🗃️Corporate Finance Unit 11 – Short–Term Financing

What's Short-Term Financing?

• Refers to the process of obtaining funds to meet a company's immediate financial obligations and working capital needs
• Typically involves borrowing money that must be repaid within a year or less
• Helps businesses manage cash flow fluctuations, such as seasonal sales patterns or unexpected expenses
• Differs from long-term financing, which is used for capital investments and has repayment terms exceeding one year
• Can be secured (backed by collateral) or unsecured (based on creditworthiness)
• Interest rates are generally higher compared to long-term financing due to the shorter repayment period and increased risk for lenders
• Examples include lines of credit, short-term loans, and trade credit

Why Do Companies Need It?

• Maintain sufficient working capital to cover day-to-day operating expenses (payroll, rent, utilities)
• Bridge the gap between the timing of cash inflows (revenue) and outflows (expenses)
• Take advantage of short-term opportunities, such as purchasing inventory at a discount or fulfilling a large customer order
• Cover unexpected costs, like equipment repairs or legal fees, without depleting cash reserves
• Smooth out seasonal fluctuations in cash flow (retailers stocking up for the holiday season)
• Avoid the long-term commitment and higher total interest costs associated with long-term debt
• Preserve liquidity and financial flexibility by not tying up funds in long-term investments

Common Types of Short-Term Financing

• Lines of credit
  • Predetermined borrowing limit that can be accessed as needed
  • Interest is only charged on the amount borrowed
  • Revolving nature allows for flexibility in borrowing and repayment
• Short-term loans
  • Lump sum borrowed for a specific purpose
  • Repaid in fixed installments over a set period (usually less than a year)
  • Can be secured or unsecured
• Trade credit
  • Purchasing goods or services on account, with payment due at a later date
  • Typically interest-free if paid within the agreed-upon terms (30, 60, or 90 days)
  • Helps conserve cash and improve working capital
• Factoring
  • Selling accounts receivable to a third party (factor) at a discount
  • Provides immediate cash inflow and transfers credit risk to the factor
• Commercial paper
  • Unsecured, short-term debt instrument issued by large, creditworthy companies
  • Sold at a discount and matures within 270 days
  • Lower interest rates compared to other short-term options due to the issuer's strong credit rating

How to Choose the Right Option

• Assess the company's specific financial needs and objectives
  • Determine the amount of funding required and the intended use of the funds
  • Consider the urgency and duration of the financial need
• Evaluate the costs associated with each financing option
  • Compare interest rates, fees, and other charges
  • Factor in the impact on the company's cash flow and profitability
• Analyze the company's creditworthiness and available collateral
  • Stronger credit profiles and valuable assets can lead to more favorable terms
• Consider the flexibility and repayment terms of each option
  • Some options, like lines of credit, offer greater flexibility in borrowing and repayment
  • Others, like short-term loans, have fixed repayment schedules
• Assess the potential risks and limitations of each financing option
  • Evaluate the impact on the company's debt-to-equity ratio and future borrowing capacity
  • Consider the consequences of defaulting on the financing agreement

Pros and Cons of Short-Term Financing

• Pros
  • Quick access to funds for immediate needs
  • Flexible repayment terms and borrowing amounts
  • Lower total interest costs compared to long-term debt
  • Helps maintain liquidity and financial agility
  • Can be used to take advantage of short-term opportunities
• Cons
  • Higher interest rates than long-term financing
  • May require collateral, limiting future borrowing capacity
  • Frequent repayments can strain cash flow
  • Overreliance can lead to a cycle of debt and financial instability
  • Limited borrowing amounts compared to long-term options
  • May not be suitable for long-term investments or growth initiatives

Key Financial Metrics to Consider

• Working capital
  • Measures a company's short-term financial health and ability to meet current obligations
  • Calculated as current assets minus current liabilities
  • Positive working capital indicates sufficient liquidity to cover short-term debts
• Current ratio
  • Assesses a company's ability to pay off short-term liabilities with current assets
  • Calculated as current assets divided by current liabilities
  • A ratio greater than 1 suggests adequate liquidity, while a ratio below 1 may signal potential cash flow issues
• Debt-to-equity ratio
  • Compares a company's total debt to its shareholders' equity
  • Calculated as total liabilities divided by total shareholders' equity
  • Higher ratios indicate greater financial leverage and risk
  • Lenders may be hesitant to provide financing to companies with high debt-to-equity ratios
• Interest coverage ratio
  • Measures a company's ability to make interest payments on its outstanding debt
  • Calculated as earnings before interest and taxes (EBIT) divided by interest expenses
  • Higher ratios suggest a greater capacity to service debt obligations

Real-World Examples

• Seasonal businesses
  • Retailers often use short-term financing to purchase inventory ahead of peak selling seasons (holiday shopping)
  • Agricultural companies may borrow to cover costs during planting and harvesting periods
• Startups and small businesses
  • New ventures frequently rely on short-term financing to cover initial operating expenses until revenue streams stabilize
  • Trade credit from suppliers can help conserve cash while building inventory and customer base
• Construction companies
  • Short-term loans or lines of credit can bridge the gap between project milestones and customer payments
  • Factoring can provide immediate cash flow by selling accounts receivable from completed projects
• Manufacturers
  • Short-term financing can be used to purchase raw materials and cover production costs
  • Lines of credit can help manage the time lag between production and sales

Wrapping It Up: Best Practices

• Develop a comprehensive short-term financing strategy aligned with the company's goals and risk tolerance
• Regularly monitor and forecast cash flow to anticipate financing needs proactively
• Maintain strong relationships with lenders and suppliers to secure favorable terms and quick access to funds
• Diversify financing sources to reduce dependence on a single lender or type of financing
• Use short-term financing judiciously, balancing the benefits against the costs and risks
• Establish clear policies and procedures for managing and repaying short-term debt
• Continuously monitor key financial metrics and adjust financing strategies as needed to maintain financial health and stability
• Consider the long-term implications of short-term financing decisions on the company's growth, profitability, and creditworthiness