Home » Debt Finance and Loans Explained, Short Term Debt Avenues

Short Term Debt Finance Explained

Short-term debt

Loans and instruments used by companies to raise funds for periods up to one year
Short-term debt is used to finance
–      Working capital requirements
–      Cash flow shortfalls
–      Trade credit

Trade Credit

Supplier of goods and services allows the purchaser a grace period before the account’s settlement date
Often includes discount for early payment (2/10 n/30)
The opportunity cost of foregoing the discount can be calculated as

Opp cost =

% discount X                                 365
100% – % discount Days difference b/t early and late settlement

= 2/98 x 365/20
= 17.65%

Intercompany loans

Insurance and finance companies and major retailers with short-term surplus funds make loans directly to other companies
Loans are normally unsecured, therefore credit risk of the borrower is critical
Brokers and merchant banks are used to locate and place funds
Loans are either overnight money (11am) or 24-hour call money

Bank overdrafts

Major source of short-term finance
Allows a firm to place its cheque (operating) account into deficit, to an agreed limit
Interest rates negotiated with bank at a margin above a periodically published indicator rate
Lender also imposes an establishment fee, account service fee and a fee for the unused overdraft

Fully drawn advances

Short or medium-term facility
Loan is drawn down at time of approval
Requires regular payment schedule
Repayment schedule negotiated with lender
–      Interest only
–      Interest and principal
–      Deferred
–      Variable or fixed interest

Commercial bills

Provide funding for non-specific transactions
Four parties involved (potentially)

(A)   Drawer (user of funds)
Issuer of the bill
Secondary liability for repayment of the bill (after the acceptor)

(B)   Acceptor (bank issuing)
Undertakes to repay the face value to the holder of the bill at maturity
Acceptors usually a bank or a merchant bank

(C)   Payee
The party to whom the bill is specified to be paid
Usually the drawer, but could select other party as payee

(D)   Discounter (buys bill)
The party that purchases the bill
The lender of the money
May also be the acceptor of the bill

Establishing bill finance
–      Borrower approaches bank or merchant bank
–      Assessment made of borrower’s credit risk
–      Credit rating of borrower affects the size of discount
–      Maturity usually 30, 60, 90, 120 or 180 days
–      Minimum face value usually $100,000
Advantage of bills
–      Lower cost than other short-term borrowing forms
–      Borrowing cost (yield) determined at issue date (not affected by subsequent changes in interest rates)
–      Term of loan may be extended by ‘roll-over’ at maturity

Discount securities – calculating price

Price = Face value/ {1 + (y x maturity/365)}

Example: a company issues a 90 day bill with face value $100,000 yielding 8.75% p.a. What amount will the company raise with this issue

Price = 100000/ {1 + (0.0875 x 90/365)}
= $97,888.03

Discount securities – rediscounting

Example: a discounter initially purchases a 180 day bill with face value $100,000. The bill now has 90 days to maturity and current 90 day yields are 7.80% p.a Calculate the rediscount price

Price = 100000/ {1 + (0.078 x 90/365)}
= $98113.01

Discount securities – calculating face value

A Company may need to raise a specific amount of funds from a bill issue.

Face Value = Price {1+ (y x maturity/365)}

Example: a company needs to raise $500,000 from the issue of a 60-day bill roll-over facility, at a yield of 8.5%. At hat face value will the bill have to be drawn?

Face Value = 500,000{1 + (0.085 x 60/365)
= $506,986.30

Discount Securities: Calculating Yield

Yield is the rate of interest on the amount outlaid to purchase the bill (or other instrument)

Yield = (face value – current price)/(current price) x (365 x 100)/(maturity)

Example: a 180 day bill with a face value of 100,000 and selling currently at $92,000 with 180 days to maturity is yielding

Yield = (100000 – 92000)/(92000) x (365 x 100)/(180)
= 17.63% p.a

Discount Securities: Calculating the Price from the Discount Rate

Discount rate is the rate of return to the buyer of the bill (or cost to the drawer)

Price = face value {1- maturity/365 x d/100}

Example: the price of a 180 day bill, with a face value of $100,000 selling at a discount of 14.75% would be

Price = 100000 {1- 180/365 x 0.1475}
= $92,726.03

Discount Securities: Calculating the Discount rate

Example: a 180 day bill with a face value of $100,000 selling currently at 92,000 and with 180 days to maturity has a discount rate of

Discount rate = (face value – current price)/(face value) x (365 x 100)/(maturity)

Discount rate = (100000 – 92000)/(100000) x (365 x 100)/(180)
= 16.22% p.a.

Promissory notes (P-notes)

Generally referred to as commercial paper
Issued with a face value payable at maturity, but discounted upon issue at the current market yield
There is no acceptor involved (one-name paper)
Seller is not required to endorse the note, therefore no contingent liability exists
Calculation- use discount securities formula
Issue programs
–      Usually arranged by one of the four major banks
–      Standardised documentation
–      Most P-note issues for 90 days, issued by
ð  Tender
ð  Tap issue
ð  Dealer bids
Underwritten issues
–      Underwriting guarantees the full issue of notes is purchased
–      Underwriter usually a commercial bank, investment or merchant bank
–      The underwritten issue can incorporate a roll-over facility, effectively extending the borrower’s line of credit beyond the short-term life of the P-note issue

Negotiable certificates of deposit (CDs)

Short-term discount security issued by bank
Maturities range up to 180 days
Issued to international investors in the wholesale money market
The short-term money market has an active secondary market in CDs
Calculation – used discount securities formula

Investment Bank Cash Facility

Made to large corporations
Generally for a term of a number of years but also available short-term
Priced at a margin above a reference rate
Reference rate fixed for short-term loan (op to 180 days) but may be periodically revised for longer-term loans

Inventory Loans

Most common form is “floor plan finance”
Particularly designed for needs of motor vehicle dealers to finance their investments
Dealer is expected to promote financier’s financial products

Accounts receivable finance
–      Extension of a loan to a business against the security of a business’ accounts receivable
–      Mainly supplied by finance companies
–      Lending company takes charge over the company’s accounts receivable, however borrowing company still responsible for debtor book and bad debts
–      Company sells its accounts receivable to a factoring company
–      Converts a future cash flow (receivables) into a current cash flow
–      Factoring provides immediate cash to the vendor, plus removes administration costs of accounts receivable
–      Main provides of factor finance are the finance companies
–      Factor is still responsible for collection of receivable
–      Notification basis: vendor is required to notify its (accounts receivables) customers that payment is to be made to the factor
–      Recourse arrangement: factor has a claim against the vendor if a receivable is not paid
–      Non-recourse arrangement: factor has no claim against vendor company