Short-Term and Mid-Term Financing Questions and Answers [With PDF]

A business does not only need money to buy machines. It also needs money every day to buy materials, pay wages and wait for customers to pay. Short-term and mid-term financing provide that money. This chapter covers trade credit, commercial paper, mid-term loans, working capital, the cash conversion cycle, receivables and inventory management (including the economic order quantity). Here are 35 important questions with clear answers and worked examples. Every calculation has been checked.

This is Chapter 3 of our Finance course. It follows Time Value of Money and comes before Long Term Financing.

Short-Term Financing

Q1. What is short-term financing?

Financing that is repaid within a short period, usually one year or less. It is used for working capital and the day-to-day operations of a business.

Q2. What are the features of short-term financing?

• The period is usually one year or less.
• It meets working capital needs.
• The cost tends to be lower than long-term finance.
• Informal sources need no security.
• It is renewable.
• It is relatively simple to arrange.

Q3. What are the advantages of short-term financing?

• It is easy and quick to obtain.
• It is cheaper than most other loans.
• It is more flexible than medium-term and long-term finance.
• Lenders offer simple terms.
• Because the repayment period is short, the lender’s risk is lower.
• Most short-term finance does not need collateral.

Q4. What are the disadvantages of short-term financing?

• Large amounts usually cannot be raised.
• The money is available for only a short period.
• Repaying a loan in a short time is riskier for the borrower, and refinancing may be needed.
• Buying on credit can mean paying a higher price or losing cash discounts.

Q5. What are the sources of short-term financing?

Q6. What is trade credit?

Trade credit is the credit a buyer gets from a supplier in the normal course of business, allowing the buyer to pay for goods some time after delivery. It is very popular because it needs no formalities or collateral.

Q7. What are the features of trade credit?

• It arises from buying or selling goods on credit, often for resale.
• It rests on the goodwill between buyer and seller.
• It has far fewer formalities than a bank loan.
• No collateral is needed.
• The cost is low, or even zero if the buyer pays within the discount period.
• The amounts are small, so repayment risk is small too.

Q8. What is the cost of trade credit, and how is it calculated?

Cost of trade credit = [Discount % / (100 – Discount %)] x [360 / (Payment period – Discount period)]

Example: Terms are “2/10, net 30”: a 2% discount if you pay within 10 days, otherwise the full amount is due in 30 days. Cost = [2 / 98] x [360 / (30 – 10)] = 0.020408 x 18 = 36.73% a year. This shows that giving up a cash discount is an expensive way to borrow.

Q9. Why is trade credit popular?

• It is widely available.
• It is easy to get, with no loan formalities.
• It is cheaper than a bank loan when discounts are taken.
• It carries less risk for the buyer.
• No collateral is needed.

Q10. What is the difference between a bank loan and trade credit?

Q11. What is commercial paper?

Commercial paper is an unsecured, short-term, transferable promissory note that large and financially strong companies sell in the money market to meet their working capital needs. It is usually sold at a discount and repaid at face value.

Q12. How do you calculate the cost of commercial paper?

Cost = [(Face value – Net sale price) / Net sale price] x [360 / Days to maturity]

Example: Paper with a face value of 100,000 is sold for 97,000 and matures in 90 days. Cost = [(100,000 – 97,000) / 97,000] x [360 / 90] = 0.030928 x 4 = 12.37% a year.

Mid-Term Financing

Q13. What is mid-term financing?

Financing for a period longer than one year but shorter than long-term finance, typically up to five years, though some books say up to seven or ten. Small and medium enterprises use it widely.

Q14. What are the characteristics of mid-term financing?

• The period is more than one year, typically up to five or so years.
• The amount is usually smaller than a long-term loan.
• It is widely used by small and medium-sized businesses.
• It is used for working capital needs, to expand or replace equipment.
• It is usually repaid in instalments.

Q15. What are the sources of mid-term financing?

• Commercial banks
• Insurance companies
• Development banks
• Development organizations
• Finance companies
• Leasing companies

Q16. Who uses mid-term financing?

• Manufacturing organizations
• Service organizations
• New and small enterprises
• Medium and large enterprises
• Farmers

Q17. What are the advantages of mid-term financing?

• It is flexible: the borrower can draw the amount as needed and renew the loan.
• Repayment by instalments is convenient.
• Agreements are easy to renew and can often be converted into a long-term loan.
• It suits quick financing.
• It involves fewer formalities.

Working Capital

Q18. What is working capital?

Working capital is the capital a business needs for its day-to-day operations. It is the investment in current assets such as cash, bank deposits, bills receivable, debtors and stock. Net working capital is current assets minus current liabilities.

Q19. What is the optimum level of working capital?

The amount that is enough to keep production and day-to-day operations running smoothly, neither too much (idle money earning nothing) nor too little (risk of not paying bills).

Q20. What factors influence working capital?

• Size of the business
• Nature of the business
• Length of the working capital cycle
• Nature of raw materials
• Sales volume
• Production policy
• Availability of loans

Q21. How is working capital classified?

Q22. What are fixed and variable working capital?

• Fixed (permanent) working capital: the minimum level of current assets a firm must always hold, whatever the season.
• Variable (temporary) working capital: the extra amount needed when demand rises, which changes with the season or the level of sales.

Q23. What is the difference between gross and net working capital?

Net working capital is positive when current assets exceed current liabilities, and negative when they do not. Example: current assets 80,000 and current liabilities 50,000 give net working capital of 30,000.

Q24. What is the difference between fixed capital and working capital?

Q25. What is working capital management?

The management of a firm’s current assets and current liabilities, such as cash, bank deposits, receivables and stock, so that the firm has enough liquidity without holding too much idle money.

Q26. What are the three policies for financing working capital?

Q27. What is the working capital cycle?

The working capital (operating) cycle is the time from when the firm buys raw materials to when it collects cash from customers. The steps are: cash is used to buy materials, materials become work in progress, then finished goods, then credit sales (debtors), and finally cash returns.

Q28. What is the cash conversion cycle?

The cash conversion (cash) cycle is the number of days between paying cash for materials and receiving cash from customers. Cash conversion cycle = Inventory period + Receivables period – Payables period.

Example: Goods stay in stock for 60 days, customers take 30 days to pay, and the firm takes 40 days to pay suppliers. Cycle = 60 + 30 – 40 = 50 days. The firm must finance its operations for 50 days. A shorter cycle means less working capital is needed.

Receivables and Inventory

Q29. What are receivables?

Receivables (debtors) are the amounts owed to a company by customers for goods or services sold on credit in the normal course of business.

Q30. What are the objectives of receivables management?

• To increase sales.
• To increase profit.
• To meet competition by offering credit terms.

Q31. What is inventory management?

Controlling the amount of stock so the business always has enough to meet demand, without the loss and cost of holding too much or the risk of running out.

Q32. What are the three main aspects of inventory management?

• Economic order quantity (EOQ): how much to order at a time.
• Reorder point: when to place the next order.
• Stock levels: the minimum, maximum and safety stock to hold.

Q33. What are the objectives of inventory management?

• Produce according to demand.
• Keep the investment in stock as low as possible.
• Make sure customers receive their goods.
• Use stock efficiently.
• Reduce damage and waste.

Q34. What is the economic order quantity (EOQ), and how is it calculated?

EOQ is the order size that gives the lowest total cost of ordering and holding stock. EOQ = square root of (2 x A x O / C), where A is the annual demand in units, O is the cost of placing one order and C is the cost of holding one unit for a year.

Example: A = 10,000 units, O = 50 per order, C = 2 per unit per year. EOQ = square root of (2 x 10,000 x 50 / 2) = square root of 500,000 = about 707 units. The firm places about 10,000 / 707 = 14 orders a year.

Q35. What are the methods of calculating EOQ, and the reorder point?

• Equation method: use the EOQ formula directly.
• Trial and error method: calculate total cost for several order sizes and pick the lowest.
• Graphical method: plot ordering cost and holding cost curves. EOQ is where total cost is lowest (where ordering cost equals holding cost).

Reorder point = (Daily usage x Lead time) + Safety stock. Example: usage of 30 units a day, lead time of 10 days and safety stock of 100 gives 30 x 10 + 100 = 400 units. When stock falls to 400, place a new order.

Quick Revision Points

• Short-term finance: one year or less. Mid-term: more than one year, typically up to five years.
• Cost of trade credit = [Discount / (100 – Discount)] x [360 / (Payment period – Discount period)].
• Commercial paper is sold in the money market by strong companies.
• Net working capital = current assets – current liabilities.
• Cash conversion cycle = inventory period + receivables period – payables period.
• EOQ = square root of (2AO / C).

Test yourself with the chapter quiz below, then continue to Long Term Financing.