16.3 Obtaining Short-Term Financing

Short-term financing is crucial for businesses to manage cash flow and meet immediate needs. From trade credit to commercial paper, companies have various options to secure quick funds without long-term commitments.

Understanding the costs and types of short-term financing is key. Whether opting for secured or unsecured loans, businesses must weigh interest expenses, discount fees, and opportunity costs to make informed financial decisions.

Sources and Types of Short-Term Financing

Short-Term Financing Sources

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• Trade credit involves purchasing goods or services on account without immediate payment, typically allowing 30, 60, or 90 days to pay the supplier, which can help businesses manage cash flow and maintain inventory levels
• Short-term loans are borrowed funds from banks or other financial institutions with a repayment period usually less than one year, providing businesses with quick access to capital for short-term needs (working capital, inventory purchases, or unexpected expenses)
• Line of credit is a pre-approved borrowing limit that can be used as needed, with interest charged only on the amount borrowed, offering flexibility and convenience for businesses to manage fluctuations in cash flow
• Commercial paper is an unsecured promissory note issued by large, creditworthy companies, sold at a discount and maturing within 270 days, allowing businesses to raise short-term funds at competitive rates compared to bank loans
• Factoring involves selling accounts receivable to a third party (factor) at a discount, with the factor collecting payments directly from customers, providing businesses with immediate cash and reducing the risk of non-payment from customers

Unsecured vs. Secured Loans

• Unsecured loans do not require collateral and are based on the borrower's creditworthiness and financial strength, resulting in higher interest rates due to increased risk for the lender (unsecured lines of credit, commercial paper)
• Secured loans require collateral (assets pledged as security), offering lower interest rates compared to unsecured loans and reducing risk for the lender (inventory financing, accounts receivable financing)

Short-Term Financing Costs

• Interest expense is the cost of borrowing funds, calculated based on the interest rate and loan amount using the formula: Interest Expense = Principal × Interest Rate × Time
• Discount fee represents the cost associated with selling commercial paper or factoring receivables, calculated as the difference between the face value and the amount received
• Opportunity cost refers to the potential benefits or returns foregone by choosing one financing option over another (investing in new equipment vs. using funds for short-term financing)
• Transaction costs include fees associated with arranging and processing the financing, such as loan origination fees, legal fees, and appraisal fees (for secured loans)
• Effective Annual Rate (EAR) represents the true annual cost of borrowing, considering compounding and fees, calculated using the formula: $EAR = (1 + \frac{r}{n})^n - 1$, where r is the nominal interest rate and n is the number of compounding periods per year