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DISCUSSION QUESTION 3
If you were CEO of a private company—so no public off ering of stocks or bonds have
occurred and there are no plans for public off erings—what would be your preferences
for your top three sources of fi nancing? Explain why you choose these three sources.
Applying Finance To...
• Institutions and Markets
We have seen in earlier chapters how
the fi nancial markets determine fi nancing rates. Interest rates facing
borrowers depend on the risk-free rate and a risk premium. Financial
institutions have developed many ways to meet the short-term fi nancing
needs of fi rms, including instruments off ering diff erent maturities,
security (collateral) requirements, and control, meaning who “super-
vises” the collateral arrangements.
516
C H A PT E R 1 6 Short-Term Business Financing
• Investments
Just as a capital market investor reviews a bond
issuer’s creditworthiness and a company’s share price appreciation
potential, similar care must be taken when analyzing a fi rm seeking a
short-term loan or other fi nancing arrangement. The primary concern
will be the fi rm’s ability to generate cash to repay the short-term loan.
Cash generation, not sales or accounting profi ts, will be paramount.
• Financial Management
Managers must balance the opportun-
ity cost of excess cash with the costs of paying short-term fi nancing
rates, and consider the dangers of a credit crunch when short-term
fi nancing dries up. A fi rm’s treasurer wants to maintain liquidity,
which includes the fi rm’s access to short-term fi nancing sources, at
all times.
Summary
LO 16.1
Working capital, it has been said, is the grease that keeps
the wheels turning in a company. Inventories are needed to meet cus-
tomer demand for the fi rm’s products. When they are sold, accounts
receivable are created that will one day be converted into cash. This
cash is used to pay suppliers, workers, creditors, taxes, and share-
holder dividends. A fi rm without working capital is a fi rm unlikely to
remain in business.
Two classes of working capital exist: permanent, the minimum
necessary for smooth company operations, and temporary, which
occurs because of seasonal or cyclical fl uctuations in sales demand.
A company fi nancing strategy that uses long-term sources to fi nance
its working capital is a conservative strategy that reduces profi ts but
increases liquidity. An aggressive strategy that uses more short-term
fi nancing has less liquidity but may increase company profi ts.
LO 16.2
Management decisions on how the fi rm should be fi nanced
are aff ected by several infl uences, including the characteristics of the
fi rm’s industry, its asset base, seasonality, sales cycles, and sales trends.
LO 16.3
A line of credit allows a business to borrow up to a stated
amount during the year for short-term fi nancing needs. To help
ensure the funds are for short-term purposes, the bank may require a
clean-up period during which the fi rm has no line of credit balances
outstanding. Whereas a line of credit can be withdrawn by the bank,
a revolving credit agreement is a guarantee the bank will make funds
available over a stated time frame. If a business is deemed to be too
risky for a conventional bank loan, the fi rm can seek a loan guarantee
for a bank loan from the Small Business Administration. In case of
default, the SBA will repay the part of the loan defaulted upon.
LO 16.4
One fi rm’s account receivable is another fi rm’s account pay-
able. Trade credit is nothing more than a fi rm’s accounts payable. As
a liability, it is a source of fi nancing to a fi rm, as the fi rm receives and
can use supplies (goods and/or services) and does not have to pay for
them immediately. As such, the trade credit helps to fi nance invent-
ory or whatever asset was purchased with the account payable. Com-
mercial fi nance companies can lend funds (secured or unsecured) as
do banks, but they are not banks as they don’t accept deposits. They
help fi nance receivables, inventory, and equipment purchases, such
as trucks and other industrial equipment. Commercial paper is basic-
ally an “IOU” sold by the most creditworthy fi rms to raise short-term
funds. Given the high credit rating of the issuers, they can fi nance
some short-term needs more cheaply with commercial paper than
from bank borrowing.
LO 16.5
Asset-backed fi nancing, such as pledging and factoring
receivables are usually higher-cost fi nancing sources, primarily
because smaller, less creditworthy fi rms rely on them for fi nancing.
In pledging, a fi rm uses its accounts receivable as collateral for a loan.
The loan, plus interest, is repaid as the receivables are collected from
customers. When receivables are factored, they are sold to the factor
and customer payments are directed to the factor. In most cases, the
factor takes on the risk of customer nonpayment—thus, the factor
will review the customer payment records and credit standing before
committing funds. In some cases, a business may outsource its credit
department to a factor, who in turn makes all the credit decisions
and sets the fi rm’s credit policy.
LO 16.6
The main considerations with inventory fi nancing are the
marketability of the items and how secure they are against theft
and spoilage. Inventory fi nancing ranges from trust receipts, where
inventory—such as cars and large home appliances—remains under
the borrower’s control, to warehouse receipts and fi eld warehouses,
where the lender takes control over inventory. In the latter case, inven-
tory isn’t released unless evidence is provided that it has been sold.
For smaller businesses, assets of the owner(s) may be required, in
some circumstances, as collateral or security for a loan. These assets
can include liquid securities, such as common stocks and bonds, or
assignment of life insurance policy cash value or the owner’s personal
guarantee (as co-maker) on the business loan.
LO 16.7
Firms have many possible sources of short-term fi nancing,
from bank loans (including lines of credit and revolving credit), to
commercial paper, to trade credit. The treasurer should use care to
evaluate the cost of each fi nancing source by calculating its eff ective
annual cost, by incorporating all interest charges and fees into the
analysis, and by comparing the principal of the loan with the usable
funds received.
Key Terms
advance factoring
asset-based lending
blanket inventory lien
commercial fi nance company
commercial paper
compensating balance
discounted loan
factor
fi eld warehouse
line of credit
maturity factoring
maturity-matching approach
net working capital
pledge
prime rate
revolving credit agreement
secured lending
trade discounts
trust receipt
warehouse receipt
working capital
Problems
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