answer 17

A revolving line of credit is a legal agreement between a borrower and a financial institution whereby the financial institution agrees to provide an amount of credit to the borrower. The line of credit may be borrowed, repaid, and then reborrowed in a “revolving” or recurring manner.

Question 18

Identify the advantages of stand-by credit for financing purposes.

Answer 18

1. Commonly available for creditworthy firms;
2. Highly flexible (debt incurred only when needed);
3. No collateral required;
4. May provide cash for general use.

Question 19

Identify the disadvantages of stand-by credit for financing purposes.

Answer 19

1. Poor credit rating = high interest rate;
2. Usually involves a fee;
3. Compensating balance may be required;
4. Requires satisfaction in the short-term.

Question 20

Define “commercial paper”.

Answer 20

Short-term unsecured promissory notes sold by large, highly creditworthy firms as a form of short-term financing (i.e., 270 days or less). SEC registration required for notes over 270 days.

Question 21

Identify the advantages of commercial paper for financing purposes.

Answer 21

1. Large amounts can be obtained;
2. Interest rate generally lower than other short-term sources;
3. No collateral required;
4. Provides cash for general use.

Question 22

Define “pledging of accounts receivable”.

Answer 22

The use of trade accounts receivable as collateral for a short-term loan, usually from a commercial bank or finance company.

Question 23

Define “factoring of accounts receivable”.

Answer 23

The sale of trade accounts receivable to a commercial bank or other financial institution, called a “factor”. Sale may be “With Recourse” or “Without Recourse.”

Question 24

Distinguish between factoring accounts receivable “with recourse” and “without recourse”.

Answer 24

1. If accounts receivable are factored “without recourse” the factor (buyer) bears the risk associated with collectability (unless fraud is involved).
2. If accounts receivable are factored “with recourse” the factor (buyer) has recourse against the selling firm for some or all of the risk associated with uncollectability.

Question 25

Describe the use of an inventory-secured loan for short-term financing.

Answer 25

A firm pledges part or all of its inventory as collateral for a short-term loan.

Question 26

Identify the disadvantages of using inventory-secured loans for short-term financing.

Answer 26

1. Not available for all inventory; 2. Pledged inventory may not be available when needed; 3. More costly than certain other forms of short-term financing; 4. Requires repayment in the short-term.

Question 27

Describe a" floating loan agreement".

Answer 27

The borrower gives a lien against all of its inventory to the lender, but retains control of its inventory, which it continuously sells and replaces.

Question 28

Describe a "terminal warehouse agreement".

Answer 28

The inventory used as collateral is moved to a public warehouse where it is held as security.