Current Liabilities Management Prepared by Keldon Bauer Spontaneous Liabilities Spontaneous liabilities arise from the normal course of business The two major spontaneous liability sources are accounts payable and accruals As a firm s sales increase accounts payable and accruals increase in response to the increased purchases wages and taxes There is normally no explicit cost attached to either of these current liabilities Spontaneous Liabilities Accounts Payable Management Accounts payable are the major source of unsecured short term financing for business firms The average payment period has two parts The time from the purchase of raw materials until the firm mails the payment Payment float time the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm s account Spontaneous Liabilities Accounts Payable Management cont The firm s goal is to pay as slowly as possible without damaging its credit rating Spontaneous Liabilities Analyzing Credit Terms Credit terms offered by suppliers allow a firm to delay payment for its purchases However the supplier probably imputes the cost of offering terms in its selling price Therefore the firm should analyze credit terms to determine its best credit strategy If a cash discount is offered the firm has two options to take the cash discount or to give it up Spontaneous Liabilities Analyzing Credit Terms cont Taking the Cash Discount If a firm intends to take a cash discount it should pay on the last day of the discount period There is no cost associated with taking a cash discount Spontaneous Liabilities Analyzing Credit Terms cont Giving Up the Cash Discount If a firm chooses to give up the cash discount it should pay on the final day of the credit period The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days Spontaneous Liabilities Analyzing Credit Terms cont Giving Up the Cash Discount Spontaneous Liabilities Analyzing Credit Terms cont Giving Up the Cash Discount Discount 365 Cost 100 Discount Credit Period Discount Period 2 365 Cost 37 24 100 2 30 10 Spontaneous Liabilities Analyzing Credit Terms cont Giving Up the Cash Discount The preceding example suggest that the firm should take the cash discount as long as it can borrow from other sources for less than 37 24 Because nearly all firms can borrow for less than this even using credit cards they should always take the terms 2 10 net 30 Spontaneous Liabilities Analyzing Credit Terms cont Using the Cost of Giving Up the Cash Discount Spontaneous Liabilities Effects of Stretching Accounts Payable Stretching accounts payable simply involves paying bills as late as possible without damaging credit rating This can reduce the cost of giving up the discount Spontaneous Liabilities Accruals Accruals are liabilities for services received for which payment has yet to be made The most common items accrued by a firm are wages and taxes While payments to the government cannot be manipulated payments to employees can This is accomplished by delaying payment of wages or stretching the payment of wages for as long as possible Unsecured Sources of Short Term Loans Bank Loans The major type of loan made by banks to businesses is the short term self liquidating loan which are intended to carry firms through seasonal peaks in financing needs These loans are generally obtained as companies build up inventory and experience growth in accounts receivable As receivables and inventories are converted into cash the loans are then retired These loans come in three basic forms single payment notes lines of credit and revolving credit agreements Unsecured Sources of Short Term Loans Bank Loans cont Loan Interest Rates Most banks loans are based on the prime rate of interest which is the lowest rate of interest charged by the nation s leading banks on loans to their most reliable business borrowers Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrowers riskiness Unsecured Sources of Short Term Loans Bank Loans cont Fixed Floating Rate Loans On a fixed rate loan the rate of interest is determined at a set increment above the prime rate and remains at that rate until maturity On a floating rate loan the increment above the prime rate is initially established and is then allowed to float with prime until maturity Like ARMs the increment above prime is generally lower on floating rate loans than on fixed rate loans Unsecured Sources of Short Term Loans Bank Loans cont Method of Computing Interest Once the nominal stated rate of interest is established the method of computing interest is determined Interest can be paid either when a loan matures or in advance If interest is paid at maturity the effective true rate of interest assuming the loan is outstanding for exactly one year may be computed as follows Annual Interest Expense Effective Interest Amount Borrowed Unsecured Sources of Short Term Loans Bank Loans cont Method of Computing Interest If the interest is paid in advance it is deducted from the loan so that the borrower actually receives less money than requested Loans of this type are called discount loans The effective rate of interest on a discount loan assuming it is outstanding for exactly one year may be computed as follows Annual Interest Expense Effective Interest Amount Borrowed Annual Interest Expense Unsecured Sources of Short Term Loans Bank Loans cont Single Payment Notes A single payment note is a short term one time loan payable as a single amount at its maturity The note states the terms of the loan which include the length of the loan as well as the interest rate Most have maturities of 30 days to 9 or more months The interest is usually tied to prime and may be either fixed or floating Unsecured Sources of Short Term Loans Bank Loans cont Line of Credit LOC A line of credit is an agreement between a commercial bank and a business specifying the amount of unsecured short term borrowing the bank will make available to the firm over a given period of time It is usually made for a period of 1 year and often places various constraints on borrowers Although not guaranteed the amount of a LOC is the maximum amount the firm can owe the bank at any point in time Unsecured Sources of Short Term Loans Bank Loans cont Line of Credit LOC In order to obtain the LOC the borrower may