Topic 9: Financing Current Assets
Outlines:
I. Accruals and Accounts Payable
II. Short-Term Bank Loans
III. Commercial Paper
IV. Long-Term Financing
V. Alternative Financing Policies
VI. Choosing a Bank
I. Accruals and Accounts Payable
Firms do not pay salaries on a daily basis. This leads to some accrued wages. Similarly,
firms do not pay taxes on a daily basis. This leads to some accrued taxes.
Accrual is a “spontaneous” (i.e., automatic) source of financing because it arises from
ordinary business operations.
Usually, firms use all the accruals they can, but they usually have little control over the
levels of these accounts.
Accounts payable, or trade credit, is a debt that arises when firms make purchases on
credit.
Accounts payable is the largest single category of current liabilities, representing about
40% of current liabilities of the average non-financial firms.
-----------------------------------------------------------------------------------------------------------Question:
Why the use of accounts payable is so popular?
-----------------------------------------------------------------------------------------------------------Accounts payable is a “spontaneous” source of financing. However, the cost of using
accounts payable can be substantial.
Example:
Suppose that your firm makes a purchase and the term is 1/10, net 30. That is, if you pay
within 10 days, you receive 1% discount. If you do not take the discount, you ought to
pay within 30 days. The EAR (effective annual rate) of not taking the discount is:
EAR = (1 + (Discount/(1 – Discount))).^(365/(Net Day – Discount Day)) – 1
= (1 + (0.01/0.99)).^ (365/(30-10)) – 1
= 1.2013 – 1
= 20.13%
Some examples of the EARs for other terms:
Credit Terms
1/10, net 20
1/10, net 30
1/10, net 45
1/10, net 60
2/10, net 20
2/10, net 30
2/10, net 45
2/10, net 60
EAR
44.32%
20.13%
11.05%
7.61%
109.05%
44.59%
23.45%
15.89%
In principle, you take the discount if you can borrow at a rate that is lower than the EAR
calculated above.
Extra factor: if you are a powerful buyer and/or in a buyer’s market, you might be able to
stretch your accounts payable by deliberately paying late. If so, the cost of not taking the
discount may be lower than the EAR calculated above.
II. Short-Term Bank Loans
Banks provide “non-spontaneous” funds because a loan may not be automatically
approved.
These loans generally appear on balance sheets as notes payable, and usually have a
maturity of 90 days. When a loan is approved, the agreement is executed by signing a
promissory note. The note is essentially a contract that specifies (1) the amount
borrowed, (2) the interest rate, (3) the repayment schedule, (4) collateral (if any), and (5)
other terms and conditions.
Sometimes, banks require borrowers to maintain an average demand deposit (checking
account) balance equal to 10-20% of the loan. This is called a compensating balance.
When a firm establishes a good relationship with a bank, unsecured (i.e., no collaterals)
bank loans may be extended under a line of credit (an informal credit agreement). A line
of credit specifies the maximum amount of unsecured loans the bank will permit the firm
to own at any one time. Typically, the line of credit will be reviewed periodically,
particularly in March because at this time many firms complete their annual reports.
Large firms may use a formal line of credit, called a revolving credit arrangement. For
this, firms need to pay a small commitment fee; the interest rate is frequently pegged to
the prime rate. The difference between a formal and an informal line of credit is that the
bank has a legal obligation to honor a revolving credit arrangement.
A line of credit is usually used as a financing source to fund temporary shortfall in OCF
(think: seasonal cycle). A line of credit is not designed as a permanent source of
financing (i.e., this is not your credit card). There is often a cleanup clause that requires
the borrower to reduce the loan balance to zero at least once a year.
III. Commercial Paper
Commercial papers are (always) unsecured (read: no collaterals) promissory notes. They
are issued by large, well-established firms and sold to banks, pension funds, money
markets, etc. Commercial paper has a larger market than bank loans.
The maturity of a typical commercial paper ranges from 1 day to 9 months. The interest
rate is usually between T-bill rate and the prime rate.
-----------------------------------------------------------------------------------------------------------Question:
Holding other factors constant, a firm would prefer to issue commercial paper.
Borrowing from a bank is not that attractive. Why?
-----------------------------------------------------------------------------------------------------------Whenever a loan involves collaterals, the interest rate will be relatively high. The reason
for this is that the book-keeping costs associated with collaterals are considerable. As a
result, unsecured short-term debts usually have a lower interest rate. This makes
commercial paper a popular form of short-term financing.
When a firm does not have a good financial standing, it frequently needs to borrow with
the use of collaterals. For short-term borrowing, short-term assets are frequently used as
collaterals. The use of marketable securities usually leads to a lower interest rate because
they are liquid. The use of inventories or accounts receivable as collaterals usually leads
to a higher interest rate.
IV. Long-Term Financing
In general, firms use short-term (long-term) funds to finance short-term (long-term)
assets.
Firms may find that using long-term financing is more beneficial in some instances. For
example, when the yield curve is flat (i.e., the interest rates on long-term and short-debt
are similar), firms may want to lock in long-term debt.
There are two forms of long-term financing: equity and debt.
A firm is able to obtain financing by selling its shares. The firm can sell it to a venture
partner (venture capital). The firm is usually in a high-tech, high-risk, high-growth
business. The venture partner provides (1) money, (2) managerial know-how in
marketing, finance and other functional areas, (3) expertise to bring the firm to primary
market (Initial Public Offerings).
A private firm can sell its shares to private investors, say relatives and friends. A publicheld firm can sell its shares to the general public and this is called a seasoned equity
offering.
Pecking order theory (Myers, 1984): firms finance new investments first with retained
earnings, then with debt, and finally with outside equity.
The most popular form of long-term debt financing is issuing bonds. But this requires
economies of scale. Bonds could be secured or unsecured.
Long-term bank loans are less popular. But this is usually the only form of long-term
financing that small businesses are able to obtain. Long-term bank loans can be secured
or unsecured.
For long-term secured borrowing, long-term assets are usually used as collaterals such as
plants, lands, etc.
V. Alternative Financing Policies
Most Businesses experience seasonal fluctuations. NOWC is up (down) when the
business is strong (weak). NOWC therefore has two components: permanent and
temporary.
There are three financing policies to deal with this seasonality: maturity matching
approach, aggressive approach, and conservative approach (P.248, Figure 20-2).
Maturity matching: Fixed assets and permanent NOWC are financed by long-term debt
and equity; temporary NOWC is financed by short-term debt.
Aggressive: Fixed assets and part of permanent NOWC are financed by long-term debt
and equity; part of permanent NOWC and temporary NOWC are financed by short-term
debt.
Conservative: Fixed assets, permanent NOWC, and part of temporary NOWC are
financed by long-term debt and equity.
VI. Choosing a Bank
There are several factors need to be considered when your firm chooses a bank.
1. Location.
2. Fees and costs.
3. Advice, counsel, and specialization. There are services. You would like to have a
bank that knows your business (specialization) and is active in providing counsel.
4. Other services. Some banks provide cash management services, foreign exchange
services, trust and estate services, and the like.
5. The willingness to assume risks. If your firm is of high risk, you may want to try a
bank (1) whose deposits are growing, and (2) with broad diversification over geographic
regions. Banks with these characteristics tend to be more willing to assume risks.
6. Loyalty to customers. Banks differ in their support of borrowers in bad times.
7. Size of the bank. Usually, big firms deal with big banks. Small firms shop between
big and small banks.