ISBN: 0-03-028931-9
Chapter 17 Financing Current Assets
This chapter examined the types of credit that can be used to finance current assets. The key concepts covered are listed below.
Permanent current assets are those current assets that the firm holds even during slack times, whereas temporary current assets are the additional current assets that are needed during seasonal or cyclical peaks. The methods used to finance permanent and temporary current assets define the firm's current asset financing policy.
A moderate approach to current asset financing, also called a maturity matching approach, involves matching, to the extent possible, the maturities of assets and liabilities, so that temporary current assets are financed with short-term non-spontaneous debt, and permanent current assets and fixed assets are financed with long-term debt or equity, plus spontaneous debt. Under an aggressive approach, some permanent current assets, and perhaps even some fixed assets, are financed with short-term debt. A conservative approach would be to use long-term capital to finance all permanent assets and some of the temporary current assets.
Short-term credit is defined as any liability originally scheduled for payment within one year. The four major sources of short-term credit are (1) accruals, (2) accounts payable, (3) loans from commercial banks and finance companies, and (4) commercial paper.
The advantages of short-term credit are (1) the speed with which short-term loans can be arranged, (2) increased flexibility, and (3) the fact that short- term interest rates are generally lower than long-term rates. The principal disadvantage of short-term credit is the extra risk the borrower must bear because (1) the lender can demand payment on short notice and (2) the cost of the loan will increase if interest rates rise.
Accruals, which are continually recurring short-term liabilities, represent free, spontaneous credit.
Accounts payable, or trade credit, is the largest category of short-term debt. Trade credit arises spontaneously as a result of credit purchases. Firms should use all the free trade credit they can obtain, but they should use costly trade credit only if it is less expensive than other forms of short-term debt. Suppliers often offer discounts to customers who pay within a stated discount period. The following equation may be used to calculate the nominal cost, on an annual basis, of not taking discounts:
Bank loans are an important source of short-term credit. Interest on bank loans may be quoted as simple interest, discount interest, or add-on interest. The effective rate on a bank loan always exceeds the quoted nominal rate except for a simple interest loan where the interest is paid once a year.
When a bank loan is approved, a promissory note is signed. It specifies: (1) the amount borrowed, (2) the percentage interest rate, (3) the repayment schedule, (4) the collateral, and (5) any other conditions to which the parties have agreed.
Banks sometimes require borrowers to maintain compensating balances, which are deposit requirements set at between 10 and 20 percent of the loan amount. Compensating balances raise the effective interest rate on bank loans.
A line of credit is an informal agreement between the bank and the borrower indicating the maximum amount of credit the bank will extend to the borrower.
A revolving credit agreement is a formal line of credit often used by large firms; it involves a commitment fee.
With a regular, or simple, interest loan interest is not compounded, that is, interest is not earned on interest.
In a discount interest loan, the bank deducts the interest in advance. Interest is calculated on the face amount of the loan but it is paid in advance.
Installment loans are typically add-on interest loans. Interest is calculated and added to the funds received to determine the face amount of the loan.
An important decision for the firm is the decision of which bank to go to for credit. There are several differences that exist amongst banks, including: (1) a bank's willingness to assume risks, (2) the advice and counsel offered by the bank, (3) loyalty to customers, (4) specialization, and (5) maximum loan size.
The annual percentage rate (APR) is a rate reported by banks and other lenders on loans when the effective rate exceeds the nominal rate of interest.
Commercial paper is unsecured short-term debt issued by large, financially strong corporations. Although the cost of commercial paper is lower than the cost of bank loans, it can be used only by large firms with exceptionally strong credit ratings.
Sometimes a borrower will find that it is necessary to borrow on a secured basis, in which case the borrower pledges assets such as real estate, securities, equipment, inventories, or accounts receivable as collateral for the loan.
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