Introduction to Finance

DISCUSSION QUESTION 1
Select one of the fi rms from Figure 16.5 or Figure 16.6 and discuss how the issues 
reviewed in this section apply to the fi rm’s choice of short-term fi nancing strategy.
16.3
Providers of Short-Term Financing
Businesses can attempt to obtain short-term fi nancing from a number of diff erent providers 
and by a number of methods. Some sources are fi nancial institutions, such as banks, which 
lend to fi rms for working capital and long-term purposes (such as equipment loans). When 
a small business is deemed too risky for a bank loan, it may be able to obtain fi nancing with 
a government loan guarantee through the U.S. Small Business Administration (SBA). With 
respect to small business equity funding, the JOBS Act makes it easier for small businesses 
to raise equity.
Although many banks require a pledge of specifi c assets, the unsecured loan remains the 
primary type of loan arrangement. The stated rate on such loans is based on the bank’s 
prime 
rate
, or the interest rate a bank charges its most creditworthy customers. Interest rates on loans 
are typically stated in terms of the prime rate plus a risk diff erential, such as prime + 2 percent. 
Loan papers will call this “prime plus 2” (or simply P + 2). Higher-risk borrowers will have 
higher diff erentials in order to compensate the bank for lending to riskier customers.
Bank Lines of Credit
A business and a bank often have an agreement regarding the amount of credit the business 
will have at its disposal. The loan limit the bank establishes for each of its business customers 
is called a 
line of credit
. The cost for a line of credit is the interest rate for the period during 
which money is borrowed.
Under a line of credit, the business does not wait until money is needed to negotiate the 
loan. Rather, it fi les the necessary fi nancial statements and other evidences of fi nancial condi-
tion with the bank prior to the need for credit. The banker is interested in how well the business 
has fared in the past and its probable future because the line of credit is, typically, extended for 
a year at a time. The banker may require that other debts of the business be subordinated to, or 
come after, the bank claim. Banks usually require their business customers to “clean up” their 
lines of credit for a specifi ed period of time each year, meaning that they have no outstanding 
borrowing against the line of credit, usually for a minimum of two weeks. This ensures the line 
of credit is being used for short-term fi nancing purposes rather than for long-term needs.
Continued access to a line of credit may be subject to the bank’s approval if the business 
operation has major changes. A major shift or change in management personnel or in the manu-
facture or sale of particular products can infl uence a company’s future success. Hence, the bank, 
having contributed substantially to the business’s fi nancial resources, is interested in these activ-
ities. The bank may seek information on the business through organized credit bureaus, through 
contact with other businesses having dealings with the fi rm, and through other banks.