SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:

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Financial Management MGT201

Lesson 41

SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following

topics:

· Financing (Short Term and Long Term Financing)

· Lease Financing

In this lecture we shall continue our discussion of working capital financing and will discuss financing,

short and long term financing and lease financing.

Working Capital Financing:

· Financial Managers spend More than 50% of their time on Working Capital Financing. This has

been observed in many companies. In other words, arrangement for funds to meet day-to-day

expenses like inventory, raw material supplies and miscellaneous expenses has great significance.

· Sources of Financing

Permanent Financing:

Permanent Financing comes in two forms:

· Long-term Loans / Bonds Duration of this source is More Than 1 Year. It has

Low Risk for Firm but has High Cost

· Common Equity / Stock - "Perpetual." By definition. Less Risk for Firm but

Highest Cost.

Recall here concepts of cost of debt and cost of equity we studied in capital structure to

decide which source of financing is better for firm and why?.

Temporary Financing:

Temporary financing also has two forms:

· Short-term Loan (An example of working capital financing) Duration of this

source is Less Than 1 Year i.e. 3 months, 6 months, 9 months, etc. Easier to obtain

than Long-term Loan as for long term loans many requirements like financial

statements and guarantees need to be fulfilled. Less costly than Long-term Loan

due to lower interest rate generally. But this interest costs is variable / uncertain as

you have to renew it each time and you are not sure whether you will get the same

lower interest rate as before. So More risky. Needs to be rolled over frequently so it

is less liquid.

· Spontaneous Financing - Current Liabilities like Trade Credit and Accrued Taxes

(payable) and Wages payable form its base. Arise "Spontaneously" from day-to-day

operations. It is in the form of money you have to pay but have not paid yet to your

suppliers. It is free loan or credit on which you do not have to pay any interest. As

you do not know the amount of money you will have and when, there is Highest

Uncertainty / Risk. It has Least Cost (can be free!). But you cannot depend on it for

day-to-day expenses as this all is just your rough idea. You are not sure.

Tradeoff between Liquidity (Risk) & Profitability (Return)

High Current Assets means High Liquidity but Low Profitability. This is due to more

money tied in current assets that have low profitability.

Low Current Assets means High Profitability but High Risk. This is due to money tied

in fixed assets may not be available for payments as they come due.

High Long-term Debt means Low Risk of illiquidity but High Cost of Debt in form of

interest.

High Current Liabilities (or short-term Spontaneous Financing like Trade Debt) means

Low Cost but High Risk of illiquidity.

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Financial Management MGT201

Graphical View of Financing

Maturity Matching Principle

Match the Maturity of Financing to Usage of Asset

Spontaneous

Value (Rupees)

TEMPORARY CURRENT ASSETS 

Current

Usage Less than 1 Year

Liabilities &

Short Term

Financing

Short Term

Financing

& Long

Term

"PERMANENT" CURRENT ASSETS

Financing

 Usage More than 1 Year

Long Term

Debt &

FIXED ASSETS 

Equity

Usage More than 1 Year

Time (Months)

If a firm uses long term financing it has higher cost of financing comparatively due to high

interest cost of long term loans. Despite of this high cost you have low risk here due to surety of access

to money for a longer period. Current liabilities as a source of financing are not reliable as you have no

surety whether you will have same amount of money available next month for financing or less amount

of money or how much money. Also, if firm keeps continue this practice and do not pay its accounts

payable will raise so much after a period that it may go bankrupt.

How Much Liquidity to Keep?

· Keep enough Liquidity to meet maturing short term obligations (i.e. Accounts Payable, Interest,

etc) on time. How much firm should keep of short term loans and how much of long term

loans? The decision is made keeping in view the following principles:

Hedging Principle (or Principle of Self-Liquidating Debt or MATURITY MATCHING)

Match Cash-flow characteristics of Asset being purchased with the maturity of the

Source of Financing used to buy the asset.

Example: Shoe Shop Owner can use Current Liability to finance seasonal expansion in

inventory during Eid Time. If he uses Long-term financing, then excess / surplus / IDLE

LIQUIDITY GIVING LOW / NO YIELD BUT COSTING INTEREST SO LOWER PROFITS.

Eid does not come each month. Shop owner needs extra money / inventory only for one month.

He should take short term loan. If he decides to take long term loan he will have to pay for extra

interest cost unnecessarily.

Another way of describing the hedging principle is Permanent Asset Investments should be

financed by Permanent Financing. Buy Temporary Assets through Temporary Financing.

Permanent Asset Investments: Fixed or Movable or EVEN CURRENT assets (i.e.

Inventory) that a firm plans to hold for > 1 Year. The economic life of such assets can

be more or less.

Temporary Assets: Current Assets that will be liquidated within 1 year. These are a

subset of current assets. Foe example, inventory in use for less than 1 year.

Example: Use Long Term Loan to buy a long term asset. Studio owner should Do NOT use

short-term loan (< 1 Year) to buy a sophisticated professional Sony Digital Camera costing

Rs.1.5 million which is expected to have an Economic Life of over 5 years and has a Payback

Period of 2 Years. Use Long Term Loan with Maturity over 2 Years so that there is sufficient

time to repay interest from cash flows of asset (i.e. Camera).

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Financial Management MGT201

Working Capital Financing Policies:

Total Assets = Fixed assets + Permanent Current assets + Temporary Current assets.

Total assets steadily grow with life of healthy company.

Temporary Current fluctuates with time. Extra spontaneous inventory can be financed

by short-term debt financing or loan

This will help us to understand which kind of policy should firm adopt according to the kind of

assets a firm have.

3 Policies of Working Capital Financing (Based on Hedging Principle of Maturity

Matching)

Aggressive

· Maximum Short-term financing at low cost (but risk of non-renewal)

· Use short-term financing for Temporary Current Assets and even partly to buy

Permanent Current Inventory

Conservative

· Maximum Long-term financing. Safe but higher interest costs.

· Use long-term financing for Fixed Assets, entire Permanent Assets, and even

part of Temporary Current Assets

Moderate

· Balance of Long and Short-term Financing. Based on Maturity Matching

Principle.

· Long Term permanent Financing for Fixed assets like land, building,

warehouse, machinery and Permanent Current Assets only.

· Spontaneous financing or short term financing is used for short term portion of

current assets

Long-term Debt Financing:

· What Affects Financing Decisions (Factors influencing the choice of long term finance by

managers)

Capital Structure: match Actual Capital Structure to Optimum. "Sticky", non-smooth,

never-ending process. It is not one day work.

Maturity Matching (Hedging Principle): match maturity of debt to asset usage time

Interest Rates: get long-term financing if long-term interest rates are low

Financial Health & Credit-worthiness: get long-term financing while firm is still

healthy

· Short-term Debt

Bank Loans: Maturity period < 1 Year. Collateral (security) required i.e. Property,

inventory, or a/c receivables.

Commercial Paper: unsecured promissory note issued by large, strong firm

· Long-term Debt Financing (Maturity Longer than 1 Year)

The following are the forms of this loan:

Bank "Term Loans": > 1 Year

Bonds: Debentures vs. Mortgage vs. Floating Rate

Syndicated Loan: for large loans, one lead bank heading team of other banks. Due to

large amount of loan one bank alone cannot take the whole risk and liability.

Project Financing: for large international infrastructural projects i.e. Electric power

plants, dams, development of highways. Group of firms invest equity capital in a New

Project. Bank gives loan to New Project. In return, bank is repaid from cash flows of

the New Project. In fact, Bank gets the cash inflows first and then decides what to do

with them! No other collateral or security is provided. So individual assets of each of

individual firms is free. So bank protects itself by keeping control of all the cash flows.

Securitization: convert private debt contract into publicly traded financial instrument. A

large loan can be divided into smaller parts that are traded in the money markets.

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Financial Management MGT201

Lease Financing

· Leasing of Fixed Assets (Financing of Capital Expenditure in Fixed Assets)

Leasing Company (Lessor) buys and owns the asset and leases it to the Lessee

(Borrower) who can use, operate, and control the asset. Lessee pays Lease Rental to

Lessor in return. Lifespan of lease can vary from few days to years.

Like Collateralized Loan (where the leased asset is the collateral). Lease Contract is

just as serious as a loan agreement. Failure to pay lease rental is just like failure to pay

interest. Can bankrupt the Lessee (Borrower). Lessor (Lender or Leasing Company) can

seize the leased asset and, if the claim is larger, also demand up to 1 year lease rental.

Ownership vs. Control

Between 10-30% of fixed assets owned by Large Companies are leased i.e. Warehouses,

offices, equipment, machinery, computers, cars, furniture, airplanes!

· General Advantages from Lessee's (Borrower / user) Point of View

It guides towards when lease financing should be used:

Less risky than investing large amount of money in fixed assets in a new businesses that

suffer from Cyclicality i.e. Airplanes.

More suitable for hi-tech assets that become Obsolete quickly like software houses

When product demand is uncertain and hence equipment life is uncertain.

Lender has to share portion of operational risk and maintenance costs e.g. IBM

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