Let’s break down the important terms in this chapter in the simplest way possible. Imagine you are running a small shop or even managing your own personal finances. These terms will help you understand how businesses and people handle short-term financial obligations.
📌 1. Key Concepts of Managing Short-Term Finances
Current Liabilities
👉 Definition: Money a business owes and must pay within a year.
📝 Example:
- A store that buys goods on credit and needs to pay its supplier in 30 days.
- A person using a credit card and needing to pay the bill next month.
📌 2. Handling Supplier Payments (Accounts Payable Management)
Accounts Payable
👉 Definition: The money a business owes to suppliers for goods/services received but not yet paid for.
📝 Example:
- A restaurant buys vegetables from a supplier but pays for them after 2 weeks.
Accounts Payable Management
👉 Definition: A business strategy of deciding when to pay suppliers to optimize cash flow.
📝 Example:
- Paying early if there’s a discount.
- Paying just before the due date to hold onto cash longer.
📌 3. Understanding Payment Terms and Discounts
Credit Terms
👉 Definition: The conditions under which a seller allows a buyer to pay later.
📝 Example:
- A supplier offers “2/10, net 30”, meaning:
- 2% discount if paid in 10 days.
- Full price if paid within 30 days.
Cost of Giving Up a Cash Discount
👉 Definition: The extra cost you pay if you don’t take a discount for early payment.
📝 Example:
- If you owe $1,000 and can get a $20 discount for paying early but don’t, that’s like paying extra interest on your money.
Stretching Accounts Payable
👉 Definition: Deliberately delaying payments to suppliers to keep cash longer.
📝 Example:
- If a store has to pay its supplier in 30 days but delays it to 45 days without penalties, it holds cash longer.
⚠️ Risk: Suppliers might stop giving good deals or future credit.
📌 4. Borrowing Money for Short-Term Needs
Unsecured Short-Term Loans
👉 Definition: Loans given without collateral (no assets pledged).
📝 Example:
- A bank lends you money just based on trust and your ability to repay.
Types of Unsecured Loans:
1️⃣ Bank Loans – Borrowing from a bank with a promise to repay.
2️⃣ Lines of Credit – Pre-approved borrowing limits (like a credit card for businesses).
3️⃣ Commercial Paper – Large businesses borrow money by issuing short-term IOUs to investors.
📌 5. Borrowing Money with Collateral (Secured Loans)
Secured Short-Term Loans
👉 Definition: Loans where you pledge something valuable (collateral) to get money.
📝 Example:
- A company pledges its inventory (stock) or unpaid invoices to get a loan.
Pledging Accounts Receivable
👉 Definition: Using money customers owe you (unpaid invoices) as security for a loan.
📝 Example:
- A business is waiting for customers to pay but needs cash now, so it borrows using invoices as security.
Factoring Accounts Receivable
👉 Definition: Selling your unpaid invoices to another company for instant cash, but at a discount.
📝 Example:
- Instead of waiting for a customer to pay $1,000 in 30 days, a business sells the invoice for $950 now to get cash immediately.
Using Inventory as Collateral
👉 Definition: Borrowing money by pledging business stock (goods).
📝 Example:
- A car dealership borrows money using its unsold cars as security.
📌 6. Special Loan Agreements for Businesses
Line of Credit
👉 Definition: A bank pre-approves a business to borrow up to a certain amount.
📝 Example:
- A business has a $100,000 limit and can borrow as needed, paying interest only on what it uses.
Revolving Credit Agreement
👉 Definition: A more secure and guaranteed version of a line of credit.
📝 Example:
- A company can borrow anytime within a set period, even if banks are short on money.
Commitment Fee
👉 Definition: A fee paid to the bank for keeping credit available (even if not used).
📝 Example:
- A business has a $1M credit line but doesn’t use it. The bank still charges a small fee for keeping it open.
Compensating Balance
👉 Definition: A borrower must keep some money in the bank to qualify for a loan.
📝 Example:
- A company borrows $1M but must keep $100K in the bank as security.
📌 7. Borrowing Money for International Trade
Letter of Credit
👉 Definition: A bank guarantees a payment on behalf of a buyer to a foreign seller.
📝 Example:
- A Philippine company buys machines from Japan but the Japanese seller wants a guaranteed payment. The bank provides a letter of credit ensuring payment.
Netting (for International Transactions)
👉 Definition: Offsetting payments between business subsidiaries to avoid unnecessary money transfers.
📝 Example:
- A US company owes its Philippine branch $10,000, but the Philippine branch also owes the US $8,000. Instead of two transactions, they “net” it to $2,000.
📌 8. How Interest Works in Business Loans
Prime Rate of Interest
👉 Definition: The best interest rate banks offer to top borrowers.
📝 Example:
- A strong business might borrow at 6%, while a riskier one gets a higher rate like 10%.
Floating-Rate Loan
👉 Definition: A loan where interest changes with market rates.
📝 Example:
- If a bank loan starts at 5% interest and rates go up, the loan rate also increases.
Fixed-Rate Loan
👉 Definition: A loan where interest stays the same.
📝 Example:
- If you borrow at 6% interest, it stays 6% for the entire loan period.
Discount Loan
👉 Definition: A loan where interest is deducted upfront.
📝 Example:
- You borrow $10,000, but the bank gives you $9,000 upfront and keeps $1,000 as interest.
💡 Final Takeaways
📌 If you’re in business, understanding these terms helps you manage money wisely, borrow smartly, and avoid unnecessary costs.
📌 If you’re managing personal finances, these ideas help you make better credit decisions, avoid debt traps, and plan smarter financial moves.
Layman’s Guide to Financial Formulas in Current Liabilities Management
Understanding formulas can seem tricky, but I’ll break them down in the simplest way possible with real-life examples.
📌 1. Cost of Giving Up a Cash Discount
Formula:Cash Discount100−Cash Discount×365Extra Days of Credit\frac{\text{Cash Discount} }{100 – \text{Cash Discount}} \times \frac{365}{\text{Extra Days of Credit}}100−Cash DiscountCash Discount×Extra Days of Credit365
👉 What it means: If a supplier offers a discount for early payment, but you choose to pay later, this formula calculates the hidden cost of not taking the discount.
📝 Example:
- You buy $1,000 worth of goods with credit terms 2/10, net 30 (meaning a 2% discount if you pay in 10 days, or full price by 30 days).
- If you don’t take the discount, you’re delaying payment by 20 extra days (30 – 10).
Calculation:2100−2×36520=37.24% annual cost\frac{2}{100 – 2} \times \frac{365}{20} = 37.24\% \text{ annual cost}100−22×20365=37.24% annual cost
💡 Takeaway: If you don’t take the discount, it’s like paying 37.24% interest annually! If your bank loan interest is lower, you should borrow money to pay early and take the discount.
📌 2. Effective Annual Interest Rate (EAR) for Loans
Formula (When Interest is Paid at Maturity):Interest PaidLoan Amount\frac{\text{Interest Paid}}{\text{Loan Amount}}Loan AmountInterest Paid
👉 What it means: If you take a loan and pay interest at the end, this formula calculates the real cost of borrowing.
📝 Example:
- You borrow $10,000 at a 10% annual interest rate.
- After 1 year, you must repay $11,000 ($10,000 + $1,000 interest).
Calculation:1,00010,000=10% (Effective Annual Rate)\frac{1,000}{10,000} = 10\% \text{ (Effective Annual Rate)}10,0001,000=10% (Effective Annual Rate)
💡 Takeaway: If you borrow and pay interest later, your real cost is the same as the stated interest rate.
📌 3. Effective Annual Rate (EAR) for Discount Loans
Formula (When Interest is Paid in Advance):Interest PaidLoan Amount−Interest Paid\frac{\text{Interest Paid}}{\text{Loan Amount} – \text{Interest Paid}}Loan Amount−Interest PaidInterest Paid
👉 What it means: Some loans deduct interest upfront before giving you the money. This formula helps you see the real interest rate you’re paying.
📝 Example:
- You borrow $10,000 with a 10% interest rate, but the bank gives you only $9,000 (they deduct $1,000 upfront).
- You still have to pay back $10,000 at the end of the year.
Calculation:1,00010,000−1,000=1,0009,000=11.1% (Effective Annual Rate)\frac{1,000}{10,000 – 1,000} = \frac{1,000}{9,000} = 11.1\% \text{ (Effective Annual Rate)}10,000−1,0001,000=9,0001,000=11.1% (Effective Annual Rate)
💡 Takeaway: Paying interest upfront makes loans more expensive than they seem. A 10% loan actually costs 11.1% in this case!
📌 4. Effective Annual Rate (EAR) for Loans with Multiple Periods
Formula:(1+Periodic Interest Rate)Number of Periods per Year−1\left(1 + \text{Periodic Interest Rate} \right)^{\text{Number of Periods per Year}} – 1(1+Periodic Interest Rate)Number of Periods per Year−1
👉 What it means: If a loan charges interest multiple times a year, this formula finds the true yearly cost.
📝 Example:
- You get a 90-day loan (4 times a year) with a 1.85% interest per 90 days.
Calculation:(1+0.0185)4−1=7.73% (Effective Annual Rate)(1 + 0.0185)^{4} – 1 = 7.73\% \text{ (Effective Annual Rate)}(1+0.0185)4−1=7.73% (Effective Annual Rate)
💡 Takeaway: If a loan compounds multiple times a year, the real cost is higher!
📌 5. How to Calculate Commercial Paper Interest Rate
Formula:Face Value−Purchase PricePurchase Price×365Days Until Maturity\frac{\text{Face Value} – \text{Purchase Price}}{\text{Purchase Price}} \times \frac{365}{\text{Days Until Maturity}}Purchase PriceFace Value−Purchase Price×Days Until Maturity365
👉 What it means: Companies issue commercial paper (short-term IOUs) at a discount. This formula calculates the return for investors and the borrowing cost for companies.
📝 Example:
- A company issues $1,000,000 worth of commercial paper at a discounted price of $990,000 for 90 days.
Calculation:1,000,000−990,000990,000×36590=4.16% (Annual Rate)\frac{1,000,000 – 990,000}{990,000} \times \frac{365}{90} = 4.16\% \text{ (Annual Rate)}990,0001,000,000−990,000×90365=4.16% (Annual Rate)
💡 Takeaway: Companies borrow cheaper through commercial paper than bank loans.
📌 6. How to Calculate Inventory or Accounts Receivable Loans
Formula:Loan Amount=Collateral Value×Advance Rate\text{Loan Amount} = \text{Collateral Value} \times \text{Advance Rate}Loan Amount=Collateral Value×Advance Rate
👉 What it means: If a company borrows money using inventory or invoices, this formula tells how much they can get.
📝 Example:
- A company has $100,000 in inventory and the bank gives a 60% loan against it.
Calculation:100,000×0.60=60,000100,000 \times 0.60 = 60,000100,000×0.60=60,000
💡 Takeaway: If a business pledges inventory or invoices, they only get a percentage of the value as a loan.
📌 7. How to Calculate Loan Costs with a Compensating Balance
Formula:Interest PaidLoan Amount−Compensating Balance\frac{\text{Interest Paid}}{\text{Loan Amount} – \text{Compensating Balance}}Loan Amount−Compensating BalanceInterest Paid
👉 What it means: Some banks require businesses to keep money in an account while borrowing. This increases the real cost of the loan.
📝 Example:
- A company borrows $1,000,000 at 10% interest.
- The bank requires them to keep $200,000 in their account.
Calculation:100,0001,000,000−200,000=100,000800,000=12.5%\frac{100,000}{1,000,000 – 200,000} = \frac{100,000}{800,000} = 12.5\%1,000,000−200,000100,000=800,000100,000=12.5%
💡 Takeaway: If a bank makes you keep a compensating balance, your loan costs more than the stated rate!
📌 8. How to Calculate Loan Costs with a Commitment Fee
Formula:Total Cost=Interest Paid+Commitment FeeAmount Borrowed\text{Total Cost} = \frac{\text{Interest Paid} + \text{Commitment Fee}}{\text{Amount Borrowed}}Total Cost=Amount BorrowedInterest Paid+Commitment Fee
👉 What it means: If a business doesn’t use all of a loan, banks still charge a fee for keeping money available.
📝 Example:
- A company has a $2M revolving credit line but only uses $1.5M.
- The bank charges 0.5% on unused credit ($500K) as a commitment fee.
- Interest paid = $112,500
- Commitment fee = $2,500
Calculation:112,500+2,5001,500,000=7.67%\frac{112,500 + 2,500}{1,500,000} = 7.67\%1,500,000112,500+2,500=7.67%
💡 Takeaway: Unused credit lines still cost money!
💡 Final Thoughts: Why These Formulas Matter
📌 If you’re in business, these formulas help you calculate the true cost of loans, discounts, and borrowing decisions.
📌 If you’re in personal finance, they help you make better credit and payment decisions.
💬 Need help with a specific formula? Let me know! 😊
4o
O
Search
ChatGPT can make mistakes. Che
