CHAPTER – FOUR

THE FINANCING DECISION

BY: ALI.H
SEP.2024
 4.1 Short Term Sources of Finance
 The repayment term of short term financing is usually shorter than one year.
Creditworthiness is an important aspect which the entrepreneur or the venture must satisfy
before any short term financing will be granted. The following aspects are considered
when assessing creditworthiness.
Character: The reputation of honesty and reliability.
Capacity: The business sense of the borrower, the level of experience and business history.
Circumstances: The general business circumstances in the industry and the economy.
Insurance Cover: The extent of the cover of insurable risks taken out by the borrower.
Guarantees: The lender may require the borrower to use assets to guarantee the loan.
 4.1.1 Different Aspects of Short Term Finance
A. Trade creditors
• the basic source of finance and many entrepreneurs do not realise that by acquiring items
on credit they are obtaining short term finance.
• Credit just like any other source of finance has interest element hidden which most are not
able to recognize.
• The discount may be offered to encourage early payment and the receiving company may
not advantage of the discount the cost arise.
B. Terms of Trade Credit
Terms of credit vary considerably from industry to industry. Theoretically, four main factors
are determined the length of credit allowed.
The economic nature of the product: products with a high sales turnover are sold on short
credit terms.
The financial position of the buyer: if the buyer is in weak liquidity position he may take
long time to settle the balance.
Cash discounts: when cash discounts are taken into account, the cost of capital can be
surprisingly high.
C. Factoring
• Factoring involves raising funds on the security of the company’s debts, so that cash is
received earlier than if the company waited for the debtors to pay.
• Most factoring companies offer these three services: Sales ledger accounting,
dispatching invoices and making sure bills are paid.
Credit management, including guarantees against bad debts is the provision of finance,
advancing clients up to 80% of the value of the debts that they are collecting.
I. Sales ledger administration
The factoring companies will takeover the administration of receivable department,
maintaining the sales records, credit control and the collection of receivables.
II. Credit management
For a fee the factor can provide up to 100% protection against non payment of approved
sales. The factoring company will always assess the credit profile of an enterprise before
entering into such an agreement.
III. Provision of finance
This is the main product which most factoring companies offer. Factor companies provide
finance which is used to boost the working capital; of the business. The factoring is not as
cheap as may be the bank overdrafts .
D. Invoice Discounting
This is purely a financial arrangement which benefits the liquidity position of the enterprise.
Invoice discounting is the transferring of invoice to a finance house in exchange with
immediate cash.
E. Bank Overdraft
One of the most commonly used sources of short term of finance because of its cost and
flexibility. When borrowed funds are no longer required they can quickly and easily be paid.
F. Counter Trade
Counter trade is a method of financing trade, but goods rather than money are used to fund
the transaction. It is a form of barter.
It is a form of barter. Goods are exchanged for the other goods. This form of business for
private enterprises is diminishing in local trading but for international trade is still a popular
way of funding the business activities.
 4.1.2. Short Term Financing and Lenders
Lenders favor businesses that exhibit strong management, steady growth potential and
reliable projected cash flow (demonstrating the business ability to pay the monthly interest
payments on this line of credit from its projected.
Why Do Firms Need Short-term Financing?
 Cash flow from operations may not be sufficient to keep up with growth-related financing
needs.
 Firms may prefer to borrow now for their inventory or other short term asset needs rather
than wait until they have saved enough.
 Firms prefer short-term financing instead of long-term sources of financing due to:
• easier availability
• usually has lower cost (remember yield curve)
• matches need for short term assets, like inventory
 4.1.3. Types of short-term loans
A. Line of Credit
• The borrowing limit that a bank sets for a firm after reviewing the cash budget.
• The firm can borrow up to that amount of money without asking, since it is pre-
approved
• Usually informal agreement and may change over time
• Usually covers peak demand times, growth spurts, etc.
• Promissory note
 A legal IOU that spells out the terms of the loan agreement, usually the loan
amount, the term of the loan and the interest rate.
 Often requires that loan be repaid in full with interest at the end of the loan period.
 Usually with a Bank or Financial Institution; occasionally with suppliers or
equipment manufacturers
B. Estimation of Cost of Short-Term Credit
 Calculation is easiest if the loan is for a one year period:
 Effective Interest Rate is used to determine the cost of the credit to be able to compare
differing terms.
Effective = Cost (interest + fees)
Interest Rate Amount you get to use
4.2. Long term debt and lease
4.2.1. The Expanding Role of Debt
A lease of ten years or longer-Long-term leases are common in commercial real estate, but
unusual in residential real estate.
• Growth in corporate debt is attributed to:
– Rapid business expansion. Inflationary impact on the economy.
– Inadequate funds generated from the internal operations of business firms.
• Expansion of the U.S. economy has placed pressure on the Government to raise capital.
– New set of rules have been developed for evaluating corporate bond issues.
4.2.2. The Debt Contract
• Contract bond: the basic long-term debt instrument for most large U.S corporations –
basic items include:
– Par value: initial value of the bond.
• Principal or face value.
– Coupon rate: actual interest rate on the bond.
– Maturity date: repayment date of the principal.
• Bond indenture, a supplement to the bond agreement.
• Secured debts have specific assets pledged to bondholders in the event of default.
– These assets are seldom actually sold and distributed (proceeds).
– Terms used to denote collateralized or secured debts:
• Mortgage agreement: real property is pledged.
• After-acquired property clause: requires any new property to be placed under the
original mortgage.
– Greater the protection offered, lower the interest rate on the bond.
• Debt that is not secured by a claim to a specific asset.
– Debenture: unsecured long-term corporate bond.
• General claim against the corporation is common for defaults.
– Subordinated debenture
• Payment to the holder will occur only after the designated senior debenture
holders.
4.2.3. Methods of Repayment
• Does not always involve a lump-sum disbursement at the maturity date.
– Repayment of bonds can be done by:
• Simplest method - single-sum payment at maturity.
• Serial payments: paid off in installments over the life of the issue.
• Sinking-fund provision: semiannual/ annual contributions made into a fund run
by a trustee.
• Conversion: converting debt to common stock.
• Call feature: retire or force in debt issue before maturity.
Bond Prices, Yields, and Ratings
 A. Bond Prices
• Financial managers must be sensitive to the bond market with regard to:
– Interest rate changes.
– Price movements.
• Market conditions will influence:
– Timing of new issues. Coupon rate offered Maturity date.
• Bonds do not maintain stable long-term price patterns.
B. Bond Yields
different ways Some of these different types of bond yields include among others, the so
called running yield, nominal yield, yield to maturity (YTM), yield to call (YTC) and yield to
worst (YTW).
C. Bond Ratings
• Two major bond rating agencies:
– Moody’s Investor Service.
– Standard and Poor’s.
• Ratings are based on a corporation’s:
– Ability to make interest payments. Working capital position
– Consistency of performance. Size. Debt-equity ratio.
4.2.4. Advantages of Debt
• Interest payments are tax-deductible.
• The financial obligation is clearly specified and of a fixed nature.
– Exception: floating rate bonds.
• In an inflationary economy, debt may be paid with ‘cheaper dollars.’
• The use of debt, up to a prudent point, may lower the cost of capital to the firm.
4.2.5. Leasing as a Form of Debt
• Leasing has the characteristics of a debt.
– A corporation contracts to lease and signs a non-cancelable, non-term agreement.
– Companies are expected to fully divulge all information about leasing obligations.
• Leasing was made official as a result of Statement of Financial Accounting Standards
(SFAS):
• Four conditions for identification include:
– The arrangement transfers ownership of the property to the lessee by the end of the
lease term.
– The lease contains a bargain purchase price at the end of the lease.
– The lease term is equal to 75% or more of the estimated life of the leased property.
– The present value of the minimum lease payments equals 90% or more of the fair
value of the leased property at the inception of the lease.
• Does not meet the conditions of a capital lease.
• Usually short-term, cancelable at the option of the lessee.
• The lessor may provide for the maintenance and upkeep of the asset.
• Does not require a capitalization, or presentation, of a full obligation on the balance sheet.
• Capital lease
 – Requires treatment similar to a purchase-borrowing arrangement.
• Intangible asset is amortized, or written off, over the life of the lease - annual expense
deduction.
• Liability account is written off through regular amortization - implied interest cost on the
balance.
• Operating lease
– Requires annual expense deduction equal to the lease payment, with no specific amortization.
Advantages of Leasing
• Takes care of lack sufficient funds or the credit capability issues to purchase assets.
• Obligation may be substantially less restrictive.
• May not require a down payment.
• Lessor’s expertise – may reduce negative effects of obsolescence.
• Lease on chattels have no such limitations for bankruptcy and reorganization proceedings.
• Tax advantage factors include:
– Depreciation write-off or research related tax credits.
• Infusion of capital can occur if a firm chooses to engage in a sale-leaseback arrangement.
– Allows the lessee to continue the usage of the asset.
 Thank you
for Your Attention