Types of Short Term Debt

There are a number of types of short-term debt, and a number of related elements.

• 1. Accounts receivable financing
• 2. Factoring
• 3. Inventory financing
• 4. Floor planning
• 5. Revolving credit
• 6. Zero-balance accounts
• 7. Lines of credit
• 8. Credit cards
• 9. Compensating balances

Accounts Receivable Financing. This is an excellent form of short-term financing that assists the company in itscash flow management. It involves using part or all of accountsreceivable as collateral for short-term loans. The collateralmight include only specific invoices if some of the invoices areover 90 days old or if some customers’ credit is not of high quality.(If the latter is true, maybe these customers shouldn’t be given creditat all.) By refusing to lend against these invoices, the bank isprotecting itself from lending against the receivables oflow-credit-rated customers. At the same time, it is giving the companysome sound advice regarding dealings with these customers. With accounts receivable financing, the companyretains the credit risk if its customers do not pay, and thecompany is responsible for collecting on its customers’ accounts. Repayment schedules for this type of financing are highlynegotiable. The company should make certain that undesirableinflexibilities are not built into the repayment terms. There are critical‘‘shades of gray’’ between financial discipline and bank-imposedrestriction. Banks and other lenders will typically create a lineof credit equal to between 70 and 90 percent of qualified accountsreceivable.

Factoring. In this financing alternative, the company actually sells its qualified accounts receivable to the bank oran independent factoring company at a discount from the face value. The company receives immediate cash for its invoices.The invoices will direct the customers to pay the funds directly tothe bank or factoring company (the factor).

This form of financing is expensive compared withalternative forms. In addition, it may lead customers to misjudgethe financial position of the company and conclude that itis having financial difficulties. The factor may have the rightto take the initiative and call overdue accounts directly.

Factoring can cost between 2 and 5 percent per month.This could significantly cut into margins, especially ifthe borrower is in a low-margin business. However, if the terms ofsale are currently 2/10, n/30, factoring may be a desirable alternative.Selling on terms of 2/10, n/30 means that the customer cantake a 2 percent discount off the invoice amount if the invoiceis paid within 10 days of the invoice date, and in any eventpayments are expected within 30 days. With these terms,customers will either take the 2 percent discount or delay paymentfor up to 30 days. If factoring can be accomplished at 2 percentand the company can get its cash immediately, factoring is anattractive alternative.

Accounts receivable can be sold to a factor with orwithout recourse. If the sale is without recourse, the buyerof the accounts receivable (the factor) assumes the full credit risk.If the customer does not pay, the factor loses the money. If the saleis with recourse, the company assumes ultimate responsibility for credit losses if the customer does not pay. Selling withoutrecourse is very expensive. Because only very high-qualityreceivables qualify for this form of financing, there is rarely a creditloss. So selling without recourse rarely pays. Companies can actuallybuy credit insurance that protects them against credit loss.

Inventory Financing. Usually only finished goods and raw materials inventory qualify as a form of collateral.There is no market for work in process. Lenders will usuallyprovide financing in the amount of one-half of the collateral thatqualifies. This is a good form of financing to cover the cost offulfilling a very large order from a high-quality customer, or perhaps,in a seasonal business, to cover a period of high cash needs thatwill be followed by a period of high cash inflows. Using inventory as collateral requires fairlysophisticated inventory control methods, including systems support. Thisimposes corporate self-discipline, which the company shouldhave anyway.

Floor Planning. Floor planning is a special form of inventory financing that is very common in the retail sale ofvery highpriced products, such as boats, cars, and appliances. Withthis form of financing, it is the vendor and its productsthat must be credit-qualified. The lender buys the products fromthe manufacturer and places them in the retailer’s store and supporting warehouse, in effect lending them to the retailer.

The lender retains title to the products. When theproduct is sold by the retail dealer, the dealer must first paythe lender in order to get title, which it can then transfer to thepurchasing customer. This may be a simultaneous transaction, sothat the retailer just receives the difference between theselling price and the loan amount.

Floor planning is often provided by a finance company owned by the manufacturer. The manufacturer and itsassociated finance company will provide various ‘‘bargains’’ toinduce the retailer to overload on inventory. This smooths outthe manufacturing process and places a lot of product in the dealer’sshowroom, which presumably will help sales. Slow-moving productis often provided to the dealer at zero financing cost asa way for the manufacturer to handle excess inventory.

As a business lesson, count the number of cars in adealer’s lot, calculate the estimated value of those cars(maybe the number of cars _ $20,000),and multiply that by 1 percent per month (the interest the dealer has to pay on the loan). Youcan get an idea of how many cars a dealer must sell each monthjust to cover its floor plan interest expense.

Revolving Credit. This is basically a working capital loan with accounts receivable and inventory as collateral.The maximum amount of the loan is based on a formula tied tohighquality inventory and accounts receivable. For example, themaximum amount might be 75 percent of accounts receivable less than 60 days old and 50 percent of finished goods andraw materials inventory less than 60 days old. This formula forcesthe company to make regular payments and reduce the outstandingdebt when the inventory is used and the receivables arecollected. Because of the pressure to repay and the constantmonitoring of working capital, it would be very dangerous for acompany to use this form of funding to support long-termprojects. Some banks require what is known as a ‘‘cleanup’’ period.This means that for some period of time, perhaps one month peryear, the loan balance must be zero.

Zero-Balance Accounts. This type of account may very well be required by another loan agreement. In a ‘‘regular’’loan, the borrower collects funds from its customers, depositsthe funds in the company checking account, and makes some sort ofpayment to the lender for principal and interest on the loan.With a zerobalance feature, the loan and the checking account areconnected. When customer payments are deposited in the checking account, the funds are automatically used to reducethe loan balance and pay the interest that is due. Since the accountbalance is therefore zero, when the company writes checks,these checks increase the loan balance.

This feature is very similar, conceptually, to theoverdraft privileges attached to individuals’ checking accounts(although individuals usually decide how much of the funds theydeposit should be used to reduce the loan balance, subject toa minimum monthly payment). This feature can be very beneficialto the company because float is reduced to zero. Customerpayments automatically reduce the loan balance. The interestrate may also be advantageous because the bank knows that as thecompany receives payments from its customers, the loan will berepaid. Also, the company borrows only the exact amount itrequires.

Lines of Credit. A line of credit is not a loan, it is a very favorable method of securing a loan. The cliche´describing this arrangement is ‘‘borrow when you don’t need it so thatyou will have it when you do.’’

Suppose that a company is considering expansion plansor a major expenditure, to take place sometime within thenext six months. The company’s balance sheet is strong, and itsneed for the loan is uncertain, or at least not immediate. Thecompany can go to the bank and arrange for a line of credit.This is an advance reservation that makes funds available, to beused only if and when they are needed.

Theadvantages of a line of credit are:

The loan is arranged at the timing of the borrower.

The funds are available; they can be used or not, atthe choice of the borrower.

The company is in a position to make major purchase commitments knowing that this and maybe otherfinancing options are available. It provides considerable purchase price bargainingpower. Interest payments do not begin until the funds areactually needed.

The company will pay a reservation fee, probably inthe range of 1 percent of the total line. Payment terms,interest, and other fees and collateral requirements will be thesame as those on any other loan and are always negotiable. This isconceptually the same as a homeowner’s equity line of credit.

Credit Cards. More and more customer orders are being placed by phone or by computer over the Internet.Allowing the customer to pay by credit card accomplishes a numberof things: It eliminates accounts receivable, thus eliminatingthe wait for the money and the associated paperwork. The customer’s creditworthiness need not be evaluated. There will be no overdue receivables. The customers can take as much time as they want topay. For smaller orders, waiting for customer payments andmaking the often inevitable collection phone calls eliminatesthe profit. Although the company must pay the credit cardfee, which is approximately 2 percent, accepting credit cardswill make small orders profitable.

Compensating Balances. Requiring compensating balances is a bank strategy that increases the effective costof borrowing money without increasing the stated interest rate. Acompensating balance means that the borrower is required to keep acertain minimum balance in the checking account at all times.

If a company borrows $1,000,000 for one year at 10percent, the interest rate is obviously 10 percent. If,however, a 10 percent compensating balance is required, the borrower has theeffective use of only $900,000. This results in an effectiverate of 11 percent. If the borrower really needs $1.0 million, it mustborrow approximately $1.1 million.

Along with loan origination fees, collateral auditfees, search fees, and other such charges, compensating balancesare a cost of borrowing and can be negotiated.