- What is Working Capital Management?
- Sources of Liquidity and Factors Affecting Firm's Liquidity
- Comparing a Firm’s Liquidity Position with its Peers
- Managing the Cash Position of a Firm
- Short Term Investment Strategies
- Evaluating the Management of Short-term Funds
- Evaluating Management of Accounts Receivables
- Management of Inventory
- Management of Accounts Payable
- Calculating the Cost of Trade Credit
- Choices of Short-term Funding Available to a Company
Choices of Short-term Funding Available to a Company
A company has access to many short-term sources of funding. These include funding from both bank and non-bank sources.
Short-term Funding from Banks
A company can avail short-term funding from banks in the following forms:
Lines of Credit
This is the most common form of funding for working capital needs. In this case a bank extends a line of credit to a company for its working capital requirements. The bank specifies the maximum loan that the company can avail at any time. Based on its needs the company will draw funds from this line of credit upto the maximum limit allowed. The advantage with a line of credit is that the company pays interest only for the funds borrowed and for the period for which the funds are borrowed.
A line of credit can take many forms:
- In an uncommitted line of credit, the bank extends the line of credit but may refuse to lend when the circumstances change. This makes uncommitted lines of credit very unreliable.
- Committed lines of credit are the regular lines of credit in which the bank is committed to fulfill any fund requirements for the company. The commitment is usually for a specified period of time, usually, 364 days, which makes it a short-term funding. Committed line of credit are usually unsecured.
- Revolving lines of credit are similar to regular lines of credit, with the difference that they are usually effective for multiple years, and are generally for much larger amounts compared to regular lines. Revolving lines of credit are considered to be the strongest form of short-term bank borrowing.
It is not possible for all companies to be able to get a line of credit from a bank. In such a case, a company may borrow from the bank in the form of a secured loan. In a secured loan, the company will keep its assets as the collateral. For short-term secured loans, the assets kept as collateral are usually its current assets such as accounts receivables and inventory.
The banks funds are secured by the collateral and may also have a blanket lien on the current and future assets of the company.
A banker’s acceptance is a bill of exchange drawn to finance trade (exports and imports) and accepted by a bank as good for payment. Its a guarantee from the bank of the buying firm that the payment will be made once the goods are received. The exporter can even sell this banker's acceptance at a discount to receive immediate funds.
Factoring is another form of short-term financing from banks. In this arrangement, the company will sell its receivables to the bank at a discount and receive immediate funds. Here the factor is the buyer of receivables, usually the bank. The factor will be responsible for collection of bills and will also bear the risk of nonpayment. The amount of discount in factoring will depend on factors such as the credit period extended, the creditworthiness of the buyer, collection history and so on.
Short-term Funding from Non-banks Sources
Companies may also use funding from non-bank sources. For example, large companies may issue commercial paper, which is a popular form of borrowing and also offers favorable interest rate compared to bank borrowing.
Many small companies with poor credit also resort to non-bank sources for their short-term funding needs. However, such funds are generally very expensive are used only when bank funding is not available.