Sources of Short-term finance

21/05/2020 1 By indiafreenotes

Bank overdraft

Bank overdraft is a temporary arrangement with the bank that allows the organization to overdraw from its current deposit account with the bank up to a certain limit. The overdraft facility is granted against securities, such as promissory notes, goods in stock, or marketable securities. The rate of interest charged on overdraft and cash credit is comparatively much higher than the rate of interest on bank deposits.

Commercial Paper:

Commercial paper is a form of financing which consists of short-term promissory notes which are unsecured and are sold in the money market. They are issued by large companies and pri­marily sold to other business firms, insurance companies, pension funds, and banks. Because they are unsecured and are sold in the money market, they are restricted in use to the most credit-worthy of the large companies.

Though the commercial paper market has a long history, much of its tremendous growth has occurred in recent years with increases in the installment financing of automo­biles and other consumer durable goods.

As credit tightens in terms of the banks’ ability to make loans, the commercial paper market increases. Many of the companies that issue these notes now look at this market as an alternative source of financing.

The Commercial Paper Market:

The commercial paper market includes a dealer distribution system and a system of direct placement. Most industrial firms, utilities, and medium-size finance companies utilize the dealer market to place their commercial paper.

Five major dealers com­prise the market, which purchases the paper from firms and then sells it to investors. Denominations of commercial paper range from Rs.25,000 to several rupees, and maturity runs from about two to six months, with an average of five months.

The cost of this paper is from 0.5 to 1 per cent below the prime lending rate. Considering that there are no compensating balance require­ments, the rate differential is still more significant. The commis­sion on the sale of paper runs from 0.125 of 1 per cent. Many firms are looking at this source of financing more in terms of a perma­nent source than as the traditional seasonal instrument.

Appraisal of the Commercial Paper Market:

Commercial paper is a much cheaper source of financing than short-term bank financing, as we have noted. Many companies are considering commercial paper as a supplement to bank credit. A company could make use of the paper market when the interest rate differential was large and borrow from the bank when the gap narrowed. This would result in the lowest borrowing cost to the firm in the short term.

Evidence has indicated that it is imperative for a firm not to impair its relations with a bank by using its services only during periods of extremely tight money, however. It is often suggested that a firm should have a backup line of credit with a bank to cover its borrowing position in the commercial paper market.

One factor which has helped the growth of the commercial paper market is a regulation that the maximum loan a national bank can make to a single borrower is 10 per cent of the bank’s capital and surplus. It is the perpetual need of short-term capital that has helped the commercial paper market to boom.

Factoring Accounts Receivable:

When a firm factors its account receivable, it actually sells them to a factor who actually buys the receivables. This may be done with or without recourse. With recourse, the factor can look to the seller of receivables for payment if there is a default on the pay­ment of the receivable. Without recourse, the factor cannot look to the seller of the receivables for collection in case of default.

The factor maintains a credit department which can undertake a credit check of a customer. If a firm sells without recourse, utilization of this service can allow it to forego the cost of main­taining a credit department of its own.

In this case, the factor assumes risk and bad-debt losses and all expenses associated with collecting slow accounts. The customer of the firm who is factor­ing the receivables may or may not be told of the factor agreement; this decision is made between the lender and the seller of the receivables.

Associated with the assumption of risk and servicing of the receivables is an added cost to the seller. Usually a fee is attached which runs from 1 to 3 per cent of the face value of the receivables. In addition, there will be interest charges for funds that are advanced before collection by the factor.

The cost of using a factor can be illustrated with the following example. A firm factors on the average Rs.100,000 per month for a year. The factor will lend 80 per cent of the face value of the receivables and will charge a factoring fee of 1 per cent of that face value.

In addition, the factor charges 1 per cent interest per month on the amount borrowed. The interest cost and the factoring fee are taken out in advance of all funds given to the firm. Assume that the firm borrows the full amount each month.

We can calcu­late the annual cost to the firm of utilizing the factoring service as shown in following equation:

Actual Cost Interest cost + Factoring fee / Actual rupees received

Inventory Financing:

Inventory is another asset that has considerable merit as collat­eral for short-term financing. The lender usually will advance only a specified percentage against the face value of the inventory. This loanable value is based on the type of inventory being consid­ered and the ability of the lender to dispose of it in case of default.

The more specialized the inventory and the market for the prod­uct, the more unwilling is the lender to advance a large percentage of the face value.

The more standard and salable the inventory, the higher the loan percentage. Frequently lenders will loan 90 per cent of the face value when they feel the inventory is standard and has a ready market, apart from the marketing organization of the borrower.

Lenders usually consider such items as marketability, perish­ability, market price stability, and difficulty in liquidating the inventory in determining the percentage value that they are will­ing to advance on an inventory loan.

The most important aspect of a lender’s analysis is to substantiate that there is enough liquidat­ing value in the inventory to cover the loan and accrued interest in case of default on the part of the borrower.

In addition, the lender must determine the ability of the borrower to service the debt by examining the cash flow structure of the firm. There are several ways in which inventory can be collateralized.

These methods are discussed below:

  1. Floating Lien:

A feature of the Uniform Commercial Code permits a borrower to pledge inventory “in general” as collateral against a loan, with­out specifying the inventory involved. This allows the lender to obtain a floating lien or claim against all of the borrower’s inven­tory. This type of arrangement is very difficult to police, and in general it is made only to provide extra security for a loan.

A floating lien can cover both receivables and inventory; thus it allows a lender to obtain a lien on the major part of the current assets of a firm. The floating lien also can cover both present and future inventory.

2. Chattel Mortgage:

A chattel mortgage provides for the borrower’s inventory to be identified specifically by a serial number or some other means. The borrower still holds title to the goods, but the lender has a lien or claim on the inventory. Under this arrangement, the lender has to give his consent before the inventory can be sold.

Any inven­tory that has a rapid turnover or is not readily identifiable would not be suited for this type of lien arrangement. Capital asset items such as machine tools and other heavy equipment are well suited for a chattel mortgage.

3. Trust Receptions:

With a trust receipt loan, the borrower holds both the inventory and the proceeds from the sale of inventory in trust for the lender. Consumer durable goods, automobiles, and equipment are good examples of the types of inventory that are well suited to serve as this form of collateral.

The automobile dealership system is an excellent example of how a trust receipt collateral system works. When automobiles are shipped to the dealer from the manufacturer, the lending institu­tion will pay the manufacturer under an arrangement made with the dealer. The dealer in turn signs a trust receipt agreement which specifies the handling of the inventory.

The dealer is allowed to sell the cars and must turn the proceeds over to the lender. Under the trust receipt arrangement, the inventory is serialized and is periodically audited by the lender. The purpose of the audit is to determine if any cars have been sold without the proceeds of the sale being remitted to the lender.

Each time a new batch of cars is acquired from the manufac­turer, a new trust receipt agreement is signed to take account of the new inventory. Though this method provides a wider margin of safety than a floating lien arrangement, there is always the possibility that a dealer will sell cars and not remit the proceeds to the lender in payment of the funds advanced.

4. Terminal Warehouse Receipt Loans:

Under another arrangement for using inventory as collateral for a loan, the borrower’s inventory is housed in a public, or terminal, Warehouse Company. A warehouse receipt which speci­fies the inventory located there provides the lender with a security interest in the inventory.

Because the goods in inventory can only be released on authorization by the lender, it can maintain strict control over the inflow and outflow of inventory. In addition, an insurance policy is usually issued which contains a loss-payable clause for the benefit of the lender.

The warehouse receipt can be in a negotiable or nonnegotiable form. If it is negotiable, the receipt can be transferred from one party to another by endorsement, but before the goods can be released the receipt must be presented to the warehouse man.

A nonnegotiable warehouse receipt is issued in favour of the lender, which has title to the goods and is the only one that can release them. The nonnegotiable receipt arrangement provides that the release of goods must be authorized in writing. Most arrange­ments are of the nonnegotiable form.

5. Field Warehouse Receipt Loans:

With the form of collateralization known as the field warehouse receipt loan, the inventory remains on the property of the bor­rower. A field warehouse company sets off a specific part of the borrower’s storage area in which to locate the inventory being used as collateral. Often this area is physically fenced off and only the field warehouse company has access to it.

Once the collateral value of the inventory is verified by the field warehouse company, the lender advances the funds. This arrangement is desirable when there is great expense involved in locating the inventory elsewhere, especially true when the borrower has a high inventory turnover ratio.

There is no question that the cost of this form of collateral financing is very high. This is primarily due to the cost of the warehouse company which acts as a third party in this arrange­ment.

The evidence of collateral is only as good as the warehouse company issuing the receipt. Historically there has been evidence indicating fraud in terms of the validity of the inventory actually being stored in a particular spot.