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Introduction to Finance/Capital Budgeting/Short-Term Financing

Capital Budgeting

Contents

Short-Term Financing

Definition of All the Terms Associated with Short-Term Financing

Financial organizations have created many financial instruments, such as factoring and trade credit, to meet the short-term financing needs of companies.

If a company determines that it does not have enough funds coming from its assets to cover its current liabilities and any unexpected costs that may arise, short-term financing is a viable option. Common methods of short-term financing include factoring, bank loans, a line of credit, trade credit, and customer advances.

Many companies work with factors to use advance factoring. A factor is an agent, usually a third-party financial institution, who purchases a company's accounts receivable at a discount. Advance factoring, or factoring, is a financial service wherein a factor advances payment to a company to purchase its accounts receivable prior to maturity minus the factor's commission; it can be done with or without recourse. Recourse factoring is a financial service in which a factor purchases a company's accounts receivable but requires the company to buy back any unpaid receivables. Thus, the risk remains with the company when factoring is done with recourse. If the factoring is done without recourse, the factor assumes the risk for any unpaid receivables, as the company is not required to buy back any unpaid receivables. Another type of short-term financing is a more traditional revolving line of credit such as a credit card, which is a way for a business to borrow money on an ongoing basis up to a certain predetermined amount.

Other common forms of short-term financing include trade credit and customer advances. Trade credit is an informal business-to-business agreement where a company can purchase a good or service without paying the supplier up front. The supplier is paid at a later date, usually 30, 60, or 90 days after the initial purchase date. The terms for trade credit are reached by an agreement between the companies involved. Trade credit provides time for companies to sell their inventory to repay the supplier or to use their available cash flow for other purposes. Trade credit also benefits the supplier because the supplier can control the terms of the agreement, such as price and repayment terms. On the other hand, a customer advance occurs when the customer pays up front for a product or service before actually receiving the product or service. Customer advances are common when companies receive large orders, especially for product releases concerning pre-orders, and money is provided in advance so the company can fund its operations.
Short-term financing can be raised through sources such as a trade credit, customer advances, and line of credit.

Overview of Short-Term Financing

Short-term loans can be secured and paid back more quickly than traditional loans, but they come with higher rates and fees.
With short-term financing, borrowers usually do not have to go to a bank. This type of financing allows borrowers to secure and pay back business loans more quickly than they can secure and pay back traditional loans granted through long-term financing. Long-term financing is the financing of large sums of money where the debt is repaid for a period longer than a year. Processing time for short-term financing, on the other hand, is short, and there is a lower barrier to entry than there is for long-term financing. One of the reasons why companies consider short-term financing is that it provides liquid assets quickly. Funds may be available to the borrower within a few days or even a few hours. Also, eligibility requirements for short-term financing are lower than requirements for long-term financing, so a company is more likely to be approved for a short-term loan, a debt that is typically repaid in one year or less. Bad credit scores are not usually a restriction for short-term financing, which means that even young companies can secure loans. Many new businesses may need a short-term loan just to begin doing business. There are several disadvantages to the short-term financing route, however. A short-term loan can come with high fees and high annual costs. The business is paying for the banks and lending institutions to take on the risk of default. Short-term financing can also require more frequent payments. Sometimes, payments can be due each week. Prompt payment is very important. Companies will consider short-term financing when they do not have enough cash and cash equivalents to pay off current obligations.

Calculation of Simple and Compound Interest

Simple and compound interest paid on a short-term loan can be easily calculated.

Determining the simple interest charge on a transaction requires a straightforward calculation. Simple interest is calculated by multiplying the daily interest rate by the principal, the initial amount that was borrowed and still needs to be paid off, and by the number of days elapsed between payments. For example, Big Systems Inc. has a savings account bank balance of $30,000. The bank will give Big Systems Inc. 7 percent interest every year. The balance in Big Systems Inc.'s account after a year would be $32,100, of which $2,100 is the interest earned.

Simple interest for the first year can be calculated.
Simple Interest=$30,000×0.07×1=$2,100{\text{Simple Interest}}=\$30{,}000\times0.07\times1=\$2{,}100
The interest is then added to the starting bank balance of $30,000 to grow to $32,100.
$30,000+$2,100=$32,100\$30{,}000+\$2{,}100=\$32{,}100
Using the same simple interest calculation, at the end of two years, Big Systems would have $34,200 in its savings account. Simple interest for the second year can be calculated.
$30,000×0.07×2=$4,200\$30{,}000\times0.07\times2=\$4{,}200
The interest is then added to the starting bank balance of $30,000.
$30,000+$4,200=$34,200\$30{,}000+\$4{,}200=\$34{,}200
However, during the second year the interest rate would in most cases be multiplied by the accumulated money in the account, $32,100, not the initial amount, $30,000. This is the calculation of compound interest. Compound interest is the interest rate multiplied by the sum of any remaining unpaid principal and unpaid cumulative interest as of the previous period. In this example, the calculation for compound interest can be calculated.
$32,100×0.07=$2,247\$32{,}100\times0.07=\$2{,}247
This interest is then added to $32,100.
$32,100+$2,247=$34,347\$32{,}100+\$2{,}247=\$34{,}347
The same process for calculating compound interest can be followed in each subsequent year.

Typically, simple interest is used for short-term personal loans and in short-term financing. This type of interest benefits consumers who pay their loans on time or early each month. It is better to pay the loans back on time or early so that more of the payment applies to the principal rather than to the interest. Compound interest is the result of reinvesting interest rather than paying it out, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.

<Cash Budgets>Long-Term Financing