Short-Term Financing

Short-term (operating) expenditures have a time frame of less than one year and cover everyday business activities — payroll, inventory, utilities. Short-term financing sources match these short-term needs.

How It Appears Per Course

ADMN 201

Three main sources of short-term financing:

graph TD
    A[Short-Term Financing] --> B[1. Trade Credit]
    A --> C[2. Secured Short-Term Loans]
    A --> D[3. Unsecured Short-Term Loans]
    B --> B1[Open-Book Credit]
    B --> B2[Promissory Notes]
    B --> B3[Trade Draft / Acceptance]
    C --> C1[Collateral Required]
    C --> C2[Promissory Note Signed]
    D --> D1[Line of Credit]
    D --> D2[Revolving Credit Agreement]
    D --> D3[Commercial Paper]

(diagram saved)

Source 1: Trade Credit

Trade credit = the granting of credit by a selling firm to a buying firm. Accounts payable are not just an expense — they are also a source of funds, because the firm uses both the goods AND the money until the bill is due. Effectively a short-term loan from your supplier.

Three forms of trade credit:

Form	How it works
Open-book credit	Most common. Informal agreement — goods shipped with invoice; buyer pays later on faith
Promissory note	Legally binding signed document stating when and how much will be paid; signed before goods are shipped
Trade draft / trade acceptance	Seller attaches document to shipment; buyer must sign the draft to take possession. Once signed = trade acceptance. Useful in international trade.

Source 2: Secured Short-Term Loans

A secured loan requires the borrower to put up collateral — an asset the lender can seize if the loan is not repaid. The borrower signs a promissory note agreeing to repay.

Common types of collateral:

Accounts receivable — the firm’s outstanding customer invoices
Inventory — physical goods on hand

The lender’s security = they can sell the collateral if the borrower defaults. This lowers the risk to the lender, which typically means lower interest rates than unsecured loans.

Source 3: Unsecured Short-Term Loans

An unsecured loan requires no collateral. However, lenders often require a compensating balance — the borrower must keep a portion of the loan on deposit with the bank in a non-interest-bearing account. This effectively raises the real cost of the loan.

Three types of unsecured short-term loans:

Line of Credit

A standing agreement between a bank and a firm where the bank specifies the maximum it will lend on short notice. The firm can draw funds up to that limit whenever needed.

Firm knows in advance it has access to funds
Bank regards the firm as creditworthy
No guarantee that the funds will actually be available (unlike revolving credit)
Example: Scotiabank grants Greenway Gardening a $100,000 line of credit for the year

Revolving Credit Agreement

Like a line of credit, but guaranteed — the lending institution promises funds will be available when needed. In exchange, the borrower pays a commitment fee:

Fee = 0.5% to 1% of the committed amount
Charged on the unused portion of the credit line
Borrower pays interest on borrowed funds AND a fee on unused funds

Example: RBC agrees to lend Greenway up to $100, 000 u n d er a re v o l v in g cre d i t a g ree m e n t . I f G ree n w a y b orro w s$ 80,000, it still has access to $20, 000. I f i tp a ys d o w n$ 50,000, $70, 000 i s a g aina v ai l ab l e . G ree n w a y p a ys in t eres t o n$ 80,000 and a fee on the $20,000 it hasn’t used.

Commercial Paper

A method of short-term fundraising available only to the largest and most creditworthy firms (banks won’t back it — it’s backed only by the issuer’s promise to pay).

How it works:

Corporation issues commercial paper with a face value
Buyers purchase it at a discount (below face value)
At the end of the specified period (30–270 days, typically 30–90), the issuer buys it back at face value
The difference = the buyer’s interest earned

Example: Air Canada needs $10 M f or 90 d a ys . I t i ss u esco mm erc ia lp a p er w i t ha f a ce v a l u eo f$ 10.2M. An insurance company buys it for $10 M . A f t er 90 d a ys, A i r C ana d a p a ys$ 10.2M. The insurance company earns $200, 000 o na$ 10M investment.

Key Points for Exam/Study

Three sources: trade credit, secured loans, unsecured loans — know all three categories and their subtypes
Trade credit is the most common form of short-term business financing
Secured = collateral; Unsecured = no collateral, but may need compensating balance
Line of credit ≠ revolving credit agreement: line is not guaranteed; revolving is (but costs a commitment fee)
Commercial paper: only for large creditworthy firms; sold at discount, repurchased at face value ≤ 270 days
Compensating balance raises the real cost of an unsecured loan
Trade draft → signed by buyer → becomes trade acceptance

Cross-Course Connections

LongTermFinancing — contrast with long-term sources
FinancialManager — short-term financing tools used in cash-flow management

Open Questions

How does a firm decide between a line of credit and a revolving credit agreement? (Cost of commitment fee vs. certainty of access)

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ShortTermFinancing