There are several sources of short-term funding available to a company, from both bank and non-bank sources, and we list the most important of these here.
Sources of Short-Term Funding from Banks
Lines of credit are used primarily by large, financially sound companies.
• Uncommitted line ofcredit. A bank extends an offer of credit for a certain amount but may refuse to lend if circumstances change.
• Committed (regulal) line ofcredit.A bank extends an offer of credit that it "commits to" for some period of time. The fact that the bank has committed to extend credit in amounts up to the credit line makes this a more reliable source of short-term funding than an uncommitted line of credit. Banks charge a fee for making such a commitment. Loans under the agreement are typically for periods of less than a year and interest charges are stated in terms of a short-term reference rate, such as LIBOR or the U.S. prime rate, plus a margin to compensate for the credit risk of the loan. Outside the U.S., similar arrangements are referred to asoverdraft lines of credit.
• A revolving line ofcreditis an even more reliable source of short-term financing than a committed line of credit. Revolving lines of credit are typically for longer terms than a committed line of credit, sometimes as long as years. Along with committed lines of credit, revolving credit lines can be verified and can be listed on a firm's financial statements in the footnotes as a source of liquidity.
Companies with weaker credit may have to pledge assets as collateral for bank
borrowings. Fixed assets, inventory, and accounts receivable may all serve as collateral
Study Session 11 Cross-Reference to CFA Institute Assigned Reading #46 - Working Capital Management and longer-term loans are secured with a claim to fixed (1onger-term) assets. The bank
may also have a blanket lien which gives it a claim to all current and future firm assets as collateral in case the primary collateral is insufficient and the borrowing firm defaults. When a firm assigns its receivables to the bank making a loan, the company still services the receivables and remains responsible for any receivables that are not paid.
Banker's acceptances are used by firms that export goods. A banker's acceptance is a guarantee from the bank of the firm that has ordered the goods stating that a payment will be made upon receipt of the goods. The exporting company can then sell this acceptance at a discount in order to generate immediate funds.
Factoring refers to the actual sale of receivables at a discount from their face values.
The size of the discount will depend on how long it is until the receivables are due, the creditworthiness of the firm's credit customers, and the firm's collection history on its receivables. The "factor" (the buyer of the receivables) takes on the responsibility for collecting receivables and the credit risk of the receivables portfolio.
Non-bank Sources of Shott-term Funding
Smaller firms and firms with poor credit may use nonbank finance companies for short- term funding. The cost of such funding is higher than other sources and is used by firms for which normal bank sources of short-term funding are not available.
Large, creditworthy companies can issue short-term debt securities called commercial paper. Whether the firm sells the paper directly to investors (direct placement) or sells it through dealers (dealer-placed paper), the interest costs are typically slightly less than the rate they could get from a bank.
In managing its short-term financing, a firm should focus on the objectives of having sufficient sources of funding for current as well as future foreseeable cash needs, and should seek the most cost-effective rates available given its needs, assets, and
creditworthiness. The firm should have the ability to prepay short-term borrowings when cash flow permits and have the flexibility to structure its short-term financing so that the debt matures without peaks and can be matched to expected cash flows. For large borrowers it is important that the firm has alternative sources of short-term funding and even alternative lenders for a particular type of financing. It is often worth having slightly higher overall short-term funding costs in order to have flexibility and redundant sources of financing.
Study Session 11
Cross-Reference to CFA Institute Assigned Reading #46 - Working Capital Management
KEy CONCEPTS
1. Short-term liquidity can be assessed using the current ratio, current assets/current liabilities, and the quick ratio,
(cash + marketable securities + receivables)/current liabilities.
2. Working capital management can be evaluated using the days of payables, days of receivables, and days of inventory.
3. The operating cycle is receivables days + inventory days. The cash conversion cycle is receivables days + inventory days - payables days.
4. Companies establish minimum acceptable cash levels and prepare cash flow forecasts for short (days, weeks), medium (months), and long (three to five years) horizons using recent results, statistical modeling, and projections of future balance sheets (capital spending and investment) and income statements (cash generated from operations).
5. Managing a firm's cash position can involve both investment in short-term securities when cash balances are higher than necessary and short-term borrowing when they are not.
6. Annualized yields on short-term pure discount securities can be calculated using simple annualization as percentage discount-basis yields (360 days), as money market yields (360 days), or as bond equivalent yields (365 days).
7. The overall objective of short-term cash management is to earn a reasonable return while taking on only very limited credit and liquidity risk.
8. An investment policy statement should include the objectives of the cash management program, details of who is authorized to purchase securities, authorization for the purchase of specific types of securities, limitations on portfolio proportions of each type, and procedures in the event that guidelines are violated.
9. A firm's inventory, receivables, and payables management can be evaluated by comparing days of inventory, days of receivables, and days of payables for the firm over time, and by comparing them to averages for peer companies. An aging schedule and weighted average days of receivables can provide additional detail for evaluating receivables management.
10. There are many choices for short-term borrowing. The firm should keep costs down while also allowing for future flexibility and alternative sources. Such funding sources as commercial paper, bank lines of credit, collateralized borrowing, nonbank financing, and factoring may be available, depending on the firm's size and creditworthiness.
Study Session 11 Cross-Reference to CFA Institute Assigned Reading #46 - Working Capital Management
CONCEPT CHECKERS '
1. Firm A and Firm B have the same quick ratio but Firm A has a greater current ratio than Firm B. Compared to Firm B, it is most likelythat Firm A has:
A. a higher inventory turnover ratio.
B. a higher receivables turnover ratio.
C. greater payables.
D. greater inventory.
2. An increase in Rowley Corp's cash conversion cycle and a decrease in Rowley's operating cycle could result from:
Cash conversion cyclei Operating cycle ,j,
A. Decreased receivables turnover Increased payables turnover B. Decreased receivables turnover Decrease in days of inventory C. Increased inventory turnover Increased payables turnover D; Increased inventory turnover Decrease in days of inventory
3. Which of the following is most likelyto increase the amount of cash needed for the next forecasting period, other things equal?
A. An increase in expected depreciation next period.
B. An increase in dividends to be received next period.
C. A reduction in payables at the end of next period.
D. A decrease in accruals at the end of next period.
4. Boyle Inc. just purchased a banker's acceptance for $25,400. Itwill mature in 80 days for $26,500. The discount-basis yield and the bond equivalent yield for this security are closestto:
Discount-basis Bond equivalent
A. 18.7% 18.7%
B. 18.7% 19.8%
C. 4.2% 18.7%
D. 4.2% 19.8%
5. Blodnick Corp. has found that its weighted average collection period has increased from 45 days last year to 55 days this year, and its average days of receivables this year is 13 compared to 22 last year. It is most likelythat:
A. Blodnick has relaxed its credit standards this year.
B. fewer of Blodnick's customers are taking advantage of discounts for early payment.
C. Blodnick's credit customers are paying more slowly this year.
D. credit sales are a greater part of Blodnick's- business this year.
6. Chapmin Corp. is a large domestic services firm with a good credit rating. The source of short-term financing it would most likely use is:
A. factoring of receivables.
B. issuing commercial paper.
Study Session 11
Cross-Reference to CFA Institute Assigned Reading #46 - Working Capital Management
1. D Inventory is in the numerator of the current ratio but not in the quick ratio. Greater inventory for Firm A is consistent with a greater current ratio for Firm A.
2. B A decrease in receivables turnover would increase days of receivables and increase the cash conversion cycle. A decrease in days of inventory would decrease the operating cycle.
3. C A decrease in estimated payables, holding other things constant, means that more accounts payable will actually be paid, requiring more cash. Neither a decrease in accruals nor an increase in depreciation has cash flow effects. An increase in expected dividends to be received would tend to decrease the amount of cash needed over the period.
4. B The actual discount on the acceptance is (26,500 - 25,400)/26,500= 4.151 %. The annualized discount, or discount-basis yield, is 4.151(360/80) =18.68%.
The holding period yield is (26,500 - 25,400)/25,400 =4.331 %. The bond equivalent yield is4.331(365/80)=19.76%.
5. C Outstanding accounts are paying more slowly since the average collection period is up.
Blodnick has less credit sales outstanding since days of receivables are down, so credit sales are asmaLLer part of Blodnick's business. Relaxed credit standards would tend to increase average days of receivables. The proportion of Blodnick's customers, taking advantage of early payment discounts cannot be reliably inferred from the information given.
6. B Large firms with good credit have access to the commercial paper market and can get lower financing costs with commercial paper than they can with bank borrowing.
Banker's acceptances are used by companies involved in international trade. Factoring of receivables is a higher-cost source of funds and is used more by smaller firms that do not have particularly strong credit.
The following is a review of the Corporate Finance principles designedto address the learning outcome statements set forth byCFA Institute®. This topic is also covered in: