ńňđ. 1
(âńĺăî 2)



Across the Disciplines

Why This Chapter Matters To You
Accounting: You need to understand how
to analyze supplier credit terms in order to
decide whether the firm should take or
give up cash discounts; you also need to
understand the various types of short-term

loans, both unsecured and secured, that
you will be required to record and report.
Information systems: You need to under-
stand what data the firm will need in order
to process accounts payable, track accru-
als, and meet bank loans and other short-

term debt obligations in a timely manner.
Management: You need to know the
sources of short-term loans so that if
short-term financing is needed, you will
understand its costs, both financial and
Marketing: You need to understand how
accounts receivable and inventory can be
used as loan collateral; the procedures
used by the firm to secure short-term
Review the key components of a
loans with such collateral could affect firm’s credit terms and the
customer relationships. procedures for analyzing them.
Operations: You need to understand the Understand the effects of stretching
use of accounts payable as a form of accounts payable on their cost, and
short-term financing and the effect on the use of accruals.
one’s suppliers of stretching payables; you
Describe the interest rates and basic
also need to understand the process by
types of unsecured bank sources of
which a firm uses inventory as collateral.
short-term loans.
Discuss the basic features of
commercial paper and the key
aspects of international short-term
Explain the characteristics of secured
short-term loans and the use of
accounts receivable as short-term-
loan collateral.
Describe the various ways in which
inventory can be used as short-term-
loan collateral.

529 529
530 PART 5 Short-Term Financial Decisions

A ccounts payable and accruals represent forms of spontaneous financing for
the firm. The longer the firm can hold the cash intended for those uses, the
longer it can use those funds for its own purposes. Firms typically, though, must
arrange for short-term loans to even out cash flows or to tide them over rough
spots. This chapter looks at various aspects of current liabilities management—
spontaneous liabilities and how best to manage them, and both unsecured and
secured sources of short-term loans.

Spontaneous Liabilities

Spontaneous liabilities arise from the normal course of business. The two major
spontaneous liabilities
spontaneous sources of short-term financing are accounts payable and accruals.
Financing that arises from the
normal course of business; the As the firm’s sales increase, accounts payable increase in response to the
two major short-term sources of
increased purchases necessary to produce at higher levels. Also in response to
such liabilities are accounts
increasing sales, the firm’s accruals increase as wages and taxes rise because of
payable and accruals.
greater labor requirements and the increased taxes on the firm’s increased earn-
ings. There is normally no explicit cost attached to either of these current liabili-
ties, although they do have certain implicit costs. In addition, both are forms of
unsecured short-term financing
unsecured short-term financing—short-term financing obtained without pledging
Short-term financing obtained
specific assets as collateral. The firm should take advantage of these “interest-
without pledging specific assets
free” sources of unsecured short-term financing whenever possible.
as collateral.

Accounts Payable Management
Accounts payable are the major source of unsecured short-term financing for
business firms. They result from transactions in which merchandise is purchased
but no formal note is signed to show the purchaser’s liability to the seller. The
purchaser in effect agrees to pay the supplier the amount required in accordance
with credit terms normally stated on the supplier’s invoice. The discussion of
accounts payable here is presented from the viewpoint of the purchaser.

Role in the Cash Conversion Cycle
The average payment period is the final component of the cash conversion cycle
introduced in Chapter 13. The average payment period has two parts: (1) the
time from the purchase of raw materials until the firm mails the payment and (2)
payment float time (the time it takes after the firm mails its payment until the
supplier has withdrawn spendable funds from the firm’s account). In the preced-
ing chapter, we discussed issues related to payment float time. Here we discuss
the management by the firm of the time that elapses between its purchase of raw
materials and its mailing payment to the supplier. This activity is accounts
accounts payable management
Management by the firm of the payable management.
time that elapses between its
The firm’s goal is to pay as slowly as possible without damaging its credit
purchase of raw materials and its
rating. This means that accounts should be paid on the last day possible, given
mailing payment to the supplier.
the supplier’s stated credit terms. For example, if the terms are net 30, then the
account should be paid 30 days from the beginning of the credit period, which is
CHAPTER 14 Current Liabilities Management

typically either the date of invoice or the end of the month (EOM) in which the
purchase was made. This allows for the maximum use of an interest-free loan
from the supplier and will not damage the firm’s credit rating (because the
account is paid within the stated credit terms).

In the demonstration of the cash conversion cycle in Chapter 13 (see page 497),
MAX Company had an average payment period of 35 days (consisting of 30
days until payment was mailed and 5 days of payment float), which resulted in
average accounts payable of $473,958. Thus the daily accounts payable gener-
ated by MAX was $13,542 ($473,958/35). If MAX were to mail its payments in
35 days instead of 30, its accounts payable would increase by $67,710
($13,542 5). As a result, MAX’s cash conversion cycle would decrease by 5
days, and the firm would reduce its investment in operations by $67,710.
Clearly, if this action did not damage MAX’s credit rating, it would be in the
company’s best interest.

Analyzing Credit Terms
The credit terms that a firm is offered by its suppliers enable it to delay payments
for its purchases. Because the supplier’s cost of having its money tied up in mer-
chandise after it is sold is probably reflected in the purchase price, the purchaser
is already indirectly paying for this benefit. The purchaser should therefore care-
fully analyze credit terms to determine the best trade credit strategy. If a firm is
extended credit terms that include a cash discount, it has two options—to take
the cash discount or to give it up.

Taking the Cash Discount If a firm intends to take a cash discount, it
should pay on the last day of the discount period. There is no cost associated with
taking a cash discount.

Lawrence Industries, operator of a small chain of video stores, purchased $1,000
worth of merchandise on February 27 from a supplier extending terms of 2/10
net 30 EOM. If the firm takes the cash discount, it must pay $980 [$1,000
(0.02 $1,000)] by March 10, thereby saving $20.

Giving Up the Cash Discount If the firm chooses to give up the cash dis-
count, it should pay on the final day of the credit period. There is an implicit cost
associated with giving up a cash discount. The cost of giving up a cash discount is
cost of giving up a cash discount
The implied rate of interest paid the implied rate of interest paid to delay payment of an account payable for an
to delay payment of an account additional number of days. In other words, the amount is the interest being paid
payable for an additional number
by the firm to keep its money for a number of days. This cost can be illustrated by
of days.
a simple example. The example assumes that payment will be made on the last
possible day (either the final day of the cash discount period or the final day of
the credit period).

In the preceding example, we saw that Lawrence Industries could take the cash
discount on its February 27 purchase by paying $980 on March 10. If
Lawrence gives up the cash discount, payment can be made on March 30. To
keep its money for an extra 20 days, the firm must give up an opportunity to
pay $980 for its $1,000 purchase. In other words, it will cost the firm $20 to
532 PART 5 Short-Term Financial Decisions

Firm Cash Discount Credit Period
Payment Options Makes Period Ends; Ends;
$1,000 Pay $980 Pay $1,000
Payment options for
Lawrence Industries


Feb. 27
Mar. 10 Mar. 30
Mar. 1
Cost of Additional 20 Days = $1,000 – $980 = $20

delay payment for 20 days. Figure 14.1 shows the payment options that are
open to the company.
To calculate the cost of giving up the cash discount, the true purchase price
must be viewed as the discounted cost of the merchandise, which is $980 for
Lawrence Industries. The annual percentage cost of giving up the cash discount
can be calculated using Equation 14.1:
CD 360
Cost of giving up cash discount (14.1)
100% CD

CD stated cash discount in percentage terms
N number of days that payment can be delayed by giving up the cash
Substituting the values for CD (2%) and N (20 days) into Equation 14.1 results
in an annualized cost of giving up the cash discount of 36.73% [(2% 98%)
(360 20)]. A 360-day year is assumed.
A simple way to approximate the cost of giving up a cash discount is to use
the stated cash discount percentage, CD, in place of the first term of Equa-
tion 14.1:
Approximate cost of giving up cash discount CD (14.2)
The smaller the cash discount, the closer the approximation to the actual cost of
giving it up. Using this approximation, the cost of giving up the cash discount for
Lawrence Industries is 36% [2% (360 20)].

Using the Cost of Giving Up a Cash Discount in Decision Making The
financial manager must determine whether it is advisable to take a cash discount.
Financial managers must remember that taking cash discounts may represent an
important source of additional profitability.
CHAPTER 14 Current Liabilities Management

TABLE 14.1 Cash Discounts and
Associated Costs for
Mason Products

cost of giving up
Supplier Credit terms a cash discount

A 2/10 net 30 EOM 36.0%
B 1/10 net 55 EOM 8.0
C 3/20 net 70 EOM 21.6
D 4/10 net 60 EOM 28.8

Mason Products, a large building-supply company, has four possible suppliers,
each offering different credit terms. Otherwise, their products and services are
identical. Table 14.1 presents the credit terms offered by suppliers A, B, C, and D
and the cost of giving up the cash discounts in each transaction. The approxima-
tion method of calculating the cost of giving up a cash discount (Equation 14.2)
has been used. The cost of giving up the cash discount from supplier A is 36%;
from supplier B, 8%; from supplier C, 21.6%; and from supplier D, 28.8%.
If the firm needs short-term funds, which it can borrow from its bank at an
interest rate of 13%, and if each of the suppliers is viewed separately, which (if
any) of the suppliers’ cash discounts will the firm give up? In dealing with sup-
plier A, the firm takes the cash discount, because the cost of giving it up is 36%,
and then borrows the funds it requires from its bank at 13% interest. With sup-
plier B, the firm would do better to give up the cash discount, because the cost of
this action is less than the cost of borrowing money from the bank (8% versus
13%). With either supplier C or supplier D, the firm should take the cash dis-
count, because in both cases the cost of giving up the discount is greater than the
13% cost of borrowing from the bank.

The example shows that the cost of giving up a cash discount is relevant
when one is evaluating a single supplier’s credit terms in light of certain bank
borrowing costs. However, other factors relative to payment strategies may also
need to be considered. For example, some firms, particularly small firms and
poorly managed firms, routinely give up all discounts because they either lack
alternative sources of unsecured short-term financing or fail to recognize the
implicit costs of their actions.

Effects of Stretching Accounts Payable
A strategy that is often employed by a firm is stretching accounts payable—that
stretching accounts payable
Paying bills as late as possible is, paying bills as late as possible without damaging its credit rating. Such a strat-
without damaging the firm’s
egy can reduce the cost of giving up a cash discount.
credit rating.

Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of
giving up the cash discount, assuming payment on the last day of the credit
period, was found to be approximately 36% [2% (360 20)]. If the firm were
534 PART 5 Short-Term Financial Decisions

In Practice
FOCUS ON ETHICS Amazon Stays Ethical
Top managers in a tiny central describing the critical role man- Consultancy Group, warns that this
Ohio company fret but say nothing agement of working capital plays unethical practice “can bite you in
publicly as a giant retailer routinely in the quest for profits, was quoted the rear end” as suppliers detect it
waits 120 days to pay its invoices in CFO magazine as saying, “This and simply jack up prices to
marked “due in 30 days.” The isn’t about trying to string our ven- counter the effect. The buyer’s
credit manager is quiet, partly dors out.” Amazon has negative average payment period repre-
because the company depends on net working capital (that is, its cur- sents its suppliers’ average collec-
this key account for survival and rent liabilities exceed current tion periods, after all.
partly because “stretching assets) but has chosen to employ Stretching payables is unethi-
payables” is the most widespread just-in-time inventory delivery from cal for two reasons. First, the
unethical practice in corporate book publishers—not delayed pay- buyer is violating the terms of its
America. ments—to reduce the need for trade credit agreement. Second,
Unlike the retailer above, short-term bank loans. One advan- the buyer is in effect doing addi-
e-tailer Amazon, despite its size tage of Amazon’s payables policy tional borrowing from its suppliers
and marketing success, pays its is that suppliers would be likely to without their knowledge or autho-
suppliers on time amidst intense work with Amazon should its cash rization. “Everybody’s doing it” is
pressures on it to become prof- position temporarily drop below never a valid excuse for trying to
itable. Amazon has changed strat- that needed to cover payables. add to shareholder wealth through
egy, emphasizing profitability over In economic downturns, com- such blatantly unethical behavior.
growth. In fact, during 2001 it panies face even greater tempta- Shareholder wealth maximization
reported its first profit—1¢ per tion to delay payments, and many is once again seen to be subject to
share. CFO Warren Jensen, do so. Stephen Payne, of REL ethical constraints.

able to stretch its account payable to 70 days without damaging its credit rating,
the cost of giving up the cash discount would be only 12% [2% (360 60)].
Stretching accounts payable reduces the implicit cost of giving up a cash discount.

Although stretching accounts payable may be financially attractive, it raises
an important ethical issue: It may cause the firm to violate the agreement it
entered into with its supplier when it purchased merchandise. Clearly, a supplier
would not look kindly on a customer who regularly and purposely postponed
paying for purchases.

The second spontaneous source of short-term business financing is accruals.
Accruals are liabilities for services received for which payment has yet to be
Liabilities for services received made. The most common items accrued by a firm are wages and taxes. Because
for which payment has yet to be
taxes are payments to the government, their accrual cannot be manipulated by
the firm. However, the accrual of wages can be manipulated to some extent. This
is accomplished by delaying payment of wages, thereby receiving an interest-free
loan from employees who are paid sometime after they have performed the work.
The pay period for employees who earn an hourly rate is often governed by union
regulations or by state or federal law. However, in other cases, the frequency of
payment is at the discretion of the company’s management.
CHAPTER 14 Current Liabilities Management

Tenney Company, a large janitorial service company, currently pays its employ-
ees at the end of each work week. The weekly payroll totals $400,000. If the firm
were to extend the pay period so as to pay its employees 1 week later throughout
an entire year, the employees would in effect be lending the firm $400,000 for a
year. If the firm could earn 10% annually on invested funds, such a strategy
would be worth $40,000 per year (0.10 $400,000).

Review Questions

14–1 What are the two major sources of spontaneous short-term financing for a
firm? How do their balances behave relative to the firm’s sales?
14–2 Is there a cost associated with taking a cash discount? Is there any cost
associated with giving up a cash discount? How do short-term borrowing
costs affect the cash discount decision?
14–3 What is “stretching accounts payable”? What effect does this action have
on the cost of giving up a cash discount?

Unsecured Sources of Short-Term Loans

Businesses obtain unsecured short-term loans from two major sources, banks and
commercial paper. Unlike the spontaneous sources of unsecured short-term
financing, bank loans and commercial paper are negotiated and result from
actions taken by the firm’s financial manager. Bank loans are more popular,
because they are available to firms of all sizes; commercial paper tends to be
available only to large firms. In addition, international loans can be used to
finance international transactions.

Bank Loans
Banks are a major source of unsecured short-term loans to businesses. The major
type of loan made by banks to businesses is the short-term, self-liquidating loan.
short-term, self-liquidating loan
An unsecured short-term loan in These loans are intended merely to carry the firm through seasonal peaks in
which the use to which the financing needs that are due primarily to buildups of inventory and accounts
borrowed money is put provides
receivable. As inventories and receivables are converted into cash, the funds
the mechanism through which
needed to retire these loans are generated. In other words, the use to which the
the loan is repaid.
borrowed money is put provides the mechanism through which the loan is
repaid—hence the term self-liquidating. Banks lend unsecured, short-term funds
in three basic ways: through single-payment notes, lines of credit, and revolving
credit agreements. Before we look at these types of loans, we consider loan inter-
est rates.

Loan Interest Rates
prime rate of interest (prime rate)
The lowest rate of interest
The interest rate on a bank loan can be a fixed or a floating rate, typically
charged by leading banks on
based on the prime rate of interest. The prime rate of interest (prime rate) is the
business loans to their most
lowest rate of interest charged by leading banks on business loans to their most
important business borrowers.
536 PART 5 Short-Term Financial Decisions

important business borrowers.1 The prime rate fluctuates with changing supply-
and-demand relationships for short-term funds.2 Banks generally determine the
rate to be charged to various borrowers by adding a premium to the prime rate
to adjust it for the borrower’s “riskiness.” The premium may amount to 4 per-
cent or more, although most unsecured short-term loans carry premiums of less
than 2 percent.

Fixed- and Floating-Rate Loans Loans can have either fixed or floating
interest rates. On a fixed-rate loan, the rate of interest is determined at a set incre-
fixed-rate loan
A loan with a rate of interest that ment above the prime rate on the date of the loan and remains unvarying at that
is determined at a set increment fixed rate until maturity. On a floating-rate loan, the increment above the prime
above the prime rate and at
rate is initially established, and the rate of interest is allowed to “float,” or vary,
which it remains fixed until
above prime as the prime rate varies until maturity. Generally, the increment
above the prime rate will be lower on a floating-rate loan than on a fixed-rate
floating-rate loan
loan of equivalent risk, because the lender bears less risk with a floating-rate
A loan with a rate of interest
loan. As a result of the volatile nature of the prime rate during recent years, today
initially set at an increment
most short-term business loans are floating-rate loans.
above the prime rate and allowed
to “float,” or vary, above prime as
Method of Computing Interest Once the nominal (or stated) annual rate is
the prime rate varies until
maturity. established, the method of computing interest is determined. Interest can be paid
either when a loan matures or in advance. If interest is paid at maturity, the effec-
tive (or true) annual rate—the actual rate of interest paid—for an assumed 1-year
period3 is equal to
Amount borrowed
Most bank loans to businesses require the interest payment at maturity.
When interest is paid in advance, it is deducted from the loan so that the bor-
discount loans
rower actually receives less money than is requested. Loans on which interest is
Loans on which interest is paid
paid in advance are called discount loans. The effective annual rate for a discount
in advance by being deducted
loan, assuming a 1-year period, is calculated as
from the amount borrowed.

Amount borrowed Interest
Paying interest in advance raises the effective annual rate above the stated
annual rate.

Wooster Company, a manufacturer of athletic apparel, wants to borrow $10,000
at a stated annual rate of 10% interest for 1 year. If the interest on the loan is
paid at maturity, the firm will pay $1,000 (0.10 $10,000) for the use of the

1. A trend away from using the prime rate as a benchmark has begun in the United States in response to various bor-
rower lawsuits against banks. Some banks now use the term base rate or reference rate rather than prime rate for
pricing corporate and other loans. In fact, the use of the London Interbank Offered Rate (LIBOR) is gaining
momentum as a base lending rate in the United States.
2. During the past 25 years, the prime rate has varied from a record high of 21.5% (December 1980) to a low of
4.75% (December 2001 through the middle of 2002). Since 1995, it has fluctuated in the range from a high of about
9.50% to a low of about 4.75%.
3. Effective annual rates (EARs) for loans with maturities of less than 1 year can be found by using the technique
presented in Chapter 4 for finding EARs when interest is compounded more frequently than annually. See
Equation 4.21.
CHAPTER 14 Current Liabilities Management

$10,000 for the year. Substituting into Equation 14.3 reveals that the effective
annual rate is therefore
If the money is borrowed at the same stated annual rate for 1 year but interest is
paid in advance, the firm still pays $1,000 in interest, but it receives only $9,000
($10,000 $1,000). The effective annual rate in this case is
$1,000 $1,000
$10,000 $1,000 $9,000
Paying interest in advance thus makes the effective annual rate (11.1%) greater
than the stated annual rate (10.0%).

Single-Payment Notes
A single-payment note can be obtained from a commercial bank by a creditwor-
single-payment note
A short-term, one-time loan made thy business borrower. This type of loan is usually a one-time loan made to a bor-
to a borrower who needs funds rower who needs funds for a specific purpose for a short period. The resulting
for a specific purpose for a short
instrument is a note, signed by the borrower, that states the terms of the loan,
including the length of the loan and the interest rate. This type of short-term note
generally has a maturity of 30 days to 9 months or more. The interest charged is
usually tied in some way to the prime rate of interest.

Gordon Manufacturing, a producer of rotary mower blades, recently borrowed
$100,000 from each of two banks—bank A and bank B. The loans were incurred
on the same day, when the prime rate of interest was 9%. Each loan involved a
90-day note with interest to be paid at the end of 90 days. The interest rate was
set at 11/2% above the prime rate on bank A’s fixed-rate note. Over the 90-day
period, the rate of interest on this note will remain at 10 1/2% (9% prime rate
1 1/2% increment) regardless of fluctuations in the prime rate. The total interest
cost on this loan is $2,625 [$100,000 (101/2% 90/360)]. The effective 90-day
rate on this loan is 2.625% ($2,625/$100,000).
Assuming that the loan from bank A is rolled over each 90 days throughout
the year under the same terms and circumstances, its effective annual interest rate
is found by using Equation 4.23. Because the loan costs 2.625% for 90 days, it is
necessary to compound (1 0.02625) for four periods in the year (that is,
360/90) and then subtract 1:
(1 0.02625)4 1
Effective annual rate
1.1092 1 0.1092 10.92%
The effective annual rate of interest on the fixed-rate, 90-day note is 10.92%.
Bank B set the interest rate at 1% above the prime rate on its floating-rate
note. The rate charged over the 90 days will vary directly with the prime rate. Ini-
tially, the rate will be 10% (9% 1%), but when the prime rate changes, so will
the rate of interest on the note. For instance, if after 30 days the prime rate rises
to 9.5%, and after another 30 days it drops to 9.25%, the firm will be paying
0.833% for the first 30 days (10% 30/360), 0.875% for the next 30 days
(10.5% 30/360), and 0.854% for the last 30 days (10.25% 30/360). Its total
538 PART 5 Short-Term Financial Decisions

interest cost will be $2,562 [$100,000 (0.833% 0.875% 0.854%)], result-
ing in an effective 90-day rate of 2.562% ($2,562/$100,000).
Again, assuming the loan is rolled over each 90 days throughout the year
under the same terms and circumstances, its effective annual rate is 10.65%:
(1 0.02562)4 1
Effective annual rate
1.1065 1 0.1065 10.65%
Clearly, in this case the floating-rate loan would have been less expensive than
the fixed-rate loan because of its generally lower effective annual rate.

Lines of Credit
A line of credit is an agreement between a commercial bank and a business speci-
line of credit
An agreement between a fying the amount of unsecured short-term borrowing the bank will make avail-
commercial bank and a business able to the firm over a given period of time. It is similar to the agreement under
specifying the amount of
which issuers of bank credit cards, such as MasterCard, Visa, and Discover,
unsecured short-term borrowing
extend preapproved credit to cardholders. A line-of-credit agreement is typically
the bank will make available to
made for a period of 1 year and often places certain constraints on the borrower.
the firm over a given period of
time. It is not a guaranteed loan but indicates that if the bank has sufficient funds avail-
able, it will allow the borrower to owe it up to a certain amount of money. The
amount of a line of credit is the maximum amount the firm can owe the bank at
any point in time.
When applying for a line of credit, the borrower may be required to submit
such documents as its cash budget, its pro forma income statement, its pro forma
balance sheet, and its recent financial statements. If the bank finds the customer
acceptable, the line of credit will be extended. The major attraction of a line of
credit from the bank’s point of view is that it eliminates the need to examine the
creditworthiness of a customer each time it borrows money.

Interest Rates The interest rate on a line of credit is normally stated as a
floating rate—the prime rate plus a premium. If the prime rate changes, the inter-
est rate charged on new as well as outstanding borrowing automatically changes.
The amount a borrower is charged in excess of the prime rate depends on its
creditworthiness. The more creditworthy the borrower, the lower the premium
(interest increment) above prime, and vice versa.

Operating-Change Restrictions In a line-of-credit agreement, a bank may
impose operating-change restrictions, which give it the right to revoke the line if
operating-change restrictions
Contractual restrictions that a any major changes occur in the firm’s financial condition or operations. The firm
bank may impose on a firm’s is usually required to submit up-to-date, and preferably audited, financial state-
financial condition or operations
ments for periodic review. In addition, the bank typically needs to be informed of
as part of a line-of-credit
shifts in key managerial personnel or in the firm’s operations before changes take
place. Such changes may affect the future success and debt-paying ability of the
firm and thus could alter its credit status. If the bank does not agree with the pro-
posed changes and the firm makes them anyway, the bank has the right to revoke
the line of credit.

Compensating Balances To ensure that the borrower will be a good cus-
tomer, many short-term unsecured bank loans—single-payment notes and lines
CHAPTER 14 Current Liabilities Management

of credit—require the borrower to maintain, in a checking account, a compensat-
compensating balance
ing balance equal to a certain percentage of the amount borrowed. Compensating
A required checking account
balance equal to a certain balances of 10 to 20 percent are frequently required. A compensating balance not
percentage of the amount
only forces the borrower to be a good customer of the bank but may also raise
borrowed from a bank under a
the interest cost to the borrower.
line-of-credit or revolving credit
Estrada Graphics, a graphic design firm, has borrowed $1 million under a line-of-
credit agreement. It must pay a stated interest rate of 10% and maintain, in its
checking account, a compensating balance equal to 20% of the amount bor-
rowed, or $200,000. Thus it actually receives the use of only $800,000. To use
that amount for a year, the firm pays interest of $100,000 (0.10 $1,000,000).
The effective annual rate on the funds is therefore 12.5% ($100,000
$800,000), 2.5% more than the stated rate of 10%.
If the firm normally maintains a balance of $200,000 or more in its checking
account, the effective annual rate equals the stated annual rate of 10% because
none of the $1 million borrowed is needed to satisfy the compensating-balance
requirement. If the firm normally maintains a $100,000 balance in its checking
account, only an additional $100,000 will have to be tied up, leaving it with
$900,000 of usable funds. The effective annual rate in this case would be 11.1%
($100,000 $900,000). Thus a compensating balance raises the cost of borrow-
ing only if it is larger than the firm’s normal cash balance.

Annual Cleanups To ensure that money lent under a line-of-credit agree-
ment is actually being used to finance seasonal needs, many banks require an
annual cleanup. This means that the borrower must have a loan balance of
annual cleanup
The requirement that for a zero—that is, owe the bank nothing—for a certain number of days during the
certain number of days during the year. Insisting that the borrower carry a zero loan balance for a certain period
year borrowers under a line of
ensures that short-term loans do not turn into long-term loans.
credit carry a zero loan balance
(that is, owe the bank nothing).
All the characteristics of a line-of-credit agreement are negotiable to some
extent. Today, banks bid competitively to attract large, well-known firms. A
prospective borrower should attempt to negotiate a line of credit with the most
favorable interest rate, for an optimal amount of funds, and with a minimum of
restrictions. Borrowers today frequently pay fees to lenders instead of maintain-
ing deposit balances as compensation for loans and other services. The lender
attempts to get a good return with maximum safety. Negotiations should pro-
duce a line of credit that is suitable to both borrower and lender.

Revolving Credit Agreements
revolving credit agreement
A revolving credit agreement is nothing more than a guaranteed line of credit. It is
A line of credit guaranteed to a
borrower by a commercial bank guaranteed in the sense that the commercial bank assures the borrower that a
regardless of the scarcity of
specified amount of funds will be made available regardless of the scarcity of
money. The interest rate and other requirements are similar to those for a line of
commitment fee credit. It is not uncommon for a revolving credit agreement to be for a period
The fee that is normally charged greater than 1 year. Because the bank guarantees the availability of funds, a com-
on a revolving credit agreement;
mitment fee is normally charged on a revolving credit agreement. This fee often
it often applies to the average
applies to the average unused balance of the borrower’s credit line. It is normally
unused balance of the borrower’s
about 0.5 percent of the average unused portion of the line.
credit line.
540 PART 5 Short-Term Financial Decisions

REH Company, a major real estate developer, has a $2 million revolving credit
agreement with its bank. Its average borrowing under the agreement for the past
year was $1.5 million. The bank charges a commitment fee of 0.5%. Because the
average unused portion of the committed funds was $500,000 ($2 million $1.5
million), the commitment fee for the year was $2,500 (0.005 $500,000). Of
course, REH also had to pay interest on the actual $1.5 million borrowed under
the agreement. Assuming that $160,000 interest was paid on the $1.5 million
borrowed, the effective cost of the agreement was 10.83% [($160,000
$2,500)/$1,500,000]. Although more expensive than a line of credit, a revolving
credit agreement can be less risky from the borrower’s viewpoint, because the
availability of funds is guaranteed.

Commercial Paper
Commercial paper is a form of financing that consists of short-term, unsecured
commercial paper
A form of financing consisting of promissory notes issued by firms with a high credit standing. Generally, only
short-term, unsecured promis-
quite large firms of unquestionable financial soundness are able to issue commer-
sory notes issued by firms with a
cial paper. Most commercial paper has maturities ranging from 3 to 270 days.
high credit standing.
Although there is no set denomination, it is generally issued in multiples of
$100,000 or more. A large portion of the commercial paper today is issued by
finance companies; manufacturing firms account for a smaller portion of this
type of financing. Businesses often purchase commercial paper, which they hold
as marketable securities, to provide an interest-earning reserve of liquidity.

Interest on Commercial Paper
Commercial paper is sold at a discount from its par, or face, value. The interest
paid by the issuer of commercial paper is determined by the size of the discount
and the length of time to maturity. The actual interest earned by the purchaser is
determined by certain calculations, illustrated by the following example.

Bertram Corporation, a large shipbuilder, has just issued $1 million worth of
commercial paper that has a 90-day maturity and sells for $980,000. At the end of
90 days, the purchaser of this paper will receive $1 million for its $980,000 invest-
ment. The interest paid on the financing is therefore $20,000 on a principal of
$980,000. The effective 90-day rate on the paper is 2.04% ($20,000/$980,000).
Assuming that the paper is rolled over each 90 days throughout the year, the effec-
tive annual rate for Bertram’s commercial paper, found by using Equation 4.23, is
8.41% [(1 0.0204)4 1].

An interesting characteristic of commercial paper is that its interest cost is
normally 2 to 4 percent below the prime rate. In other words, firms are able to
raise funds more cheaply by selling commercial paper than by borrowing from
a commercial bank. The reason is that many suppliers of short-term funds do
not have the option, as banks do, of making low-risk business loans at the
prime rate. They can invest safely only in marketable securities such as Treasury
bills and commercial paper. The yields on these marketable securities on May 1,
2002, when the prime rate of interest was 4.75 percent, were about 1.73 per-
cent for 3-month Treasury bills and about 1.80 percent for 3-month commer-
cial paper.
CHAPTER 14 Current Liabilities Management

Although the stated interest cost of borrowing through the sale of commer-
cial paper is normally lower than the prime rate, the overall cost of commercial
paper may not be less than that of a bank loan. Additional costs include the fees
paid by most issuers to obtain the bank line of credit used to back the paper, fees
paid to obtain third-party ratings used to make the paper more salable, and flota-
tion costs. In addition, even if it is slightly more expensive to borrow from a com-
mercial bank, it may at times be advisable to do so to establish a good working
relationship with a bank. This strategy ensures that when money is tight, funds
can be obtained promptly and at a reasonable interest rate.

International Loans
In some ways, arranging short-term financing for international trade is no differ-
ent from financing purely domestic operations. In both cases, producers must
finance production and inventory and then continue to finance accounts receiv-
able before collecting any cash payments from sales. In other ways, however, the
short-term financing of international sales and purchases is fundamentally differ-
ent from that of strictly domestic trade.

International Transactions
The important difference between international and domestic transactions is that
payments are often made or received in a foreign currency. Not only must a U.S.
company pay the costs of doing business in the foreign exchange market, but it
also is exposed to exchange rate risk. A U.S.-based company that exports goods
and has accounts receivable denominated in a foreign currency faces the risk that
the U.S. dollar will appreciate in value relative to the foreign currency. The risk to
a U.S. importer with foreign-currency-denominated accounts payable is that the
dollar will depreciate. Although exchange rate risk can often be hedged by using
currency forward, futures, or options markets, doing so is costly and is not possi-
ble for all foreign currencies.
Typical international transactions are large in size and have long maturity
dates. Therefore, companies that are involved in international trade generally
have to finance larger dollar amounts for longer time periods than companies
that operate domestically. Furthermore, because foreign companies are rarely
well known in the United States, some financial institutions are reluctant to lend
to U.S. exporters or importers, particularly smaller firms.

Financing International Trade
Several specialized techniques have evolved for financing international trade. Per-
haps the most important financing vehicle is the letter of credit, a letter written by
letter of credit
A letter written by a company’s a company’s bank to the company’s foreign supplier, stating that the bank guar-
bank to the company’s foreign antees payment of an invoiced amount if all the underlying agreements are met.
supplier, stating that the bank
The letter of credit essentially substitutes the bank’s reputation and creditworthi-
guarantees payment of an
ness for that of its commercial customer. A U.S. exporter is more willing to sell
invoiced amount if all the
goods to a foreign buyer if the transaction is covered by a letter of credit issued by
underlying agreements are met.
a well-known bank in the buyer’s home country.
Firms that do business in foreign countries on an ongoing basis often finance
their operations, at least in part, in the local market. A company that has an
542 PART 5 Short-Term Financial Decisions

assembly plant in Mexico, for example, might choose to finance its purchases of
Mexican goods and services with peso funds borrowed from a Mexican bank.
This not only minimizes exchange rate risk but also improves the company’s
business ties to the host community. Multinational companies, however, some-
times finance their international transactions through dollar-denominated loans
from international banks. The Eurocurrency loan markets allow creditworthy
borrowers to obtain financing on very attractive terms.

Transactions Between Subsidiaries
Much international trade involves transactions between corporate subsidiaries. A
U.S. company might, for example, manufacture one part in an Asian plant and
another part in the United States, assemble the product in Brazil, and sell it in
Europe. The shipment of goods back and forth between subsidiaries creates
accounts receivable and accounts payable, but the parent company has consider-
able discretion about how and when payments are made. In particular, the parent
can minimize foreign exchange fees and other transaction costs by “netting”
what affiliates owe each other and paying only the net amount due, rather than
having both subsidiaries pay each other the gross amounts due.

Review Questions

14–4 How is the prime rate of interest relevant to the cost of short-term bank
borrowing? What is a floating-rate loan?
14–5 How does the effective annual rate differ between a loan requiring inter-
est payments at maturity and another, similar loan requiring interest in
14–6 What are the basic terms and characteristics of a single-payment note?
How is the effective annual rate on such a note found?
14–7 What is a line of credit? Describe each of the following features that are
often included in these agreements: (a) operating-change restrictions; (b)
compensating balance; and (c) annual cleanup.
14–8 What is a revolving credit agreement? How does this arrangement differ
from the line-of-credit agreement? What is a commitment fee?
14–9 How is commercial paper used to raise short-term funds? Who can issue
commercial paper? Who buys commercial paper?
14–10 What is the important difference between international and domestic
transactions? How is a letter of credit used in financing international trade
transactions? How is “netting” used in transactions between subsidiaries?

Secured Sources of Short-Term Loans

When a firm has exhausted its sources of unsecured short-term financing, it may
secured short-term financing
be able to obtain additional short-term loans on a secured basis. Secured short-
Short-term financing (loan) that
term financing has specific assets pledged as collateral. The collateral commonly
has specific assets pledged as
takes the form of an asset, such as accounts receivable or inventory. The lender
CHAPTER 14 Current Liabilities Management

obtains a security interest in the collateral through the execution of a security
security agreement
The agreement between the agreement with the borrower that specifies the collateral held against the loan. In
borrower and the lender that addition, the terms of the loan against which the security is held form part of the
specifies the collateral held
security agreement. They specify the conditions required for the security interest
against a secured loan.
to be removed, along with the interest rate on the loan, repayment dates, and
other loan provisions. A copy of the security agreement is filed in a public office
within the state—typically, a county or state court. Filing provides subsequent
lenders with information about which assets of a prospective borrower are
unavailable for use as collateral. The filing requirement protects the lender by
legally establishing the lender’s security interest.

Characteristics of Secured Short-Term Loans
Although many people believe that holding collateral as security reduces the risk
of a loan, lenders do not usually view loans in this way. Lenders recognize that
holding collateral can reduce losses if the borrower defaults, but the presence of
collateral has no impact on the risk of default. A lender requires collateral to
ensure recovery of some portion of the loan in the event of default. What the
lender wants above all, however, is to be repaid as scheduled. In general, lenders
prefer to make less risky loans at lower rates of interest than to be in a position in
which they must liquidate collateral.

Collateral and Terms
Lenders of secured short-term funds prefer collateral that has a duration closely
matched to the term of the loan. Current assets—accounts receivable and inven-
tory—are the most desirable short-term-loan collateral, because they can nor-
mally be converted into cash much sooner than fixed assets. Thus the short-
term lender of secured funds generally accepts only liquid current assets as
Typically, the lender determines the desirable percentage advance to make
percentage advance
The percent of the book value of against the collateral. This percentage advance constitutes the principal of the
the collateral that constitutes the
secured loan and is normally between 30 and 100 percent of the book value of
principal of a secured loan.
the collateral. It varies according to the type and liquidity of collateral.
The interest rate that is charged on secured short-term loans is typically
higher than the rate on unsecured short-term loans. Lenders do not normally con-
sider secured loans less risky than unsecured loans. In addition, negotiating and
administering secured loans is more troublesome for the lender than negotiating
and administering unsecured loans. The lender therefore normally requires added
compensation in the form of a service charge, a higher interest rate, or both.

Institutions Extending Secured Short-Term Loans
The primary sources of secured short-term loans to businesses are commercial
banks and finance companies. Both institutions deal in short-term loans secured
commercial finance companies primarily by accounts receivable and inventory. The operations of commercial
Lending institutions that make
banks have already been described. Commercial finance companies are lending
only secured loans—both short-
institutions that make only secured loans—both short-term and long-term—to
term and long-term—to
businesses. Unlike banks, finance companies are not permitted to hold deposits.
544 PART 5 Short-Term Financial Decisions

Only when its unsecured and secured short-term borrowing power from the
commercial bank is exhausted will a borrower turn to the commercial finance
company for additional secured borrowing. Because the finance company gener-
ally ends up with higher-risk borrowers, its interest charges on secured short-
term loans are usually higher than those of commercial banks. The leading U.S.
commercial finance companies include the CIT Group and GE Capital.

The Use of Accounts Receivable as Collateral
Two commonly used means of obtaining short-term financing with accounts
receivable are pledging accounts receivable and factoring accounts receivable.
Actually, only a pledge of accounts receivable creates a secured short-term loan;
factoring really entails the sale of accounts receivable at a discount. Although fac-
toring is not actually a form of secured short-term borrowing, it does involve the
use of accounts receivable to obtain needed short-term funds.

Pledging Accounts Receivable
A pledge of accounts receivable is often used to secure a short-term loan. Because
pledge of accounts receivable
The use of a firm’s accounts accounts receivable are normally quite liquid, they are an attractive form of
receivable as security, or collat-
short-term-loan collateral.
eral, to obtain a short-term loan.

The Pledging Process When a firm requests a loan against accounts receiv-
able, the lender first evaluates the firm’s accounts receivable to determine their
desirability as collateral. The lender makes a list of the acceptable accounts, along
with the billing dates and amounts. If the borrowing firm requests a loan for a
fixed amount, the lender needs to select only enough accounts to secure the funds
requested. If the borrower wants the maximum loan available, the lender evalu-
ates all the accounts to select the maximum amount of acceptable collateral.
After selecting the acceptable accounts, the lender normally adjusts the dollar
value of these accounts for expected returns on sales and other allowances. If a
customer whose account has been pledged returns merchandise or receives some
type of allowance, such as a cash discount for early payment, the amount of the col-
lateral is automatically reduced. For protection from such occurrences, the lender
normally reduces the value of the acceptable collateral by a fixed percentage.
Next, the percentage to be advanced against the collateral must be deter-
A publicly disclosed legal claim
mined. The lender evaluates the quality of the acceptable receivables and the
on collateral.
expected cost of their liquidation. This percentage represents the principal of the
nonnotification basis
loan and typically ranges between 50 and 90 percent of the face value of accept-
The basis on which a
able accounts receivable. To protect its interest in the collateral, the lender files a
borrower, having
WW lien, which is a publicly disclosed legal claim on the collateral. For an example of
pledged an account W
the complete pledging process, see the book’s Web site at www.aw.com/gitman.
receivable, continues
to collect the account
payments without notifying
Notification Pledges of accounts receivable are normally made on a non-
the account customer.
notification basis, meaning that a customer whose account has been pledged as
notification basis collateral is not notified. Under the nonnotification arrangement, the borrower
The basis on which an account
still collects the pledged account receivable, and the lender trusts the borrower to
customer whose account has
remit these payments as they are received. If a pledge of accounts receivable is
been pledged (or factored) is
made on a notification basis, the customer is notified to remit payment directly to
notified to remit payment directly
the lender.
to the lender (or factor).
CHAPTER 14 Current Liabilities Management

Pledging Cost The stated cost of a pledge of accounts receivable is normally
2 to 5 percent above the prime rate. In addition to the stated interest rate, a ser-
vice charge of up to 3 percent may be levied by the lender to cover its administra-
tive costs. Clearly, pledges of accounts receivable are a high-cost source of short-
term financing.

Factoring Accounts Receivable
Factoring accounts receivable involves selling them outright, at a discount, to a
factoring accounts receivable
The outright sale of accounts financial institution. A factor is a financial institution that specializes in purchas-
receivable at a discount to ing accounts receivable from businesses. Some commercial banks and commercial
a factor or other financial
finance companies also factor accounts receivable. Although it is not the same as
obtaining a short-term loan, factoring accounts receivable is similar to borrowing
factor with accounts receivable as collateral.
A financial institution that
specializes in purchasing
Factoring Agreement A factoring agreement normally states the exact con-
accounts receivable from
ditions and procedures for the purchase of an account. The factor, like a lender
against a pledge of accounts receivable, chooses accounts for purchase, selecting
only those that appear to be acceptable credit risks. Where factoring is to be on a
continuing basis, the factor will actually make the firm’s credit decisions, because
this will guarantee the acceptability of accounts.4 Factoring is normally done on a
notification basis, and the factor receives payment of the account directly from
the customer. In addition, most sales of accounts receivable to a factor are made
on a nonrecourse basis. This means that the factor agrees to accept all credit
nonrecourse basis
The basis on which accounts risks. Thus, if a purchased account turns out to be uncollectible, the factor must
receivable are sold to a factor
absorb the loss.
with the understanding that the
Typically, the factor is not required to pay the firm until the account is col-
factor accepts all credit risks on
lected or until the last day of the credit period, whichever occurs first. The factor
the purchased accounts.
sets up an account similar to a bank deposit account for each customer. As pay-
ment is received or as due dates arrive, the factor deposits money into the seller’s
account, from which the seller is free to make withdrawals as needed.
In many cases, if the firm leaves the money in the account, a surplus will exist
on which the factor will pay interest. In other instances, the factor may make
advances to the firm against uncollected accounts that are not yet due. These
advances represent a negative balance in the firm’s account, on which interest is

Factoring Cost Factoring costs include commissions, interest levied on
advances, and interest earned on surpluses. The factor deposits in the firm’s
account the book value of the collected or due accounts purchased by the factor,
less the commissions. The commissions are typically stated as a 1 to 3 percent dis-
count from the book value of factored accounts receivable. The interest levied on
advances is generally 2 to 4 percent above the prime rate. It is levied on the actual

4. The use of credit cards such as MasterCard, Visa, and Discover by consumers has some similarity to factoring,
because the vendor that accepts the card is reimbursed at a discount for purchases made with the card. The differ-
ence between factoring and credit cards is that cards are nothing more than a line of credit extended by the issuer,
which charges the vendors a fee for accepting the cards. In factoring, the factor does not analyze credit until after the
sale has been made; in many cases (except when factoring is done on a continuing basis), the initial credit decision is
the responsibility of the vendor, not the factor that purchases the account.
546 PART 5 Short-Term Financial Decisions

amount advanced. The interest paid on surpluses is generally between 0.2 and 0.5
WW percent per month. An example of the factoring process is included on the book’s
Web site at www.aw.com/gitman.
Although its costs may seem high, factoring has certain advantages that make
it attractive to many firms. One is the ability it gives the firm to turn accounts
receivable immediately into cash without having to worry about repayment.
Another advantage of factoring is that it ensures a known pattern of cash flows.
In addition, if factoring is undertaken on a continuing basis, the firm can elimi-
nate its credit and collection departments.

The Use of Inventory as Collateral
Inventory is generally second to accounts receivable in desirability as short-term
loan collateral. Inventory normally has a market value that is greater than its
book value, which is used to establish its value as collateral. A lender whose loan
is secured with inventory will probably be able to sell that inventory for at least
book value if the borrower defaults on its obligations.
The most important characteristic of inventory being evaluated as loan col-
lateral is marketability, which must be considered in light of its physical proper-
ties. A warehouse of perishable items, such as fresh peaches, may be quite mar-
ketable, but if the cost of storing and selling the peaches is high, they may not be
desirable collateral. Specialized items, such as moon-roving vehicles, are not
desirable collateral either, because finding a buyer for them could be difficult.
When evaluating inventory as possible loan collateral, the lender looks for items
with very stable market prices that have ready markets and that lack undesirable
physical properties.

Floating Inventory Liens
A lender may be willing to secure a loan under a floating inventory lien, which is
floating inventory lien
a claim on inventory in general. This arrangement is most attractive when the
A secured short-term loan
against inventory under which firm has a stable level of inventory that consists of a diversified group of relatively
the lender’s claim is on the
inexpensive merchandise. Inventories of items such as auto tires, screws and
borrower’s inventory in general.
bolts, and shoes are candidates for floating-lien loans. Because it is difficult for a
lender to verify the presence of the inventory, the lender generally advances less
than 50 percent of the book value of the average inventory. The interest charge
on a floating lien is 3 to 5 percent above the prime rate. Commercial banks often
require floating liens as extra security on what would otherwise be an unsecured
loan. Floating-lien inventory loans may also be available from commercial
WW finance companies. An example of a floating lien is included on the book’s Web
trust receipt
site at www.aw.com/gitman.
inventory loan
A secured short-term loan
Trust Receipt Inventory Loans
against inventory under which
the lender advances 80 to 100
A trust receipt inventory loan often can be made against relatively expensive
percent of the cost of the
borrower’s relatively expensive automotive, consumer durable, and industrial goods that can be identified by ser-
inventory items in exchange for ial number. Under this agreement, the borrower keeps the inventory, and the
the borrower’s promise to repay
lender may advance 80 to 100 percent of its cost. The lender files a lien on all the
the lender, with accrued interest,
items financed. The borrower is free to sell the merchandise but is trusted to remit
immediately after the sale of
the amount lent, along with accrued interest, to the lender immediately after the
each item of collateral.
CHAPTER 14 Current Liabilities Management

sale. The lender then releases the lien on the item. The lender makes periodic
checks of the borrower’s inventory to make sure that the required amount of col-
lateral remains in the hands of the borrower. The interest charge to the borrower
is normally 2 percent or more above the prime rate.
Trust receipt loans are often made by manufacturers’ wholly owned financ-
ing subsidiaries, known as captive finance companies, to their customers. Captive
finance companies are especially popular in industries that manufacture con-
sumer durable goods, because they provide the manufacturer with a useful sales
tool. For example, General Motors Acceptance Corporation (GMAC), the
financing subsidiary of General Motors, grants these types of loans to its dealers.
Trust receipt loans are also available through commercial banks and commercial
finance companies.

Warehouse Receipt Loans
A warehouse receipt loan is an arrangement whereby the lender, who may be a
warehouse receipt loan
A secured short-term loan commercial bank or commercial finance company, receives control of the pledged
against inventory under which
inventory collateral, which is stored by a designated agent on the lender’s behalf.
the lender receives control of the
After selecting acceptable collateral, the lender hires a warehousing company to
pledged inventory collateral,
act as its agent and take possession of the inventory.
which is stored by a designated
Two types of warehousing arrangements are possible. A terminal warehouse
warehousing company on the
lender’s behalf. is a central warehouse that is used to store the merchandise of various customers.
The lender normally uses such a warehouse when the inventory is easily trans-
ported and can be delivered to the warehouse relatively inexpensively. Under a
field warehouse arrangement, the lender hires a field warehousing company to set
up a warehouse on the borrower’s premises or to lease part of the borrower’s
warehouse to store the pledged collateral. Regardless of which type of warehouse
is used, the warehousing company places a guard over the inventory. Only on
written approval of the lender can any portion of the secured inventory be
released by the warehousing company.
The actual lending agreement specifically states the requirements for the
release of inventory. As in the case of other secured loans, the lender accepts only
collateral that is believed to be readily marketable and advances only a portion—
generally 75 to 90 percent—of the collateral’s value. The specific costs of ware-
house receipt loans are generally higher than those of any other secured lending
arrangements because of the need to hire and pay a warehousing company to
guard and supervise the collateral. The basic interest charged on warehouse
receipt loans is higher than that charged on unsecured loans, generally ranging
from 3 to 5 percent above the prime rate. In addition to the interest charge, the
borrower must absorb the costs of warehousing by paying the warehouse fee,
which is generally between 1 and 3 percent of the amount of the loan. The bor-
rower is normally also required to pay the insurance costs on the warehoused
WW merchandise. An example of the procedures and costs of a warehouse receipt
loan is included on the book’s web site at www.aw.com/gitman.

Review Questions

14–11 Are secured short-term loans viewed as more risky or less risky than
unsecured short-term loans? Why?
548 PART 5 Short-Term Financial Decisions

14–12 In general, what interest rates and fees are levied on secured short-term
loans? Why are these rates generally higher than the rates on unsecured
short-term loans?
14–13 Describe and compare the basic features of the following methods of
using accounts receivable to obtain short-term financing: (a) pledging
accounts receivable, and (b) factoring accounts receivable. Be sure to
mention the institutions that offer each of them.
14–14 For the following methods of using inventory as short-term loan collat-
eral, describe the basic features of each, and compare their use: (a) float-
ing lien; (b) trust receipt loan; and (c) warehouse receipt loan.

Current liabilities represent an important and generally inexpensive source of financing for
a firm. The level of short-term (current liabilities) financing employed by a firm affects its
profitability and risk. Accounts payable are an inexpensive spontaneous source of short-
term financing. They should be paid as late as possible without damaging the firm’s credit
rating. This strategy will reduce the firm’s required investment in operating assets. If ven-
dors offer cash discounts, the firm must consider the economics of giving up versus taking
the discount. Accruals, another spontaneous liability, should be maximized because they
represent free financing. Notes payable, which represent negotiated short-term financing,
can be obtained from banks on an unsecured basis. They should be obtained at the lowest
cost under the best possible terms. Large, well-known firms can obtain unsecured short-
term financing through the sale of commercial paper. On a secured basis, the firm can
obtain loans from banks or commercial finance companies, using either accounts receivable
or inventory as collateral.
The financial manager must obtain the right quantity and form of current liabilities
financing in order to provide the lowest-cost funds with the least risk. Such a strategy
should positively contribute to the firm’s goal of maximizing the stock price.

deciding whether to take or give up a cash discount.
Review the key components of a firm’s credit
Cash discounts should be given up only when a firm
terms and the procedures for analyzing them.
in need of short-term funds must pay an interest
The major spontaneous source of short-term financ-
rate on borrowing that is greater than the cost of
ing is accounts payable, which are the primary
giving up the cash discount.
source of short-term funds. Accounts payable result
from credit purchases of merchandise. The key fea-
Understand the effects of stretching accounts
tures of this form of financing are summarized in
payable on their cost, and the use of accruals.
part I of Table 14.2. Credit terms may differ with
Stretching accounts payable can lower the cost of
respect to the credit period, cash discount, cash dis-
giving up a cash discount. This is because the firm
count period, and beginning of the credit period.
can keep its money longer if it gives up the discount.
The cost of giving up cash discounts is a factor in
Summary of Key Features of Common Sources of Short-Term Financing
TABLE 14.2

Type of
short-term financing Source Cost or conditions Characteristics

I. Spontaneous liabilities
Accounts payable Suppliers of No stated cost except when a cash discount is Credit extended on open account for 0 to 120 days.
merchandise offered for early payment. The largest source of short-term financing.

Accruals Employees and Free. Result because wages (employees) and taxes
government (government) are paid at discrete points in time
after the service has been rendered. Hard to manip-
ulate this source of financing.

II. Unsecured sources of short-term loans

Bank sources
(1) Single-payment notes Commercial banks Prime plus 0% to 4% risk premium—fixed or A single-payment loan used to meet a funds shortage
floating rate. expected to last only a short period of time.

(2) Lines of credit Commercial banks Prime plus 0% to 4% risk premium—fixed or A prearranged borrowing limit under which funds, if
floating rate. Often must maintain 10% to 20% available, will be lent to allow the borrower to meet
compensating balance and clean up the line seasonal needs.

(3) Revolving credit Commercial banks Prime plus 0% to 4% risk premium—fixed or A line-of-credit agreement under which the availa-
agreements floating rate. Often must maintain 10% to 20% bility of funds is guaranteed. Often for a period
compensating balance and pay a commitment fee greater than 1 year.
of approximately 0.5% of the average unused

Commercial paper Business firms— Generally 2% to 4% below the prime rate of An unsecured short-term promissory note issued by
both nonfinancial interest. the most financially sound firms.
and financial

Current Liabilities Management

Summary of Key Features of Common Sources of Short-Term Financing (continued)
TABLE 14.2

Type of
short-term financing Source Cost or conditions Characteristics

III. Secured sources of short-term loans
Accounts receivable
(1) Pledging Commercial banks 2% to 5% above prime plus up to 3% in fees. Selected accounts receivable are used as collateral.
and commercial Advance 50% to 90% of collateral value. The borrower is trusted to remit to the lender on
finance companies collection of pledged accounts. Done on a non-
notification basis.

(2) Factoring Factors, 1% to 3% discount from face value of factored Selected accounts are sold—generally without
commercial banks, accounts. Interest of 2% to 4% above prime recourse—at a discount. All credit risks go with the
and commercial levied on advances. Interest between 0.2% and accounts. Factor will lend (make advances) against
Short-Term Financial Decisions

finance companies 0.5% per month earned on surplus balances left uncollected accounts that are not yet due. Factor will
with factor. also pay interest on surplus balances. Typically
done on a notification basis.

Inventory collateral
(1) Floating liens Commercial banks 3% to 5% above prime. Advance less than 50% of A loan against inventory in general. Made when
and commercial collateral value. firm has stable inventory of a variety of inexpensive
finance companies items.

(2) Trust receipts Manufacturers’ 2% or more above prime. Advance 80% to 100% Loan against relatively expensive automotive,
captive financing of cost of collateral. consumer durable, and industrial goods that can be
subsidiaries, identified by serial number. Collateral remains in
commercial banks, possession of borrower, who is trusted to remit
and commercial proceeds to lender upon its sale.
finance companies

(3) Warehouse receipts Commercial banks 3% to 5% above prime plus a 1% to 3% warehouse Inventory used as collateral is placed under control
and commercial fee. Advance 75% to 90% of collateral value. of the lender either through a terminal warehouse or
finance companies through a field warehouse. A third party—a ware-
housing company—guards the inventory for the
lender. Inventory is released only on written
approval of the lender.
CHAPTER 14 Current Liabilities Management

Accruals, which result primarily from wage and tax On transactions between subsidiaries, “netting” can
obligations, are virtually free. The key features of be used to minimize foreign exchange fees and other
this spontaneous liability are summarized in part I transaction costs.
of Table 14.2.
Explain the characteristics of secured short-term
Describe the interest rates and basic types of loans and the use of accounts receivable as
unsecured bank sources of short-term loans. short-term-loan collateral. Secured short-term loans
Banks are the major source of unsecured short-term are those for which the lender requires collateral—
loans to businesses. The interest rate on these loans typically, current assets such as accounts receivable
is tied to the prime rate of interest by a risk pre- or inventory. Only a percentage of the book value of
mium and may be fixed or floating. It should be acceptable collateral is advanced by the lender. These
evaluated by using the effective annual rate. This loans are more expensive than unsecured loans; col-
rate is calculated differently, depending on whether lateral does not lower the risk of default, and
interest is paid when the loan matures or in increased administrative costs result. Both commer-
advance. Bank loans may take the form of a single- cial banks and commercial finance companies make
payment note, a line of credit, or a revolving credit secured short-term loans. Both pledging, which is the
agreement. The key features of the various types of use of accounts receivable as loan collateral, and fac-
bank loans are summarized in part II of Table 14.2. toring, which is the outright sale of accounts receiv-
able at a discount, involve the use of accounts receiv-
Discuss the basic features of commercial paper able to obtain needed short-term funds. The key
and the key aspects of international short-term features of loans using accounts receivable as collat-
loans. Commercial paper is an unsecured IOU eral are summarized in part III of Table 14.2.
issued by firms with a high credit standing. The key
features of commercial paper are summarized in Describe the various ways in which inventory
part II of Table 14.2. International sales and pur- can be used as short-term-loan collateral.
chases expose firms to exchange rate risk. They are Inventory can be used as short-term-loan collateral
larger and of longer maturity than typical transac- under a floating lien, a trust receipt arrangement, or
tions, and they can be financed by using a letter of a warehouse receipt loan. The key features of loans
credit, by borrowing in the local market, or through using inventory as collateral are summarized in part
dollar-denominated loans from international banks. III of Table 14.2.

SELF-TEST PROBLEM (Solution in Appendix B)
ST 14–1 Cash discount decisions The credit terms for each of three suppliers are shown
in the following table.

Supplier Credit terms

X 1/10 net 55 EOM
Y 2/10 net 30 EOM
Z 2/20 net 60 EOM

a. Determine the approximate cost of giving up the cash discount from each

ńňđ. 1
(âńĺăî 2)