What is Short-Term Financing? A Simplified Approach

💲 We simplify Corporate Treasury Concepts - 🎙️ From the podcast Corporate Treasury 101

What is Short-Term Financing? A Simplified Approach

Have you ever asked yourself, “How does a company decide on the best option for short-term financing?” We understand your curiosity, so we’ve crafted this comprehensive guide to short-term financing. It’s a deep dive into an intricate yet fascinating world of corporate financial decisions that power the wheels of businesses. This guide promises to satisfy your curiosity and give you a strong understanding of this complex subject, regardless of your background.

Now, we know you may be thinking that this sounds not very easy. But trust us; it doesn’t have to be. With a little guidance and explanation, you’ll realize that this crucial financial strategy is approachable and, more importantly, anyone can grasp it. In fact, after reading this article, you might find yourself chatting about short-term financing at your next dinner party! We’re here to show you that learning about corporate finance can be not just easy but fun and exciting.

Consider this article your one-stop shop for understanding short-term financing and its importance in business. You’ll discover the various methods a company might use, including bank overdrafts, credit facilities, commercial papers, and even internal financing. You’ll even learn how these choices can impact a company’s financial health. And to ensure a comprehensive understanding, we highly recommend diving into our episode 21 about cash flow forecasting and cash positioning. Buckle up for a fascinating exploration and get ready to step into the shoes of a corporate treasurer, embarking on a journey to transform your understanding of corporate finance.

By reading this article, you’ll:

  • Gain insight into the intriguing world of short-term financing, breaking it into bite-sized, understandable chunks.
  • Learn how corporate treasurers decide which financing method to choose and what factors influence those choices.
  • Understand the implications of different short-term financing options, such as bank overdrafts, revolving credit facilities, and commercial papers.
  • Discover how internal financing within a global company can work and the considerations that must be considered.
  • Get familiar with the concept of ‘flexibility’ in short-term financing and its impact on the cost.
  • Realize the importance of financial ratios and covenants in making short-term financing decisions.
  • Be introduced to the idea of tax implications when moving money between different regions of a multinational company.

What Does Funding Mean in the Context of Corporate Treasury?

When a company talks about funding, they refer to securing money from external sources to support their business operations. Sometimes a company’s revenues aren’t enough to cover all its costs. For example, they might not have enough cash to pay their suppliers or be facing a situation where their expenses exceed their incoming cash, known as a “negative cash flow.” That’s when they need to look for funding.

Funding can also be used to fuel growth. A company might want to expand into new territories, open new branches, invest in new equipment, or launch marketing campaigns. All these activities require money, and sometimes, funding can be the best solution.

The Two Types of Funding: Short-term and Long-term

Funding can be categorized into two main types:

  1. Short-term funding: It means money that a company plans to use and repay within a year. Companies often use it for immediate expenses like payroll or taxes. This is the main focus of our discussion here, as this falls under the responsibilities of a company’s treasury department.
  2. Long-term funding: This is money borrowed for more than a year. It’s often used for big investments like opening new branches or starting large projects. While it’s not the focus of this episode, it’s still important because it affects a company’s cash flow forecasting, which is part of the corporate treasury’s job.

Understanding the Conditions of Funding

When a company decides to seek funding, the lenders usually set conditions. These conditions help lenders, like banks or investors, protect their investments. They want to make sure they’ll get their money back!

The conditions may include the following:

  1. Interest: The company will have to pay back more than it borrowed. This extra money is called “interest.”
  2. Repayment schedule: The company must pay back the borrowed money according to a schedule. This could be monthly, quarterly, or yearly payments.
  3. Collateral: The company might have to offer something valuable as a guarantee. The lender can take this collateral if they can’t repay the loan. For example, if a company borrows money to buy a building, the building might be the collateral.
  4. Financial covenants: These are financial ratios that help the lender assess the company’s financial health. They help the lender determine whether the company can repay the loan and the interest on time.

Understanding these conditions is crucial when looking for external funding. Not only will they affect how much a company can borrow, but they will also impact its cash flow and future financial planning. By keeping these in mind, a company can make informed funding decisions and ensure financial stability.

What are the Financial Ratios Banks Use to Assess a Company’s Ability to Repay Debt?

In this part of the discussion, Hussam and Guillaume delve into the financial ratios banks use to assess a company’s ability to repay its debt. Banks use these ratios to decide how much money they will lend a company and under what terms.

Guillaume starts by mentioning that banks look at certain financial ratios, which include:

  1. Debt to Equity Ratio: This ratio compares a company’s total debt to the total equity. In simpler terms, it shows how much money a company owes compared to how much the shareholders have put into it. A lower ratio is generally more favorable as it indicates that the company is less dependent on borrowed money and has a strong equity base.
  2. Earnings Before Interest and Taxes (EBIT): This measures a company’s profitability before considering interest and tax expenses. Banks use this ratio to see how much money a company makes from its operations without considering the cost of borrowing and tax liabilities.
  3. Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): This is similar to EBIT, but it also excludes the costs of depreciation and amortization, which are non-cash expenses related to long-term assets like equipment or buildings.
  4. Cash Flow Ratios: Banks may also examine a company’s cash flows. This could be the net cash flow, the difference between the cash coming into the company and the cash going out. A positive net cash flow is generally a good sign as it indicates that the company generates more cash than its spending.
  5. Operating Expenses: This ratio considers the company’s regular, ongoing business costs, like rent, utilities, and salaries. Generally, a company with fewer operating expenses appears more financially stable.

These financial ratios, Guillaume mentions, are a crucial part of the dialogue between a company and its potential lenders. They impact not only how much a company can borrow but also the conditions of the loan. And they directly affect a company’s treasury operations and strategy.

How Does Funding Relate to Cash Flow and Financial Covenants?

Funding is directly linked to a company’s cash flow. For instance, if a company doesn’t have enough cash (low cash liquidity) or spends more cash than it’s making (negative cash flow), it might need to seek short-term funding. This could be due to various reasons, like tax season or having to pay bonuses, leading to high cash outflows. In such cases, a company might need to borrow money from a bank with conditions like interest rates and repayment terms.

One of the conditions banks often set is related to financial covenants, essentially the financial ratios discussed earlier. These ratios give the banks an idea of the risk they’re taking by lending money to the company. By managing these ratios well, a company can have easier access to debt when needed.

What are the Roles of a CFO and Treasurer Regarding Debt Management, and How Can Corporates Fund Without Debt?

In this part of their conversation, Hussam and Guillaume discuss the roles of a Chief Financial Officer (CFO) and a Treasurer in managing a company’s debt. Additionally, they explore alternative ways companies can raise funds without taking on bank debt.

The Joint Responsibility of CFO and Treasurer in Debt Management

When Hussam asks whether managing debt is the role of the CFO or the Treasurer, Guillaume clarifies that it’s a shared responsibility. Here’s why:

  • The CFO typically oversees the long-term debt strategy of the company. They decide to borrow for long-term investments, like buying property or expanding into new markets. The CFO’s role involves planning the company’s financial future.
  • The Treasurer, on the other hand, plays a significant role in managing short-term debt and optimizing the company’s cash flows. They ensure that the company has enough cash to cover day-to-day expenses and that any excess cash is invested wisely.

While the CFO looks at the bigger picture of the company’s financial health, the Treasurer focuses on the here and now.

Alternatives to Debt Financing

In response to Hussam’s next question about other ways of funding without taking on bank debt, Guillaume mentions a few alternatives:

  1. Equity Financing: This involves raising money from shareholders. A company can do this by issuing new shares. Unlike a loan, you don’t pay interest on equity financing. However, you might have to pay dividends to your shareholders, which is a share of your company’s profits.
  2. Debt Instruments from Non-Bank Investors: A company can borrow from investors on the financial markets using debt instruments like bonds. A bond is essentially an IOU that the company issues to investors. The company promises to repay the borrowed amount and interest after a set period. The interest rate can vary based on factors like the loan’s length and the repayment terms’ flexibility.

What are the Different Strategies or Instruments for Short-Term Funding?

Hussam and Guillaume now delve into the practical aspects of funding. They discuss strategies or instruments a company can use to address short-term funding needs. Here’s what you need to know about these strategies:

Overdrafts: The Safety Net for Shortfalls

One common short-term debt instrument is an overdraft. Think of an overdraft as a safety net for your bank account. It’s linked directly to your account and kicks in when the account goes below zero due to a transaction.

Ordinarily, if an account hits zero, the bank blocks further transactions to prevent the account from going into the negatives. But with an overdraft, the bank allows the transaction to go through even if there isn’t enough money in the account. This can be handy if you need extra cash to cover expenses before your next inflow. The bank charges interest on the amount you borrow through the overdraft.

Money Market Loans: A Short-Term Borrowing Solution

Another instrument is a money market loan. This is a short-term loan with an interest rate based on money market rates. Money markets are markets for short-term financial assets. They can be very liquid and are often seen as a safe place to park money.

The interest rate for a money market loan usually involves a benchmark rate like the LIBOR (London Interbank Offered Rate) plus the bank’s margin. It’s worth noting that these kinds of loans are linked to managing interest rate risk, which is another topic altogether.

Revolving Credit Facilities: An Open Line of Credit

A revolving credit facility is a type of credit line. It’s like having an agreed pot of money you can dip into and repay whenever needed.

Here’s how it works: the bank says, “Here’s X amount of money. You can borrow from it and repay it however you like over this period.” Once you repay some or all of the money, you can borrow it again, up to the agreed limit.

The bank expects all borrowed money to be repaid at the end of the agreed period. You pay interest on the amount you borrow, plus a fee for the overall credit facility.

How Do Short-Term Investments or Fund Short-Term Needs Work with Financial Markets?

In this section, Hussam inquires about short-term investments or meeting short-term needs with financial markets, and Guillaume provides insightful responses. Let’s explore those financial instruments, namely commercial paper, repurchase agreements, and factoring, that can be useful for short-term funding.

Commercial Paper: A Go-to Tool for Short-Term Funding

Commercial paper is a common instrument used for short-term funding. It’s essentially a promise to repay more money than you borrow after a certain period. Let’s take an example:

Imagine you need $100. You can issue a commercial paper worth $105 but only ask an investor for $100. When you repay the debt, you give the investor the full $105. So, the investor makes a profit, and you cover your immediate need for cash.

Companies often use commercial paper to finance short-term needs like paying their employees’ salaries or covering invoices from suppliers.

Repurchase Agreements: For Ultra-Short-Term Needs

Repurchase agreements (also known as repos) work similarly to commercial papers. The main difference is that they’re for even shorter-term needs – we’re talking about a few days or overnight.

You need $10 million today, but you’ll receive $15 million from a client tomorrow. You could use a repurchase agreement to get the money you need right now and repay it when your client’s payment comes through.

Factoring: Turning Future Money into Now Money

Factoring is a bit different. It’s about getting money for invoices you won’t be paid for until later. Here’s an example:

Suppose you sold a car to a friend and gave them 60 days to pay the $10,000 price. But what if you need the money right now? You could go to a factoring company and say, “My friend owes me $10,000 in 60 days, but I need the money now. Would you buy my account receivable for $9,000?”

If the factoring company agrees, you get $9,000 right away. You get less money overall, but you get the cash you need when needed. This is how factoring works.

How Does a Corporate Treasurer Decide Which Financial Instrument to Use for Short-Term Needs?

In this part of the conversation, Hussam asks how a corporate treasurer decides which financial instrument to meet short-term needs. Guillaume responds with an explanation of the factors that play into this decision.

What Factors Matter?

When deciding which financial instrument to use, you, as a corporate treasurer, would consider several things.

  • Flexibility and Cost: You need to figure out how much money you need and how quickly you need it. Money comes with a cost, especially when it’s easily accessible and flexible. Overdrafts, for example, are super flexible and can be tapped into whenever needed, but they’re usually more expensive. Remember, the more flexible the arrangement, the higher the price.
  • Term Length: The length of the loan term also affects the cost. The longer you need to hold onto the money, the more expensive it’s likely because the bank or investor can’t use that money for other investments during this time.
  • Impact on Financial Ratios: Some financial instruments can affect your financial ratios or covenants (the promises you make to your lenders about your financial behavior). Other instruments, however, don’t have this impact. It’s essential to consider how these tools might affect your financial health.
  • Tax Considerations: In many countries, the interest you pay on borrowed money is tax-deductible. So, you might want to consider borrowing money to reduce your tax bill.
  • Amount Needed: The amount of money you need is a big factor. Overdrafts are flexible, but they’re usually for smaller amounts. You might go for a revolving credit facility or a financial market instrument if you need a larger sum.
  • Credit Rating: Financial market instruments like commercial papers and repurchase agreements typically have lower interest rates, but your company needs to have a good credit rating and solid financial ratios to get these.
  • Overall Strategy and Needs: Finally, the choice of financial instrument depends on your overall strategy. Do you need money quickly due to a sudden, unexpected expense, or was this something you saw coming and had time to prepare for?

In conclusion, the choice between short-term financing tools, such as bank overdrafts, money market loans, revolving credit facilities, commercial papers, repurchase agreements, and factoring, depends on several factors.

As a corporate treasurer, it’s essential to look at your immediate cash needs and how these choices affect the company’s overall financial health and future. Corporate treasury plays a key role in a company’s overall strategy, making the job complex but extremely rewarding.

Can Companies Handle Short-Term Financing Needs Internally Without External Parties?

Deal being concluded for short term financing
Image by Gerd Altmann from Pixabay

Hussam inquires whether a company can manage its short-term financing needs internally without involving third parties. Guillaume explains that this can be done and proceeds to elaborate on how this might work.

Internal Financing: What’s That All About?

When we’re talking about managing financial needs internally, we’re referring to using a company’s resources rather than turning to external sources like banks or other lending institutions. Let’s take an example of a company with branches worldwide.

Imagine you’re a successful business owner with cafes in Latin America, Asia, and Europe. The Latin American branches are very profitable and have plenty of cash, while the new Asian branches are still struggling to become profitable and need more money to operate effectively.

In such a situation, you could transfer some surplus cash from the Latin American branches to the Asian ones, providing the funds they need without borrowing from external sources. This is what’s known as internal financing or “self-funding.”

Things to Consider

While it sounds like a straightforward solution, there are several factors you need to consider when deciding to go down the internal financing route:

  • Tax Implications: Moving money between different parts of a company, especially across borders, can have tax implications. You want to ensure you’re not paying more taxes than necessary. Always consult with a tax expert before making such decisions.
  • Future Cash Needs: Consider whether the money you’re considering moving might be needed in its original location. For instance, if you take cash out of Latin America, what happens if those branches suddenly need that cash for something unexpected? You need to weigh the potential risks and rewards before making your decision.

In summary, while companies can manage short-term financing needs internally, it’s not a decision to be taken lightly. You need to consider the tax implications and the potential future cash needs of different parts of your company. By considering these factors and making informed decisions, you can better manage your company’s finances and set it up for future success.

Wrapping It Up:

Mastering the landscape of short-term financing is a vital task for any business. It’s not just about getting the cash when needed but understanding the myriad options available: bank overdrafts, credit facilities, commercial paper, repurchase agreements, factoring, or internal funding.

Short-term financing isn’t a one-size-fits-all approach. The method chosen by any business depends on its unique needs and circumstances. Factors like the amount of money needed, flexibility of the funding source, cost, and the impact on financial ratios all play a critical role in the decision-making process.

Remember, it’s not always about contacting third parties for funding. Sometimes, the solution lies within your own company. Internal financing can effectively manage short-term financial needs, provided you consider the tax implications and future cash requirements.

Ultimately, the goal is to align the short-term financial strategies with the company’s long-term objectives. And it’s always essential to stay adaptable, review the choices regularly, and make necessary adjustments as the company grows and the market changes.

In conclusion, the realm of corporate treasury and short-term financing is intricate but fascinating, with decisions that can impact a company’s financial health and strategy. As you navigate this financial maze, let knowledge, prudence, and adaptability guide your company toward enduring financial success.

If you liked the article, why not spreading the Treasury word? :)

Leave a Reply

Your email address will not be published. Required fields are marked *