– Short-term financing is best considered a function of the company’s line of business and maturity matching. The firm should plan to use short-term financing as required by the business being pursued, with the condition that such financing is best done in association with short-term investments, for balance of risk and return.
– There are policies that must be set for such a system to be run with optimality.
– One consideration is the extent to which payables (creditors) are managed efficiently as a separate unit.
– When a firm takes advantage of credit extended by a vendor (known as trade credit), there is usually a set of payment conditions associated. Almost always these conditions have a time when final payment is due, but also a (shorter) time during which payment would produce a discount from the market price of what has been bought.
– Usually these payment terms are described by a phrase such as 2/10 net 30 which signifies that there is a 2% discount for payment within 10 days of invoicing and that payment beyond that is at full market price and is due in 30 days.
– The proper standard to judge when to pay is the cost of financing the money that would be used to pay early, or the interest rate on such short term borrowing.
– This interest cost is composed of an annualised discount percentage given for early payment. The formula is:
i = (1 + [discount % / (1 – discount %)]365/discount days
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