There are two sources of short-term financing:
Bank Sources
Unsecured Loans: A form of debt for money borrowed that is not backed by the pledge of specific assets.
- Line of credit (L/C).
- A bank provides a letter of credit, for a fee, guaranteeing the investor that the company's obligation will be paid. It is a promise from a bank for payment in the event that certain conditions are met.
- It is frequently used to guarantee payment of an obligation.
- Committed lines of credit are stronger than those that are uncommitted because of the bank's formal commitment.
- Revolving credit agreement: A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.
- Banker's acceptance.
- These are short-term promissory trade notes for which a bank (by having "accepted them") promises to pay the holder the face amount at maturity.
- They are used to facilitate foreign trade or the shipment of certain marketable goods.
Secured Loans: A form of debt for money borrowed in which specific assets have been pledged to guarantee payment.
- Factoring accounts receivable. Factoring is the selling of receivables to a financial institution, the factor, usually "without recourse."
- A factor is often a subsidiary of a bank holding company.
- A factor maintains a credit department and performs credit checks on accounts.
- This type of loans allows a firm to eliminate its credit department and the associated costs.
- Contracts are usually for 1 year, but are renewable.
- Inventory-backed loans. Loan evaluations are made on the basis of marketability, price stability, perishability, and difficulty and expense of selling for loan satisfaction.
- Floating Lien: A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified.
- Trust Receipt: A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender.
- Terminal Warehouse Receipt: A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan.
Nonbank Sources
- Commercial paper.
- Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs).
- Cheaper than a short-term business loan from a commercial bank.
- Dealers often require a line of credit to ensure that the commercial paper is paid off.
- Nonbank finance companies.
The best mix of short-term financing depends on:
- Cost of the financing method;
- Availability of funds;
- Timing;
- Flexibility;
- Degree to which the assets are encumbered.
Cost of Borrowing
The fundamental rule is to compute the total cost of borrowing and divide that by the net proceeds.
- Collect basis: interest is paid at maturity of the note.
- Example: $100,000 loan at 10% stated interest rate for 1 year.
- $10,000 in interest / $100,000 in usable funds = 10.00%.
- Discount basis: interest is deducted from the initial loan.
- Example: $100,000 loan at 10% stated interest rate for 1 year.
- $10,000 in interest / $90,000 in usable funds = 11.11%.
- Compensating balances: demand deposits maintained by a firm to compensate a bank for services provided, credit lines, or loans.
- Example: $1,000,000 loan at 10% stated interest rate for 1 year with a required $150,000 compensating balance.
- $100,000 in interest / $850,000 in usable funds = 11.76%.
- Commitment fees: The fee charged by the lender for agreeing to hold credit available on the unused portions of credit.
Example
$1 million revolving credit at 10% stated interest rate for 1 year; borrowing for the year was $600,000; a required 5% compensating balance on borrowed funds; and a .5% commitment fee on $400,000 of unused credit. What is the cost of borrowing?
Interest: ($600,000) x (10%) = $60,000
Commitment Fee: ($400,000) x (0.5%) = $2,000
Compensating Balance: ($600,000) x (5%) = $30,000
Usable Funds: $600,000 - $30,000 = $570,000
Cost = ($60,000 in interest + $2,000 in commitment fees) / $570,000 in usable funds = 10.88%