SHORT TERM FINANCING

Definition of Short Term Financing

Short Term Financing is that form of financing which includes borrowing or lending of funds for a
short period of time. It refers to the finance obtained on short term basis usually one year or less in
duration. It is secured financing and current asset and inventories. Short term finance is also known
as working capital, which is the express of current assets over current liabilities. Current liabilities
become due within one year and indicate the amount of short term financing
Scholars’ View
1. Short term credit is defined as any liability originally scheduled for payment within
one- Brigham
2. Short-Term loan has an original maturity of less than one year. - Benton.
3. Short Term Financing is the debt that matures in one year or less and used to fulfill
seasonal and current assets needs. - L. J. Gitman

 Objective of Short-Term Financing

The funds are available for a period of one year or less is called Short Term Finance. The objectives
of it are given below:
1. Duration: Short Term Financing is or a short period of time say one year or less.
2. Cost of Fund: short term credit may be obtained with lower cost than the long term finance
because of priority o creditors in general.
3. Easier to obtain: It can be obtained more easily than long term credit.
4. Use of Funds: In practically all types of business, there is lesser use of short term credit
among larger concerns. The small concerns make more use of Short Term Financing.
5. Sources of Funds: Short-term finance comes from the internal and external as well as
formal and informal sources.
6. Flexibility: it is flexible in the sense that the firm is able to secure funds as they are needed
and repay them as soon as the need vanished.
7. Collection and control:There are no formalities to raise funds for its, so it is easy to collect
and control short-term financing.
8. Security: Short-term financing may not require any security to collect the funds.
9. Risk: Funds are available from well-known sources of business, so it may be riskless short-
term finance.
10. Renewal: Some short-term financing is refinanced continuously or automatically.

 Types of Short-Term Financing

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Short-term finance can be collected from different sources. Those are given below with following
diagram:

Short-Term Financing

1. Spontaneous financing
2. Money Market
3. Bank Loan
A. Trade Credit A. Commercial Paper A. Unsecured Bank Loan

i. Open Account B. Bankers’ Acceptance i. Transection Loan

ii. Notes Payable ii. Line of Credit

iii. Trade Acceptance iii. Revolving Credit

B. Advanced Payment iv. Compensating

Balance
C. Accrued Expenses
B. Accounts Receivable

C. Inventories

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 SHORT TERM FINANCING

There are also other sources from which the business can secure funds for short period. They are
friends and relatives, loan from deposit, company’s internal sources and others.

1. Spontaneous Financing:
Spontaneous financing is raised from the normal course of business operation. The major
spontaneous sources of short-term financing are trade credit, advance and accrual payment’s. They
are naturally from the firm’s day to day transection.
Scholars View:
1. Spontaneous financing arises from the normal course of business. - L. J. Gitman.
2. Spontaneous sources of financing in the sense that it arises from ordinary business
transactions. -Brigham.
So, Spontaneous financing is the automatic sources of short-term fund arising in the normal course
of business operations. Special types of financing are
I. Trade Credit
II. Advance Payment and
III. Accrued Expense.

(A) Trade Credit

Firms generally make purchases from others firms on credit, recording the debt as an account
payable. This types of financing are called trade credit. Trade credit is a kind of business credit,
which is extended by seller of goods to the buyer of the same at all levels of production and
distribution process down to the retailer.

Scholars View:
1. Trade Credit is a spontaneous source of financing in the sense that it arises from ordinary
business transactions. – Brigham.
2. Trade Credit is a credit granted from one business to another. – Van Horne.

 Terms of Trade Credit

Credit terms refers to the conditions under which the supplier sells on the buyer and the buyer is
required to repay the credit. We can explain the terms of trade credit by analyzing their elements.

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1. Cash on Delivery (COD): the only risk the seller undertakes is that the buyer may refuse the
shipment. Under such circumstances the seller will be struck with the shipping costs.
2. Cash before Delivery (CBD): Occasionally a seller might ask for CBD to avoid all risk.
Under either COD or CBD terms, the seller does not extend credit.
3. Net Period- No Cash Discount: when credit is extended the seller specifies the period of
time allowed for payment. For Example, the term- net 30 indicate that the invoice/ bill must
be paid within 30 days.
4. Net period with Cash Discount: In addition to expending credit, the seller may offer a cash
discount if the bill is paid during the early part of the net period. For example, the term 2/10,
net 30- indicate that the seller offers a 2 percent discount if the bill is paid within 10 days,
otherwise the buyer must pay the full amount within 30 days.
5. Seasonal Dating: In a seasonal business, sellers frequently use dating to encourage
customers to place their orders before a heavy selling period.

(B) Advance Payment

Advance Payment is the amount made by customers constitutes the main item of differed income.
Deferred income represents funds received by the firm for goods and services which it has agreed to
supply in future.

Scholars’ View:
1. Advances to the firm against uncollected accounts that are not yet due. – L. J. Gitman
2. Advance payments made by customers constitute the main item of deferred income. – L.
M. Panday.
(C) Accrued Expenses
Accrued expenses represent a liability that a firm has to pay for the services which it has already
received. Thus they represent a spontaneous, interest free source of finance.
Scholars’ View:
1. Accrued are liabilities for service received for which payment has yet to be made. – L. J.
Gitman
2. Accrued expenses are amounts owed but not yet paid. – Van Horne

2. Money Market
Financial market has divided in two classes, the money market and capital market. Money market is
the market for short term securities. it also includes government securities issued with maturities of
more than one year but that now have a year or less until maturity.
Scholars View:

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1. Money market is the markets for the short term, highly liquid securities. - Brigham
2. The short term market companies of securities with maturities of one year or less and is
referred to as money market. - Block and Hirt.
(A) Commercial Paper
Commercial paper represents and unsecured, short term, negotiable promissory note sold in the
money market. Generally, quite large firm of unquestionable financial soundness are able to issue
commercial paper. Most paper has maturities ranging from 3 to 270 days.
Scholars View:
1. Commercial paper is a short term unsecure promissory notes generally used by large
corporation. – Van Horne
2. Commercial paper is unsecured short term debt use by large, financially strong
corporation. - Brigham
3. Bank Loan
Banks are a major source of unsecured short term loans to business. the major types of loan made by
banks to business is the short term, self-liquidating loan. This loans are intended merely to carry the
firm through seasonal peaks in financing needs.
Scholars’ View:
1. Unsecured short term financing is short term financing obtain without pledging specific
assets as collateral. – L. J. Gitman
(A) Features of bank loan (Unsecured Bank Loan)
Banks lend unsecured short term funds in four basic ways. The features of bank loans are discussed
in the following paragraphs:
I. Line Credit: A line of credit is an informal agreement between a bank and its customer with
respect to the minimum amount of unsecured loan. the bank will permit the firm to owe at
any one time.
For example: the bank manager may indicate to the financial manager of a fund that the bank
regards his firm as good for up-to 10000000 for the next year. Subsequently, the manager
signs a promissory note for TK 3000000 for 90 days. The amount is credit to the firm
account at the bank. Before repayment of TK 3000000 the firm may grow additional amount
up to TK 7000000.

II. Revolving Credit: A Revolving Credit is credit which is automatically renewed or restore
from time to time after the bills draw under it have been duly honored by payment. As long
as the commitment is inforce, the bank must extend credit to the grower anytime he wishes to
grow, provided total growing’s do not exceed the maximum amount specific.

If the revolving credit is, for example, for TK 8000000 is already owing, the borrower can
borrow an additional TK 2000000 at any time.

III. Transection Loan:For these type of loan, a bank evaluates is request by the borrower as a
separate transaction. In this evaluations, the cash flow ability of borrower to pay the loan is
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usually of per amount importance. So transactions loan is a short term, one-time loan made to
borrower who needs funds for a specific purpose for a short period.

IV. Compensating Balance: In addition to charging interest on loans bank may require the
borrower to maintain not interest bearing deposit balance at the bank in direct proportion to
the amount of fund borrowed either the commitment. This minimum balance is known as
compensating balance.

For example, if a finds needs TK 80-00000 to pay of outstanding of obligations but it must
mention a 20% compensating balance, then it must borrow TK 10000000to obtain a useable
TK 8000000. If the stated interest rate is 8% the effective interest rate is 10%, TK 8000000
interest divided by TK 8000000 of usable funds equals 10%

(B) Secured Bank Loan:

When a firm has exhausted it source of unsecured short term financing, it may be able to
obtain additional short term loans on a secured basis. Secured short term financing has
specific assets pledged as collateral.

Scholars’ View:
1. Secured short term loan is the short term financing that has specific assets pledged as
collateral. – L J. Gitman

 Types of Secure Bank Loan

Two types of secured bank loan are-

 Accounts Receivable
 Inventories
Problem- 01
Salsabil Company’s raw materials suppliers offer credit terms of 2/5, net 35, what are the cost of
foregoing cash discount and effective interest rate?

Solution:
DR 360
Kt =( 100−DR x
CP−DP ) Here,
2 360
=(
100−2 35−5 )
x DR = 2%

CP = 35 Days
2 360
= x DP = 5 Days
98 30
=0.02040816 x 12 Kt = Cost of Trade Credit =?

= 0.2449
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 SHORT TERM FINANCING

= 24.49%
EIR = (1+ R)N −1 Here,
= (1+0.02040816)12−1 DR = 2%; CP = 35 Days; DP = 5 Days
= (1.02040816)12−1 DR 2 2
R = = = =
= 1.2743-1 100−DR 100−2 98
0.02040816
= 0.2743
360 360 360
= 27.43% N= = = = 12
CP−DP 35−5 30
EIR = Effective Interest Rate =?

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Problem- 02
Ashfi& Company wants to buy materials on the following credit terms:
A. 2/20, net 50, if account payable is stretched by 20 days.
B. 3/15, net 60, if discount period is stretched by 5 days.
Find out the cost of trade credit & which alternative is better?

Solution:
Alternative A:
DR 360
Kt =( 100−DR x
CP−DP )

2 360
=(
100−2 70−20 )
x
Here,

2 360 DR = 2%
= x
98 50
CP = 50+20 = 70 Days
= 0.02040816 x 7.2
DP = 20 Days
= 0.1469
Kt = Nominal Annual Cost =?
= 14.69%

EAR = (1+ R)N −1 Here,

= (1+0.02040816)7.2−1 R = 0.02040816
= (1.02040816)7.2−1 N = 7.2
= 1.1566−1 EAR = Effective Annual Rate =?
= 0.1566
= 15.66%
Alternative B:
DR 360
Kt =( 100−DR x
CP−DP )

3 360
=(
100−3 60−20 )
x
Here,

3 360 DR = 3%
= x
97 40
CP = 60 Days
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Kt = Nominal Annual Cost =?
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 SHORT TERM FINANCING

= 0.030927 x 9
= 0.2784
= 27.84%

EAR = (1+ R)N −1 Here,

= (1+0.030927)9−1 R = 0.030927
= (1.030927)9−1 N=9
= 1.3154−1 EAR = Effective Annual Rate =?
= 0.3154
= 31.54%
Financing Decision Table:
Alternatives Annual Cost Decision
Credit Option- A 15.66% Better Alternative
Credit Option- B 31.54%
Problem- 03
Anamika & Company company wants to borrow Tk. 15 lakh as a working capital. Three
alternatives are avail for financing:
A. To forgo cash discount granted on the basis of 3/15, net 40, if account payable is
stretched by 10 days.
B. To borrow Tk. 15 lakh a bank loan at 10% interest rate & 20% compensating balance.
Interest will be paid in advance.
C. To issue Tk. 15 lakh commercial paper, which sales at 10% discount. 6 months’ paper
flotation cost is Tk. 20000.
Which alternative should the company choose?
Solution:
Alternative A: (Trade Credit) Here,
DR 360
Kt =( 100−DR x
CP−DP )
DR = 3%

CP = 40 + 10 = 50 Days
3 360
=(
100−3 50−15 )
x DP = 15 Days

Kt = Nominal Annual Cost =?

3 360
= x
97 35 EAR= Effective Annual Rate =?
= 0.030927 x 10.2857 EAR =(1+ R)N −1

Page 9 = (1.030927)10.2857 −1
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= 1.3679 −1 = 36.79%
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 SHORT TERM FINANCING

= 31.81%

Alternative B: (Bank Loan)

Interest
EAR =
Loan−Compensating Balance−Interest
1,50,000 Interest = 15,00,000x0.10
=
15,00,000−3,00,000−1,50,000
= 1,50,000
1,50,000
= Com. Bal. = 15,00,000x0.20
10,50,000
= 3,00,000
= 14.29%
Alternative C: (Commercial Paper)
FV = 15,00,000
Face Value−Net Sale Value 360
Kc = x
Net Sale Value Duration Days Discount = 15,00,000x0.10 = 1,50,000

15,00,000−13,30,000 360 Issuing Cost = 20,000

= x
13,30,000 180
Net Sale Value = FV - Discount - Fl. Cost
1,70,000
= x2 = 15,00,000-1,50,000-20,000
13,30,000
=0.1278 x 2 = 13,30,000

= 25.56% Kc = Nominal Annual Cost =?

EAR = Effective Annual Rate =?

EAR = (1+ R)N −1

= (1.1278)2−1
= 1.2719-1
= 27.19%

Alternatives Annual Cost Decision

Trade Credit 36.79%
Bank Loan 14.29% Better Alternative
Commercial Paper 27.19%

Problem- 04
Mozo Beverage Company requires working capital of Tk. 10 lakh. There are three
alternatives. What should the company do?

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 SHORT TERM FINANCING

A. Trade Credit: Terms of credit sale 2/30, net 90.

B. Bank Loan: Actual Bank Ltd. Is interested to grant Tk. 10,00,000 as a loan @ 12%
P.A. after reduction of 25% as compensating balance.
C. Commercial Paper: To issue commercial paper @ 12%. The cost of issuing would be
Tk. 20,000 in each quarter.

Solution:
Alternative A: (Trade Credit)
DR 360
Kt = ( 100−DR x
CP−DP )
2 360
=(
100−2 90−30 )
x
2 360
= x
98 60
= 0.020408 x 6
= 12.24% 2
R=
98
= 0.0204
N
EIR = (1+ R) −1
= (1+0.0204)6 −1 360
N= =6
= 1.1288-1 60
= 0.1288
= 12.88%
Alternative B: (Bank Loan)
Interest = 10,00,000 x 0.12 =
Interest 1,20,000
EAR =
Loan−Compensating Balance
Com. Bal. = 10,00,000 x 0.25 =
1,20,000 2,50,000
=
10,00,000−2,50,000
1,20,000
=
7,50,000
= 16% Interest = 10,00,000 x 0.12 = 1,20,000
Alternative C: (Commercial Paper) Issuing Cost = 20,000 x 4 = 80,000
Face Value−Net Sale Value 360 Flotation Cost = 2,00,000
Kc = x
Net Sale Value Duration Days
FV =10,00,000
10,00,000−8,00,000 360
= x
8,00,000 360 NSV = FV – Flotation Cost

2,00,000 = 10,00,000 -2,00,000

= x1
8,00,000
= 8,00,000

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= 25%
Comment:
A. Cost of Trade Credit = 12.88% (It is the cheapest cost)
B. Cost of Bank Loan = 16%
C. Cost of Commercial Paper = 25%
Therefore, the company should choice Trade Credit.
Problem- 05
A company needs Tk.8,00,000 to meet working capital requirements immediately. It has the
following alternative sources:
A. The company can buy Tk. 10,00,000 of raw materials on term 3/30, net 90.
B. A bank will lend Tk. 10,00,000 at 13% interest with 20% compensating balance.
Interest will be paid in advance.
C. To issue commercial paper of Tk. 10,00,000 for six months’ period and net sales
value is Tk. 9,50,000
Which alternative should company choose and why?
Solution:
Alternative A: (Trade Credit)
DR 360
Kt = ( 100−DR x
CP−DP ) DR = 3%
3 360
=(
100−3 90−30 )
x CP = 90 Days
3 360 DP = 30 Days
= x
97 60
= 0.030927 x 6 Kt = Nominal Account Cost =?
= 18.56%
EAR = Effective Annual Rate =?
EAR = (1+ R)N −1
= (1+0.030927)6−1
= 20.05%

Alternative B: (Bank Loan)

Interest
EAR =
Loan−Compensating Balance−interest
1,30,000 Interest = 10,00,000 x 0.13 = 1,30,000
=
10,00,000−2,00,000−1,30,000 Com. Bal. = 10,00,000 x 0.20 = 2,00,000
1,30,000
=
6,70,000
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= 19.40%

Alternative C: (Commercial Paper)

Face Value−Net Sale Value 360
Kc = x
Net Sale Value Duration Days
10,00,000−9,50,000 360
= x
9,50,000 180
50,000
= x2
9,50,000
= 0.052632x2
= 10.53%
EAR = (1+ R)N −1
= (1+0.052632)2−1
=1.108033-1
= 10.80%

Financing Decision Table:

Alternatives Annual Cost Decision
Trade Credit 20.05%
Bank Loan 19.40%
Commercial Paper 10.80% Best Alternative
The company should choose Alternative C

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