Short term finance & investments

The main types of short-term finance are:
 trade payables
 factoring or invoice discounting of trade receivables
 bank overdrafts and short-term loans
 financing exports

 alleviates cash flow difficulties
 cash can earn a return whilst still
in the paying entity's account

 loss of any settlement discount
 could obtain a poor credit rating
 supplier may stop further
supplies
 supplier may increase future
selling prices to compensate
 could face legal action from the
supplier

The debts of the entity are effectively sold to a factoring company (normally
owned by a bank). The factor may take on the responsibility to collect the debt
for a fee. The factor offers three services:

1 Debt collection – The credit control function. This is outsourcing of the
credit control department to the factoring entity.

2 Financing – Funds may be advanced to the company prior to the debt
being collected. This may provide the financing element of the
arrangement.

3 Credit insurance – The factor may take the responsibility for
irrecoverable debt. For this to be the case the factor would dictate to
whom the entity was able to offer credit. This is called ‘without recourse’
factoring.

The factor is often more successful at enforcing credit terms, leading to a lower
level of debts outstanding. Factoring is therefore not only a source of short-term
finance but also an external means of controlling or reducing the level of
receivables.

This is a service also provided by a factoring entity. Selected invoices are used
as security against which the entity may borrow funds. This is a temporary
source of finance, repayable when the debt is cleared. The key advantage of
invoice discounting is that it is a confidential service and the customer need not
know about it

 Flexibility
 Only pay for what is used, so
generally cheaper

 Repayable on demand
 May require security
 Variable finance costs

Bank loans are a contractual agreement for a specific sum, loaned for a fixed
period, at an agreed rate of interest. They are less flexible than overdrafts, can
be more expensive but provide greater security

Entities exporting goods to other countries often have much greater problems
with credit and finance than entities selling goods and services to domestic
markets.
Several methods are available for dealing with the problems of financing
exports and controlling the credit risk. These include:
 documentary credits
 bills of exchange
 export factoring
 forfaiting

Trading between other countries can be complex, particularly when it will take a
considerable time to ship the goods from the exporter’s country to the importer.
The exporter might want payment as soon as possible, but the importer needs
to be satisfied that the exporter has complied with the terms of the sale
agreement before paying.
The problem of guaranteeing payment can be overcome by using an
irrevocable letter of credit, also called an irrevocable documentary credit. A
letter of credit is an undertaking given by its issuer that payment will be
guaranteed for the exporter, provided that the exporter complies with certain
specific requirements within a specified time limit.
A letter of credit is a document, issued by a bank on behalf of a customer,
authorising a person to draw money to a specified amount from its branches or
correspondents, usually in another country, when the conditions set out in the
document have been met

A bill of exchange is used primarily in international trade and binds one party to
pay a fixed sum of money to another party on demand or at a predetermined
date. They are similar to post-dated cheques.
For example, a supplier of goods (the drawer) can draw a bill of exchange on a
customer (the drawee). The customer, by signing the bill of exchange,
acknowledges the debt exists and commits to paying it.
There are two types of bill of exchange:
(i) a sight draftill – which is payable immediately
(ii) a time draftill – which is payable at a predetermined future date (can be
described as term bills)
The drawer of a bill of exchange (the supplier) can sell an accepted time draft to
a third party (this is known as discounting) in order to receive cash earlier than it
would if it waited for the bill of exchange to mature. Alternatively, the drawer of
an accepted time draft could transfer the bill to one of its own suppliers in
settlement of its own debt (this effectively transfers the customer’s debt to a
third party).
The drawer and the payee are often the same person.
A significant characteristic of bills of exchange is that:
 the drawee is given a period of credit before having to pay a term bill, but
 the drawer or payee can obtain payment earlier than the bill’s maturity
date, by means of discounting the bill.
When a bill is discounted, it is sold in the financial markets at a discount to face
value. The size of the discount reflects the rate of interest that the buyer of the
bill requires from holding the bill to maturity.
Bills of exchange can also be known as ‘acceptance credit

Export factoring is similar to ordinary factoring, with the exception that the
factoring organisation agrees to factor the client’s export trade receivables
(overseas trading).
The factor’s services include administration of the receivables ledger and
collecting payment, and providing factor finance. The export factor buys the
seller’s overseas receivables for a lump sum which is often lower than the
outstanding debt owed.
In view of the problems that can arise with collecting payments from customers
in other countries, the expertise of an export factor can be very helpful,
particularly for small and medium-sized businesses with little experience in
collecting foreign payments.

Forfaiting is the same as export factoring except that the seller (exporter) will
receive 100% of the receivable as a lump sum from the forfaiter.
The exporter will draw a bill of exchange from an importer (the buyer). This bill
of exchange is purchased by a forfaiting company (typically banks) without
recourse to the exporter.
The exporter receives the total amount owed, the forfaiter chases the debt and
the importer settles direct to the forfaiter.
The exporter has obtained payment for the goods, without any risk of having to
return the money if the importer fails to meet its payment obligations.
The key features of forfaiting are that:
 The importer obtains medium-term finance for much of the purchase cost
of the goods.
 The exporter receives immediate payment.
 The credit risk is accepted by the forfaiting bank, although this risk is
reduced by the guarantee of the promissory notes (another name for a bill
of exchange

It means there is no risk to the company, the financer is assuming the risk of chasing the debt

 Interest-bearing bank accounts
 Negotiable instruments
 Short-dated government bonds
 Other short-term investments

When a business has surplus cash to invest temporarily, it has to decide which
investments to select from the different choices available. There are several
criteria that should be considered when making these choices:
 maturity
 return
 risk
 liquidity
 diversification

 bank deposit accounts
 money market deposits

 Some deposit accounts are ‘instant access’ accounts, which allow
the investor to withdraw the money without notice and without loss
of interest. The interest rate is usually low on these accounts, and
they are used when the investor wants to earn some interest on
surplus cash, but places great importance on instant liquidity.
 Some deposit accounts or savings accounts allow the investor to
withdraw funds without notice, but the investor will suffer some
loss of interest. For example, a deposit account might require a
notice of withdrawal of at least seven days, but the investor might
be permitted to withdraw the funds without notice with a penalty of
seven days’ lost interest.
 In some cases, an investor might be unable to withdraw funds
from the account without giving a minimum notice period.

Money market deposits are amounts of money deposited through a
bank in the money markets. These are the financial markets for short-
term borrowing and lending. The money markets are used largely by
banks and other financial institutions, for depositing and lending funds.
Banks can deposit short-term funds with other banks, or borrow short-
term from other banks in the inter-bank market.
Interest yields in the inter-bank market are often reasonably attractive,
and it is now quite common for entities with large temporary cash
surpluses to arrange with their bank to have the money deposited in the
money markets (inter-bank market) or at money market interest rates

Money invested in a money market deposit cannot be withdrawn until
the deposit matures. It is therefore important that money should not be
invested for a period longer than the investor’s expected cash surplus.
Money market deposits can be for very short periods of time, as little as
one day, or for as long as several months (and even up to one year).
However, very short-term deposits should be large amounts of money,
so that the interest earned justifies the effort of making the deposits

Negotiable instruments are financial instruments that may be obtained as
investments. A key feature of negotiable instruments is that title passes when
the instrument is handed from one person to another. They are ‘bearer
instruments’, and ownership does not have to be recorded in a register of
owners. This means that a negotiable instrument can easily be sold by one
person to another or one entity to another.
Examples of negotiable instruments are:
 Bank notes
 Bearer bonds
 Certificates of Deposit
 Bills of exchange
 Treasury bills
The most important negotiable instruments as short-term investments are
Certificates of Deposit and Treasury bills, and bills of exchange (particularly
bank bills of high quality banks).

A Certificate of Deposit or CD is a negotiable instrument that provides
evidence of a short-term deposit with a bank for a fixed term and
earning a specified amount of interest. The maturity of the deposit is
usually 90 days or less, but can be longer. The amount deposited is at
least US$100,000 (or its equivalent in other currencies), but usually larger. The holder of the CD at maturity has the right to take the deposit with interest. The CD holder presents the CD at maturity to a recognised bank, which will then present the instrument to the bank holding the deposit, and arrange for the withdrawal of the deposit with interest. Until maturity, the money is ‘locked up’ with the bank, and cannot be withdrawn. When an organisation has a temporary cash surplus, it might arrange with its bank to place the money in a fixed term deposit account, and for the bank to issue a CD. The CD will state the identity of the bank, the amount deposited, the maturity date of the deposit and the interest that will accumulate.  The organisation can hold the CD until maturity and then claim the money.  Alternatively, if it needs cash before the deposit matures, it can sell the CD. There is an active secondary market in Certificates of Deposit, and a company can arrange for its bank to sell a CD on its behalf. Another company with a short-term cash surplus could either arrange its own Certificate of Deposit or purchase an existing CD in the secondary market. Investment yield on CDs Since Certificates of Deposit are negotiable instruments, they are more attractive investments than money market deposits from the point of view of liquidity. A CD holder can sell the CD to obtain funds quickly, whereas a money market deposit cannot be withdrawn until maturity. Yields on CDs are therefore slightly lower than interest yields on money market deposits.

The significance of bills of exchange as a short-term investment is that
they are negotiable instruments. There is an active money market for
bills of exchange (which is called the discount market) and investors
can buy bills. The market is particularly active in bills of exchange that
are payable by top-quality banks: in the UK these are sometimes called
‘eligible bank bills’.
The buyer of a bill of exchange obtains the right to receive payment by
the issuer of the bill when it matures. A bill of exchange is usually an
undertaking to pay a fixed sum of money at maturity, with no interest.
An investor in a bill will therefore buy the bill at a discount to face value
(and hence the right to receive the payment). Bills of exchange are
therefore examples of discount paper.
Although it is possible to buy bills of exchange that have been accepted
(and so are payable) by trading entities, investors place more value in
bank bills. These are bills of exchange that have been accepted by a
bank, and are payable by the bank. If the bank has a high credit status,
the risk of investing in its bills is very low.
Yields on bills vary according to the credit risk associated with the bill,
and an investor will be prepared to pay more for a top-quality bank bill
than for a trade bill with much higher credit risk.

Treasury bills are negotiable instruments issued by the government,
with a maturity of less than one year. In practice, most Treasury bills
have a maturity of three months (91 days). Treasury bills are used by a
government to finance short-term cash requirements, and in countries
such as the US and the UK, Treasury bills are issued at regular
intervals when investors are invited to apply to buy bills in the new
issue.
Since Treasury bills are debts of the government, they have a high
credit quality, risk is low, and yields for investors are also lower than for
many other short-term investments. Treasury bills issued by a
government and denominated in the domestic currency should be risk-
free. For example, US Treasury bills are risk-free investments, because
there is no doubt that the US government will redeem the debt at
maturity.
Treasury bills are redeemable at face value. For example, the US
government will redeem a 91-day $1,000 Treasury bill for $1,000 91
days after its issue. Since the bills are redeemable at par, investors pay
less than face value to buy them. Like bills of exchange, Treasury bills
are examples of discount paper.
Although yields on Treasury bills are relatively low, they can be
attractive short-term investments because of their risk-free nature and
their liquidity. There is a large and active secondary market in Treasury
bills, such as US Treasury bills in the US and UK government Treasury
bills in the UK.

Entities can invest temporary surplus cash in government bonds. If they do:
 they will receive interest on the due payment dates
 they can liquidate their investment at any time by selling the bonds in the
secondary market
 if the bonds are short-dated when purchased, they can hold the bonds to
maturity and have them redeemed at par
However, there is some price risk with bonds, particularly longer-dated bonds. If
interest rates change in the market, the market value of bonds will rise or fall.
Bond prices rise when interest rates fall, but prices fall when interest rates go
up. The movement in price is greater for longer-dated bonds.

This chapter has described the short-term investments that are most commonly
purchased or used by entities. There are other short-term investments such as:
 corporate bonds, and
 commercial paper (CP)
These are more likely to be purchased by investment institutions rather than by
entities with a short-term cash surplus

Corporate bonds are bonds issued by an entity. They are long-term
investments, and so unsuitable for investing a short-term cash surplus,
and they can also be a high risk investment. Bond prices fluctuate with
movements in the general level of interest rates, and corporate bond
values are also affected by the perceived credit risk of the entity issuing
the bonds.

Commercial paper consists of short-dated negotiable debt instruments
issued by an entity, and sold by a bank managing the entity's
commercial paper programme. In practice, although CP is negotiable, it
is generally purchased by large investment institutions and held to
maturity. It is not normally regarded as a suitable type of short-term
investment of cash surpluses by a trading entity