Alternatives in Short Term Financial Instruments and Criteria for Short Term Financing Decisions

Table of Content

Executive Summary

List of Abbreviations

List of Figures

List of Tables

Introduction

1. Financing
1.1 Systematization of Financing Alternatives
1.2 The Role of Working Capital

2. Alternatives in Short Term Financial Instruments
2.1. Interest bearing Short Term Financial Instruments
2.1.1 Overdraft credit
2.1.2 Discount credit
2.1.3 Advance against security
2.2 Non Interest bearing Short Term Financial Instruments
2.2.1 Trade Credit

3. Managing of Working Capital
3.1 Inventory Management
3.2 Accounts Receivable Management
3.2.1 Pledging of receivables
3.2.2 Factoring
3.2.3 Credit and Collection Policy
3.3 Managing Payables and Accruals

4. The Short Term Financing Decision

5. Conclusion

6. Bibliography

7. ITM Checklist

Executive Summary

This work first provides a short systematization of financing alternatives, mentioning that short term financial instruments have a maturity up to one year. Then it goes on with the description of the importance of working capital and managing of the cash-flow cycle. The main and also simple outcome of this chapter is that the company has to make sure that the time between paying money and getting money has to be as short as possible. The next two big chapters, interest bearing and non interest bearing short term financial instruments, give an overview of the different alternatives the company has. Interest bearing instruments, e.g. different kinds of credits, have the advantage that they are fast available and commonly used but their disadvantages are that the company has to pay interest, fees or provisions to get money in this way. The company also is very dependent form the banks by taking credit. So it should not be fixed on credit taking for short term financing. A non interest bearing instrument mentioned in this work is the trade credit which has the advantage of having no interest payments but causes some disadvantages like coming in trouble with suppliers or customers. The third large part of this work deals with the working capital management, e.g. inventory or accounts receivable management. The main result of this chapter is that managing the working capital can be a very efficient way of making the company independent from banks or other parties providing interest bearing financing alternatives. The company can improve by itself the cash-flow and so its capacity to act although the banks grant no money. Last but not least one can read about short term decision making and that the manager has to use the optimal combination of short term financing instruments to decrease the costs for the company and to improve the cash-flow for a good capacity to act in a short term. The conclusion recapitulates the results which tell the reader that the manager has to use combinations of different instruments, to look at all the relevant costs of his decision, to influence the overall capital structure by short term decision making and therefore to look far more in the future than the twelve months of short term decisions.

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Figure 1 Cash-Flow Time Line and the Short Term Operating

Activities of a Typical Manufacturing Firm

(Ross et al. 2008, p. 628)

List of Tables

Table 1 Example for an Aging Schedule of Accounts Receivable (Ross et al. 2008, p. 703)

Introduction

Financing has always been essential for companies to operate in daily life and in longer perspectives. Especially the short term financing guarantees the company’s capacity to act, e.g. to buy raw materials, to pay interest rates or to pay wages. But nowadays, due to the financial crisis, it became more and more difficult to get money in the well-established way, e.g. by credits. According to an ifo survey, 40% of all companies say that bank’s granting of credits is very restrictive at the moment. So, companies have to include all their financial instruments to provide money for their daily operations. The manager has to weigh pros and cons, if there are hidden costs or hidden advantages. The companies can improve their working capital management, e.g. the inventory management or their collection policy. This work will provide examples for short term financial instruments and helps the reader to weigh the pros and cons mentioned above to come to the right conclusion in the financing decision making process.

Problem Definition

This assignment tries to answer the following questions: What are the common financial instruments and what are their advantages and disadvantages? What are the criteria of the right financing decision?

Objectives

The assignment discusses different short term financial instruments, their advantages and disadvantages. The author would like to give an overview about the common instruments without trying to mention them all.

Methodology

The content of this work is based on literature research, focusing on the management of working capital. After a short overview of what financing and especially short term financing is, the following chapters will introduce the reader to interest and non interest bearing short term financial instruments as well as the managing of working capital. The last chapter refers to the decision making and after that, the results will be summarized in a conclusion.

1. Financing

It is important for companies to make sure that they have enough financial resources to realize strategic measures and to have enough space for actions (Prätsch et al. 2007, p. 1). With money they can e.g. buy goods which they need for providing services or for producing goods for the market. Brealey and Myers call this the “cumulative capital requirement” (2003, p. 378), what means money for investments like plants, machinery or inventory. Financing as part of the business financing is defined by Prätsch et al. as the planning, regulation and the control of financial procedures as well as the purchasing and the use of these financial sources (2007, p. 2). Another definition can be found in Peters et al. who say that financing includes all measures of purchasing and provision of money (2005, p. 75). Both definitions have in common that financing has the task to provide money which can be used by the company. So in the following this work will provide information about how to purchase money for the company.

1.1 Systematization of Financing Alternatives

If one talks about financing there are different methods to systematize the alternatives. Prätsch et al. categorize financing with the following system: the legal status of the investor, the origin or the source of capital, the maturity and the reason of financing (2007, p. 26 et seqq.). Peters et al. also categorize it by the source of the money and the legal status of the investor (2005, p. 75). In Peters et al. the maturity and the reason of financing are not single categories, they are rather considered as sub-criteria of the two categories mentioned above. So in this work it would be better to use the first categorization because the factor time characterizes the topic of this work. Prätsch et al. divide the maturity in short term, medium-term and long-term maturities (2007, p. 27), which means a maturity up to one year, from one to five years and maturities above five years. Ross et al. mention that short term finance differs from long-term finance by the criterion of cash inflows and outflows (2008, p. 624). They define short term financial decisions by the “cash inflows and outflows that occur within a year or less” (ibid, p. 624) what matches with the period mentioned above. So, usually short term financing alternatives have a maturity briefer than one year. Ross et al. say that the short term financial management is often called “working capital management” (2008, p. 624) on which this work will focus on in the next chapter.

1.2 The Role of Working Capital

As mentioned above companies have to make sure that they have always enough financial resources so they are not facing financial problems e.g. the inability to pay bills. Maness and Zietlow mention that even a profitable company can run out of money if the managers do not keep an eye on operating the cash flow accurately (2005, p. 5). This could be the case if too much money is bound e.g. in raw material stores or if there is a bad management of the accounts receivable. So it is important to look at the working capital which means the short term assets and the short term liabilities together (Ross et al. 2008, p. 4). In the United States, the] working capital of all manufacturing companies in 1998 was nearly $2,300 bn, which consisted of around $1,300 bn current assets and $1,000 bn current liabilities (Brealey and Myers 2003, p. 376). So one can imagine how large the potential of the working capital is. In the given literature one can find also the term net working capital, so it makes sense to distinguish both terms from each other. Net working capital means the difference between current assets and current liabilities (Maness and Zietlow 2005, p. 28). It is also defined by Ross et al. as the “difference between current assets and current liabilities” (2008, p. 624). So, net working capital can be seen as the balance of the working capital. For the example of the United States working capital mentioned above, the net working capital was around $300 bn. The task of working capital management or short term financial management is to create a good balance of the working capital so the company has a positive net working capital which avoids that the company is running out of financial resources. If one has a look at the short term assets as one part of the working capital it is important to optimize the inventory and to have a look at the accounts receivable. On the other side the manager has to look at the current liabilities e.g. for resources the company got. For our United States example of 1998 the accounts receivable of all the manufacturing companies was about $480 bn with a sum of nearly $300 bn accounts payable. The time between these two actions, i.e. paying money for e.g. raw materials and getting money for receivables, is called conversion period by Maness and Zietlow (2005, p. 6) and has to be as short as possible to avoid a high value loss.

illustration not visible in this excerpt

Figure 1: Cash-Flow Time Line and the Short Term Operating Activities of a Typical Manufacturing Firm

Ross et al. call it the Cash Cycle and also mean, as you can see in figure 1, the time between the point when the company paid for the inventory it needed and the point when it received the money for a sold product (2008, p. 627). Anyway the period between the two time points should be as short as possible. Otherwise the manager has to foresee the gap and think about methods of getting money. In such cases the company working capital management could lead to few or a negative net working capital. It could be the case e.g. in phases of “rapid growth and the early phase of the working capital cycle” (ibid, p. 570) which means especially the time when the company has a lot of accounts receivable and still not used inventory in its stores. In this case the manager needs a strategy or a plan how he will get money in a little while. For this task he can use some instruments to organize money for the company.

In the following chapters this work introduces some alternatives of short term financial instruments and shows which advantages and disadvantages they have.

2. Alternatives in Short Term Financial Instruments

As one could read above, there are different ways to systematize financing alternatives. This would be the same for the different financial instruments which will be discussed in the next chapters. This work divides the different instruments in two large groups: the interest bearing instruments and the non interest bearing instruments as well as managing of working capital. In my opinion this would be an

appropriate classification because for the right choice of financial instruments it would be important how much cost do the companies have by using each instrument and what can they do in their organisation to save money which then could be used for more important investments. In the main part there are discussed the most frequently mentioned instruments with a specific focus on availability and costs. So, first of all the interest bearing short term financial instruments are described in the following.

2.1 Interest Bearing Short Term Financial Instruments

The Financial Instruments which are interest bearing are often called bank loan or loans and Prätsch et al. divide them into overdraft credits, discount credits and credits against securities (2007, p. 136). These three kinds of credits are also mentioned by Peters et al. as the mostly used short term credits (2005, p. 85). Short term loans normally have a maturity till 12 months and are the most common kinds of credits used for the payment of liabilities (Prätsch et al. 2007, p. 135). Ross et al. differentiate the short term borrowing in secured and unsecured loans (2008, p. 641). Unsecured loans are often used by arranging a line of credit before getting the loan. This means that the company can get money of a special amount without making a special credit contract. If it needs the money it could overdraw its account. Maness and Zietlow mention that the line of credit normally is limited to a year (2005, p. 573) what fits with the time frame mentioned above. Today there exist a lot of possible credit forms which can not all be mentioned in this work. Therefore some of them will be explained exemplarily. One possible form of line of credit is the overdraft credit to which the next chapter relates to.

2.1.1 Overdraft credit

The overdraft or open time limit credit as an interest bearing short term financial instrument is, according to Prätsch et al., the classical form of a credit often used by companies (2007, p. 139). With an overdraft credit the company can get money till a certain amount. This amount is defined by the above mentioned line of credit. In Germany the overdraft credit is ruled by law and must fit special regulations e.g. that one contractual partner has to be a merchant (ibid, p. 139 et seq.). The overdraft credit is mostly used by companies as working capital credit and they use it for payments of salaries or to use discount effects in the purchasing. Normally the company can use the overdraft credit by its current account or a special overdraftcredit account by drawing money till the above described line. If the company crosses this line there would be a higher fee for the money borrowed over the line of credit (ibid, p. 140). The overdraft credit does not cost only the debit interests; in fact there are some additional costs like credit provisions or account fees if committed. Maness and Zietlow mention as additionally cost the compensating balance and the commitment fee (2005. p. 573). Compensating balance means that there has to be a special amount of money on the company’s account, e.g 20% of the borrowed amount of money (Ross et al. 2008, p. 642). So the company can pay lower interest rates. If the company uses money of these 20% it has to pay a higher interest rate to the bank. So it could come to higher costs for the company. Ross et al. give a good example of the cost of a compensating balance, which could give hints whether a company should use this instrument in every situation or not (2008, p. 642 et seqq.). They mention a line of credit over $100,000 and a compensating balance of 10%, which means that the company has to borrow $60,000 if it needs $54,000. The rest, $6,000, is given to the bank as the compensating balance mentioned above. If the interest rate of the credit is 16% p.a., the company had to pay 9,000$ per year as interests to the bank. Because of getting only 54,000$ the company has to pay an effective interest rate of 17.78%. So the company has to compare the effective interest rate to other short term financial instruments to get comparable data.

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