SHORT-TERM FINANCING
Now we turn to short-term financing. In general, these forms of financing are classified as unsecured and secured. The cost of short-term financing is a function of many factors, including
(1) the prevailing interest rates,
(2) creditworthiness of borrower (credit rating),
(3) length of maturity of borrowing,
(4) level of seniority,
(5) collateral, and
(6) backup line of credit.
In comparing the cost of alternative short-term financing arrangements, the you must put the cost on an effective annual basis in order to facilitate this comparison. To do so, the you must consider any discount interest, compensating balance requirements (explained below), and fees.
Unsecured Financing
In some types of financing, the creditor is counting on being paid the promised interest and principal, relying on the general creditworthiness of the borrower. But other creditors want more assurance of being paid back. This assurance is provided in the form of the borrower's property specified to be transferred to the lender if the borrower fails to pay as promised.
A loan that is "backed" by specific property is a secured loan. A loan that is backed only by the general credit of the borrower is an unsecured loan. There are several different types of unsecured loans. We take a look at the more widely used types of unsecured credit: trade credit, bank loans, commercial paper, and bankers' acceptances.
1) Trade Credit
Trade credit is granted by a supplier to a customer purchasing goods or services. Trade credit arises spontaneously as the customer acquires goods or services and promises to pay some time in the future. From the seller's point of view, trade credit is a way of making more sales. From the customer's point of view, trade credit is an easy way to finance the purchase of goods. Once a satisfactory relationship is established between the seller and the customer, trade credit is granted automatically. For the seller, trade credit creates accounts receivable; for the customer, trade credit creates accounts payable.
2) Bank Financing
Banks lend money to firms under different financing arrangements. The financing arrangement may be straightforward, such as a single payment loan. Or a firm may obtain from a bank its promise to lend, such as a line of credit or revolving credit.
A single payment loan is the simplest short-term financing arrangement. In a single payment loan, the borrower negotiates a loan of a specific sum from the lender, usually a bank, and agrees to repay the loaned amount at the end of a specified period.
Short-term bank loans are generally self-liquidating. That is, they are used to acquire assets and the cash flows from these assets are sufficient to pay off the loan. Bank loans are represented in the form of a promissory note, which specifies the amount of the loan, the maturity date, and any interest. With single payment interest, the borrower receives the amount of the loan, paying back the full amount of the loan plus interest at maturity. The interest rate in a single payment loan may be either fixed or floating. Rates are often quoted relative to LIBOR or the prime rate. The prime rate is the rate banks charge their most creditworthy customers.
A line of credit is an agreement wherein a bank will make available to a firm a loan up to a specific limit—the "line"—if the firm requests these funds. The bank extends this line of credit for a specified period, typically one year.
A line of credit is a flexible source of credit. When a firm borrows under a line of credit, it takes out notes payable to the bank, which range in maturity from one to 90 days. A bank may require that the borrower "clean-up" the line—pay off the borrowings completely—for a specified period of time.
A line of credit may be uncommitted or committed. In an uncommitted line of credit, the bank makes a verbal agreement to lend funds up to the line within the specified period, but is not legally bound to do so. In a committed line of credit, the bank makes a written agreement to lend funds and is legally bound to do so under the terms of the line of credit. The cost of the line of credit comprises two costs. First, the borrower pays interest at a specified rate only on the funds borrowed and for the time borrowed. Second, if the agreement is a committed line of credit, the borrower pays either a commitment fee—from 1/4% to 1/2% of the unused portion of the line of credit—or must maintain a specified compensating balance for the period of the line of credit. A
compensating balance is a cash balance in a non-interest-bearing or low-interest-bearing account required by banks in exchange for banking services such as a bank loan. By keeping a balance in an account that is non-interest bearing or low-interest bearing, the borrower is effectively compensating the bank for the loan. In the case of the line of credit, the firm incurs some cost, though likely quite small, even if it does not borrow anything against the line.
In addition to the fee or compensating balance, there may be some covenants that limit the actions of the borrower. Covenants may require that the borrower provide financial statements periodically or that the certain financial ratios, such as a minimum interest coverage or current ratio, be satisfied. These covenants do not usually restrict the decision making of the borrower, but serve to protect the lender in extreme cases.
A revolving credit agreement is similar to a line of credit agreement, but is usually for a longer period—two to three years. The borrower can borrow and repay the credit many times within this period in a series of short-term notes. The cost of the revolving credit comprises two parts: (1) the commitment fee or compensating balance, and (2) the interest on any borrowings under the agreement. Unlike the line of credit, revolving credit agreements usually specify a floating rate. Typically, the borrower and lender renegotiate the revolving line of credit prior to maturity, insuring a continuous source of funds for the borrower.
3) Commercial Paper
Commercial paper is an unsecured promissory note with a fixed maturity issued by the borrower. Almost all commercial paper is backed up by a line of credit from a bank. If commercial paper is backed and the borrower is unable to pay the lender at maturity, the bank stands ready (for a fee) to lend the borrower funds to pay off the maturing paper.
Most commercial paper notes issued in the United States have maturities from 3 to 270 days, but average 30 days. This is because if a security has a maturity of more than 270 days, the issuer must register the security with the SEC. Doing so would delay the issuance and increase the cost of issuing the paper. Though these maturities are relatively short, some firms tend to use commercial paper for financing over longer periods of time. They do this by rolling over the paper—as the paper matures, they issue new commercial paper to pay off the maturing commercial paper.
Finance companies and nonfinancial companies issue commercial paper. Finance companies, such as General Motors Acceptance Corporation (GMAC) and C.I.T. Financial Corporation, are in the business of lending funds to consumers, usually for consumer durables such as automobiles. Finance companies tend to continually roll over their commercial paper since it is the major source of funds to use for their lending business. Non-financial companies tend to issue commercial paper to meet their seasonal financing needs.
Commercial paper is classified as either direct paper or dealer paper. Direct paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary. The vast majority of the issuers of direct paper are financial firms. Because financial firms require a continuous source of funds in order to provide loans to customers, they find it cost effective to establish a sales force to sell their commercial paper directly to investors. Direct issuers post rates at which they are willing to sell commercial paper with financial information vendors such as Bloomberg, Reuters, and Telerate. In the case of dealer-placed commercial paper, the issuer uses the services of a securities firm to sell its paper.
Although commercial paper is a short-term security, it is issued within a longer term program: U.S. commercial paper programs are often open-ended. For example, the CFO might establish a five-year commercial paper program with a limit of $300 million. Once the program is established, the company can issue commercial paper up to this amount. The program is continuous and new commercial paper can be issued at any time, daily if required.
4) Bankers' Acceptances
A bankers' acceptance is a bank's commitment to pay someone else's promise to pay a specified amount at a specified date as represented by a time draft.
With a bankers' acceptance, the bank is committing itself to making the specified payment at the maturity of the draft if the issuer of the draft does not pay. Bankers' acceptances are typically used in international trade, though they may be used domestically as well. They generally have maturities of less than 270 days. Although there are a variety of ways a bankers' acceptance can be arranged, the basic idea behind all of them is that a letter of credit is transformed into a financial instrument that can be bought and sold in the open market. The cost of a bankers' acceptance includes a commitment fee or commission for the commitment, and the interest rate on the loan if the bank makes the payment on behalf of the issuer.
A bankers' acceptance is similar to commercial paper. They both can be traded among investors, both have maturities of less than 270 days, and both generally have discount interest. But they differ in two ways. The first is the way in which they are created. The second is their risk. Commercial paper is backed by the issuer, which may have a backup line of credit; bankers' acceptance is backed by the issuer, yet the bank stands ready to pay the face value.
The lower risk on the bankers' acceptances results in slightly lower cost than the costs of commercial paper.
For more Information:
Financial Management Center
Tools & Techniques of Financial Planning, Strategic Corporate Finance, The Finance Controller's Function
Now we turn to short-term financing. In general, these forms of financing are classified as unsecured and secured. The cost of short-term financing is a function of many factors, including
(1) the prevailing interest rates,
(2) creditworthiness of borrower (credit rating),
(3) length of maturity of borrowing,
(4) level of seniority,
(5) collateral, and
(6) backup line of credit.
In comparing the cost of alternative short-term financing arrangements, the you must put the cost on an effective annual basis in order to facilitate this comparison. To do so, the you must consider any discount interest, compensating balance requirements (explained below), and fees.
Unsecured Financing
In some types of financing, the creditor is counting on being paid the promised interest and principal, relying on the general creditworthiness of the borrower. But other creditors want more assurance of being paid back. This assurance is provided in the form of the borrower's property specified to be transferred to the lender if the borrower fails to pay as promised.
A loan that is "backed" by specific property is a secured loan. A loan that is backed only by the general credit of the borrower is an unsecured loan. There are several different types of unsecured loans. We take a look at the more widely used types of unsecured credit: trade credit, bank loans, commercial paper, and bankers' acceptances.
1) Trade Credit
Trade credit is granted by a supplier to a customer purchasing goods or services. Trade credit arises spontaneously as the customer acquires goods or services and promises to pay some time in the future. From the seller's point of view, trade credit is a way of making more sales. From the customer's point of view, trade credit is an easy way to finance the purchase of goods. Once a satisfactory relationship is established between the seller and the customer, trade credit is granted automatically. For the seller, trade credit creates accounts receivable; for the customer, trade credit creates accounts payable.
2) Bank Financing
Banks lend money to firms under different financing arrangements. The financing arrangement may be straightforward, such as a single payment loan. Or a firm may obtain from a bank its promise to lend, such as a line of credit or revolving credit.
A single payment loan is the simplest short-term financing arrangement. In a single payment loan, the borrower negotiates a loan of a specific sum from the lender, usually a bank, and agrees to repay the loaned amount at the end of a specified period.
Short-term bank loans are generally self-liquidating. That is, they are used to acquire assets and the cash flows from these assets are sufficient to pay off the loan. Bank loans are represented in the form of a promissory note, which specifies the amount of the loan, the maturity date, and any interest. With single payment interest, the borrower receives the amount of the loan, paying back the full amount of the loan plus interest at maturity. The interest rate in a single payment loan may be either fixed or floating. Rates are often quoted relative to LIBOR or the prime rate. The prime rate is the rate banks charge their most creditworthy customers.
A line of credit is an agreement wherein a bank will make available to a firm a loan up to a specific limit—the "line"—if the firm requests these funds. The bank extends this line of credit for a specified period, typically one year.
A line of credit is a flexible source of credit. When a firm borrows under a line of credit, it takes out notes payable to the bank, which range in maturity from one to 90 days. A bank may require that the borrower "clean-up" the line—pay off the borrowings completely—for a specified period of time.
A line of credit may be uncommitted or committed. In an uncommitted line of credit, the bank makes a verbal agreement to lend funds up to the line within the specified period, but is not legally bound to do so. In a committed line of credit, the bank makes a written agreement to lend funds and is legally bound to do so under the terms of the line of credit. The cost of the line of credit comprises two costs. First, the borrower pays interest at a specified rate only on the funds borrowed and for the time borrowed. Second, if the agreement is a committed line of credit, the borrower pays either a commitment fee—from 1/4% to 1/2% of the unused portion of the line of credit—or must maintain a specified compensating balance for the period of the line of credit. A
compensating balance is a cash balance in a non-interest-bearing or low-interest-bearing account required by banks in exchange for banking services such as a bank loan. By keeping a balance in an account that is non-interest bearing or low-interest bearing, the borrower is effectively compensating the bank for the loan. In the case of the line of credit, the firm incurs some cost, though likely quite small, even if it does not borrow anything against the line.
In addition to the fee or compensating balance, there may be some covenants that limit the actions of the borrower. Covenants may require that the borrower provide financial statements periodically or that the certain financial ratios, such as a minimum interest coverage or current ratio, be satisfied. These covenants do not usually restrict the decision making of the borrower, but serve to protect the lender in extreme cases.
A revolving credit agreement is similar to a line of credit agreement, but is usually for a longer period—two to three years. The borrower can borrow and repay the credit many times within this period in a series of short-term notes. The cost of the revolving credit comprises two parts: (1) the commitment fee or compensating balance, and (2) the interest on any borrowings under the agreement. Unlike the line of credit, revolving credit agreements usually specify a floating rate. Typically, the borrower and lender renegotiate the revolving line of credit prior to maturity, insuring a continuous source of funds for the borrower.
3) Commercial Paper
Commercial paper is an unsecured promissory note with a fixed maturity issued by the borrower. Almost all commercial paper is backed up by a line of credit from a bank. If commercial paper is backed and the borrower is unable to pay the lender at maturity, the bank stands ready (for a fee) to lend the borrower funds to pay off the maturing paper.
Most commercial paper notes issued in the United States have maturities from 3 to 270 days, but average 30 days. This is because if a security has a maturity of more than 270 days, the issuer must register the security with the SEC. Doing so would delay the issuance and increase the cost of issuing the paper. Though these maturities are relatively short, some firms tend to use commercial paper for financing over longer periods of time. They do this by rolling over the paper—as the paper matures, they issue new commercial paper to pay off the maturing commercial paper.
Finance companies and nonfinancial companies issue commercial paper. Finance companies, such as General Motors Acceptance Corporation (GMAC) and C.I.T. Financial Corporation, are in the business of lending funds to consumers, usually for consumer durables such as automobiles. Finance companies tend to continually roll over their commercial paper since it is the major source of funds to use for their lending business. Non-financial companies tend to issue commercial paper to meet their seasonal financing needs.
Commercial paper is classified as either direct paper or dealer paper. Direct paper is sold by the issuing firm directly to investors without using a securities dealer as an intermediary. The vast majority of the issuers of direct paper are financial firms. Because financial firms require a continuous source of funds in order to provide loans to customers, they find it cost effective to establish a sales force to sell their commercial paper directly to investors. Direct issuers post rates at which they are willing to sell commercial paper with financial information vendors such as Bloomberg, Reuters, and Telerate. In the case of dealer-placed commercial paper, the issuer uses the services of a securities firm to sell its paper.
Although commercial paper is a short-term security, it is issued within a longer term program: U.S. commercial paper programs are often open-ended. For example, the CFO might establish a five-year commercial paper program with a limit of $300 million. Once the program is established, the company can issue commercial paper up to this amount. The program is continuous and new commercial paper can be issued at any time, daily if required.
4) Bankers' Acceptances
A bankers' acceptance is a bank's commitment to pay someone else's promise to pay a specified amount at a specified date as represented by a time draft.
With a bankers' acceptance, the bank is committing itself to making the specified payment at the maturity of the draft if the issuer of the draft does not pay. Bankers' acceptances are typically used in international trade, though they may be used domestically as well. They generally have maturities of less than 270 days. Although there are a variety of ways a bankers' acceptance can be arranged, the basic idea behind all of them is that a letter of credit is transformed into a financial instrument that can be bought and sold in the open market. The cost of a bankers' acceptance includes a commitment fee or commission for the commitment, and the interest rate on the loan if the bank makes the payment on behalf of the issuer.
A bankers' acceptance is similar to commercial paper. They both can be traded among investors, both have maturities of less than 270 days, and both generally have discount interest. But they differ in two ways. The first is the way in which they are created. The second is their risk. Commercial paper is backed by the issuer, which may have a backup line of credit; bankers' acceptance is backed by the issuer, yet the bank stands ready to pay the face value.
The lower risk on the bankers' acceptances results in slightly lower cost than the costs of commercial paper.
For more Information:
Financial Management Center
Tools & Techniques of Financial Planning, Strategic Corporate Finance, The Finance Controller's Function
Letter of Credits can be utilized via sight payment (immediate payment upon presentation of documents), negotiation drafts drawn by the Beneficiary, and acceptance. Acceptance hence is only one way of getting paid under an LC.
ReplyDeleteIn case you have any questions regarding letters of credit, please visit the Letter of Credit Forum which hosts several articles on international trade finance, sample documents, and a blog. Of course you can ask questions in the forum which is frequented by many banking experts.