CHAPTER 15: CURRENT LIABILITIES MANAGEMENT

A. OVERVIEW
Definition: Short-term credits refer to any liabilities originally scheduled for payment within one year

Secured Sources: Short-term financing obtained by pledging specific assets as collateral

1. Accounts receivable
2. Inventory

Unsecured Sources: Short-term financing obtained without pledging specific assets as collateral

Spontaneous: Arise from ordinary business transactions

1. Accruals (wages and taxes)
2. Account payable (trade credit among firms)

Non-spontaneous: Does not arise from ordinary business transactions; financial needs
1. Loans from commercial banks *
2. Commercial paper

B.SECURED SOURCES OF SHORT-TERM LIABILITIES

Definition: Short-term financing obtained by pledging specific assets as collateral
– Accounts receivable
– Inventory

1. Pledging accounts receivable

• Accounts receivable as security to obtain a short-term loan
• Pledging process
– Lender evaluates borrower’s accounts receivable
– Select accounts to secure the funds requested
– Adjust the dollar value of these accounts (discount payment)
– Determine the principal of the loan (50-90% of the face value of acceptable accounts
receivable)
– Lender files a lien: publicly disclosed legal claim on collateral
– Pledging cost:
• Normally 2-5% above the prime rate
• 3% service charge

2. Factoring accounts receivable:

– Sell accounts receivable at a discount to a factor
– Factor: Financial institution that purchases accounts receivable
– Factoring cost: commissions and interest
– Non-recourse basis: the factor assumes the credit risk of the purchased accounts receivable
3. Pledging inventory
• Inventory as security to obtain a short-term loan (marketability)

• Floating inventory lien

– A claim on the borrower’s general inventory as collateral for a secured loan

• Trust receipt inventory loans

– Relatively expensive inventory
– Borrower keeps inventory
– Lender advances 80-100 % of its cost
– Lender files a lien on all the items financed
– Borrower free to sell inventory: remit amount borrowed against each item immediately
after sale

• Warehouse receipt loan

– Lender receives control of the pledged collateral
– Warehoused by a designated agent on the lender’s behalf

C. INTERNATIONAL MANAGERIAL FINANCE: SHORT-TERM FINANCING

• International loans not denominated in home currency
– Interest rate payments
– Exchange rate risks

• Financing international trade

– Letter of Credit
– Eurocurrency loan market

• Transactions between subsidiaries of multinationals

D. ACCRUALS
Definition: Accruals are continually recurring short-term liabilities
– Services received for which payment has yet to be made

Example: Accrued wages, taxes, interests

Motivation:
• Employees paid on a regular basis (weekly, bi-weekly, monthly)
• Income taxes, sale taxes, income taxes withheld from employee payrolls are also paid on weekly
/ monthly / quarterly basis
– balance sheet typically shows some accrued wages and taxes

Characteristics:
• Accruals increase spontaneously as a firm’s operations expand

• This type of debt is “free”

– No interest must be paid on funds raised through accruals

• Firms cannot ordinarily control their accruals

– Time of payroll / taxes are set by laws

Example A firm pays its wages at end of week with a weekly total of $400,000. Suppose interest rate is
10% on short-term invested funds. Find the benefit of stretching accruals by 1 week throughout the year.
E. ACCOUNTS PAYABLE (TRADE CREDITS)
Definition: Trade credit refers to inter-firm debt arising through credit sales and is recorded as account
payable

Terminology :
• If accounts payable > accounts receivable Æ receiving net trade credit (usually smaller firm)
• If accounts receivable > accounts payable Æ extending net trade credit
• Credit terms: 2/10 net 30 EOM
– Length of credit period 30 days
– Discount 2%
– Discount period 10 days
– Credit period begins at the end of each month

Two common types of credit period:

• End of Month (EOM):
– Credit period begins on the first day of the month immediately following

• Date of invoice:
– Credit period begins on the date specified on the invoice for the purchase

Example: Purchased on Sept. 10 on terms 2/10 net 30:

Discount taken Net amount paid
Date of invoice Sept. 20 Oct. 10
End of Month (EOM) Oct. 10 Oct. 30

Formula: The cost of not taking discount (Cost of Giving Up Cash Discount CGUCD)

Example A firm just made a purchase on April 30 on term 2/10 net 30 (EOM). Use 365 days a year. If the
firm can obtain external financing at 10% interest rate, should the firm give up the cash discount?

F. SHORT-TERM BANK LOANS

Note 1: Differences among banks
• Policies towards risks
– Lending official
– Characteristics of the bank’s deposit liabilities
– Size of banks (diversification within bank)
• Other services
– Advice and counsel
– Support for borrower esp. during bad times (bank’s degree of loyalty)
– Loan specialization
– Maximum loan amount
– Other services (lock box, fund transfer, foreign currency)

Note 2: Applying for a bank loan

• Cover letter
– Purpose
– Amount
– Loan period
– Secured vs. unsecured
• Historical financial data
 • Projected / pro forma / financial statements
• Brief history of the firm (resume of major officers)

Note 3: Terminology
• Loan interest rate
– Prime rate: lowest rate of interest charged by the nation’s leading banks on large
corporations with exceptionally good financial standing / credit rating
• Based on Bank Rate (Bank of Canada for monetary policy)
– Fixed rate: rate of interest as set increment above the prime rate, unvarying until
maturity
– Floating rate: an increment above the prime rate, varies with prime rate until maturity

Note 4: Features of bank loans

• Maturity: usually a year or less
• Promissory note:
– Document specifying the terms and conditions of a loan such as the amount, any
collateral, percentage interest rate, and repayment schedule
• Compensating balance:
– A minimum checking account balance that a firm must maintain with a commercial bank,
generally 10-20% of the loan balance
• Single-payment note:
– Short-term, one-time loan payable as a single amount at its maturity

Example A firm obtains a single payment 90-day note of $100,000 with a fixed interest rate
charged at prime plus 1.5%. The prime right is 9%. Use 360 days a year. Find effective annual rate
if automatically rolled over for a year with interest cumulated over the year.

Example A firm obtains a 90-day single payment note of $100,000 with a floating interest rate of
prime plus 1%. Suppose that within the 90 days, the prime rate increases from 9% in the first 30
days to 9.5% in the next 30 days. In the last 30 days, prime rate is 9.25%. Find effective annual
rate if automatically rolled over for a year with interest cumulated over the year

• Line of credit:
– An arrangement whereby a financial institution commits itself to lend up to a maximum
amount of funds during a specified period
• Prime + risk premium
• Operating-change restriction
• Revolving credit agreement:
– A formal line of credit extended to a firm by a bank or other financial institutions
– Usually has a commitment fee on unused balance + interest on used funds

Example A firm obtains a revolving credit agreement of $2 million, which has a commitment fee
of 0.5%. Suppose that the average borrowing last year was $1.5 million with an interest of
$160,000. Find the effect annual rate.

Note 5: Cost of bank loans

• Three ways to calculate interest rates on bank loans:
a. Single payment note: Simple interest
b. Discount loans: Discounted interest
c. Installment loans: add-on interest
d. Compensating balances apply
– Simple interest
– Discounted interest
Formula: Simple interest (single payment note)
Definition: Simple interest is an interest calculated on funds received and paid on maturity of a loan

Example: Diana Inc. receives a loan of $100,000 at 10% for 1 year

Formula: Discounted interest (discount loans)

Definition: Discounted interest is an interest calculated on the face amount of a loan be deducted in
advance

Example: Diana Inc. receives a loan of $100,000 at a discount basis at 10% for 1 year.

Formula: Add-on interest (installment loan)

Definition: Add-on interest is an interest calculated and added to funds received to determine the face
amount of an installment loan
– Automobile / installment loans

Example: Diana Inc. receives a loan of $100,000 at 10% repay in 12 monthly installments.

Formula: Compensating balances, simple interest

Example: Diana Inc. needs $100,000. Bank lends at 10% simple interest rate, compensating balance at
20%. Find effective rate.

Formula: Compensating balances, discounted interest

Example: Diana Inc. needs $100,000. Bank lends at 10% discounted interest rate, compensating balance
at 20%. Find effective rate.

G. COMMERCIAL PAPER
Characteristics:
• Like a bank check issued by a large corporation
• Promise to pay the bearer
• Maturities vary from 2-6 months from the original date of issue
• Unsecured
 • Often restricted to small number of large firms, exceptionally good credit rating
• Disadvantage to debtor: if in financial difficulty Æ receive little help (unlike bank loans)

Formula: Effective annual rate for commercial paper (recall from chapter 6):
⎛ i×n⎞
V = P × ⎜1 + ⎟
⎝ 365 ⎠

Example A firm sells $1 million worth of commercial paper, 90-day maturity. The sell price is $980,000.
Find effective annual rate of return.