Corporate finance

Meaning
1. Corporate finance is the area of finance dealing with the sources of
funding and the capital structure of corporations and the actions that
managers take to increase the value of the firm to the shareholders, as
well as the tools and analysis used to allocate financial resources.

DEFINITION OF 'CORPORATE FINANCE'

1) The financial activities related to running a corporation.
2) A division or department that oversees the financial activities of a
company. Corporate finance is primarily concerned with maximizing
shareholder value through long-term and short-term financial planning and
the implementation of various strategies. Everything from capital
investment decisions to investment banking falls under the domain of
corporate finance.

INVESTOPEDIA EXPLAINS 'CORPORATE FINANCE'

Among the financial activities that a corporate finance department is
involved with are capital investment decisions. Should a proposed
investment be made? How should the company pay for it; with equity or
with debt, or combination of both? Should shareholders be offered
dividends on their investment in the company? These are just some of the
questions a corporate financial officer attempts to answer on a consistent
basis. Short-term issues include the management of current assets and
current liabilities, inventory control, investments and other short-term
financial issues. Long-term issues include new capital purchases and
investments.

Wikipedia
Corporate finance is the area of finance dealing with the sources of funding and
the capital structure of corporations and the actions that managers take to
increase the value of the firm to the shareholders, as well as the tools
and analysis used to allocate financial resources. The primary goal of corporate
finance is to maximize or increase shareholder value.[1] Although it is in principle
different from managerial finance which studies the financial management of all
firms, rather than corporations alone, the main concepts in the study of corporate
finance are applicable to the financial problems of all kinds of firms.
Investment analysis (or capital budgeting) is concerned with the setting of criteria
about which value-adding projects should receive investment funding, and
whether to finance that investment with equity or debt capital. Working
capital management is the management of the company's monetary funds that
deal with the short-term operating balance of current assets and current liabilities;
the focus here is on managing cash, inventories, and short-term borrowing and
lending (such as the terms on credit extended to customers).[citation needed]
The terms corporate finance and corporate financier are also associated
with investment banking. The typical role of an investment bankis to evaluate the
company's financial needs and raise the appropriate type of capital that best fits
those needs. Thus, the terms corporate finance and corporate financier may
be associated with transactions in which capital is raised in order to create,
develop, grow or acquire businesses. Recent legal and regulatory developments
in the U.S. will likely alter the makeup of the group of arrangers and financiers
willing to arrange and provide financing for certain highly leveraged
transactions.[2]
Financial management overlaps with the financial function of the Accounting
profession. However, financial accounting is the reporting of historical financial
information, while financial management is concerned with the allocation of
capital resources to increase a firm's value to the shareholders.
Sources of capital
Debt capital[edit]
Further information: Bankruptcy and Financial distress
Corporations may rely on borrowed funds (debt capital or credit) as sources of
investment to sustain ongoing business operations or to fund future growth. Debt
comes in several forms, such as through bank loans, notes payable, or bonds

issued to the public. Bonds require the corporations to make

regular interest payments (interest expenses) on the borrowed capital until the
debt reaches its maturity date, therein the firm must pay back the obligation in
full. Debt payments can also be made in the form of sinking fund provisions,
whereby the corporation pays annual installments of the borrowed debt above
regular interest charges. Corporations that issue callable bonds are entitled to
pay back the obligation in full whenever the company feels it is in their best
interest to pay off the debt payments. If interest expenses cannot be made by
the corporation through cash payments, the firm may also use collateral assets
as a form of repaying their debt obligations (or through the process
of liquidation).
Equity capital[edit]
Corporations can alternatively sell shares of the company to investors to raise
capital. Investors, or shareholders, expect that there will be an upward trend in
value of the company (or appreciate in value) over time to make their investment
a profitable purchase. Shareholder value is increased when corporations invest
equity capital and other funds into projects (or investments) that earn a positive
rate of return for the owners. Investors prefer to buy shares of stock into
companies that will consistently earn a positive rate of return on capital in the
future, thus increasing the market value of the stock of that corporation.
Shareholder value may also be increased when corporations payout excess
cash surplus (funds from retained earnings that are not needed for business) in
the form of dividends.
Preferred stock[edit]
Preferred stock is an equity security which may have any combination of
features not possessed by common stock including properties of both an equity
and a debt instruments, and is generally considered a hybrid instrument.
Preferreds are senior (i.e. higher ranking) to common stock, but subordinate
to bonds in terms of claim (or rights to their share of the assets of the
company).[7]
Preferred stock usually carries no voting rights,[8] but may carry a dividend and
may have priority over common stock in the payment of dividends and
upon liquidation. Terms of the preferred stock are stated in a "Certificate of
Designation".
Similar to bonds, preferred stocks are rated by the major credit-rating
companies. The rating for preferreds is generally lower, since preferred

dividends do not carry the same guarantees as interest payments from bonds
and they are junior to all creditors.[9]
Preferred stock is a special class of shares which may have any combination of
features not possessed by common stock. The following features are usually
associated with preferred stock:[10]
Preference in dividends
Preference in assets, in the event of liquidation
Convertibility to common stock.
Callability, at the option of the corporation
Nonvoting
Working capital[edit]

Working capital is the amount of funds which are necessary to an organization to

continue its ongoing business operations, until the firm is reimbursed through
payments for the goods or services it has delivered to its
customers.[29] Working capital is measured through the difference between
resources in cash or readily convertible into cash (Current Assets), and cash
requirements (Current Liabilities). As a result, capital resource allocations
relating to working capital are always current, i.e. short term. In addition to time
horizon, working capital management differs from capital budgeting in terms
of discounting and profitability considerations; they are also "reversible" to some
extent. (Considerations as to Risk appetite and return targets remain identical,
although some constraints such as those imposed by loan covenants may be
more relevant here).
The (short term) goals of working capital are therefore not approached on the
same basis as (long term) profitability, and working capital management applies
different criteria in allocating resources: the main considerations are (1) cash
flow / liquidity and (2) profitability / return on capital (of which cash flow is
probably the most important).

The most widely used measure of cash flow is the net operating cycle, or cash
conversion cycle. This represents the time difference between cash payment
for raw materials and cash collection for sales. The cash conversion cycle
indicates the firm's ability to convert its resources into cash. Because this
number effectively corresponds to the time that the firm's cash is tied up in
operations and unavailable for other activities, management generally aims at
a low net count. (Another measure is gross operating cycle which is the same

as net operating cycle except that it does not take into account the creditors
deferral period.)
In this context, the most useful measure of profitability is Return on
capital (ROC). The result is shown as a percentage, determined by dividing
relevant income for the 12 months by capital employed; Return on
equity (ROE) shows this result for the firm's shareholders. As above, firm
value is enhanced when, and if, the return on capital exceeds the cost of
capital.
WORKING CAPITAL MANAGEMENT

Working capital refers to the firms investment in short-term assets (cash,

marketable securities, accounts receivable and inventories). Net working capital
is the difference between a firms current assets and its current liabilities.
Working capital management involves administering to both short-term assets
and short-term liabilities. Assets and liabilities must be matched and
coordinated in order to keep costs to a minimum and to control risks. Generally,
we want to match the firms financing with the lives of its assets. If we consider
a company that is growing over time, then its assets can be decomposed into
three categories fixed assets, permanent current assets and fluctuating current
assets.
Short-term
Fluctuating
Current Assets

Permanent
Current Assets

Long-term

Fixed Assets

Fixed assets should be financed long-term, either equity or long-term debt,

since the assets are long-lived and need financing for a long period of time. The
current assets can be broken down into two portions, permanent current assets
and fluctuating current assets. The permanent current assets represent base
levels of inventories, receivables, etc., that will always be on hand. The
fluctuating current assets represent the seasonal build-ups that occur, such as
inventories before Christmas and receivables after Christmas. The fluctuating
current asset levels should be financed short-term since we dont want to pay
financing charges all year if we only need the money for a four-month period.

While the permanent current assets are, individually, short-lived assets, as

a category they are always there (hence, permanent) and will always need to be
financed. Thus, the permanent current assets should also be financed longterm, just like the fixed assets. While it is possible to finance some of our
permanent needs using short-term debt, it is risky to do so. (Such financing is
described as an aggressive working capital financing policy in your text
aggressive being associated with risky.) The risk of financing permanent needs
with short-term financing is twofold: first, short-term interest rates fluctuate
much more than long-term interest rates. Rolling over short-term debt year after
year will subject you to greater fluctuation in your financing costs as a result.
Probably a bigger risk is the inability to roll over the short-term debt every year.
You may have a bad year and find that lenders are unwilling to refund the debt
(forcing you to default).

Of course, some companies take the opposite approach they will finance
some of their seasonal needs of the fluctuating current assets with long-term
financing. This is a conservative approach, but the financing is there when it is
needed but it costs money during those times when it is not needed.

Banks generally do not want companies to utilize them as a source of

permanent financing. For this reason, many banks will require that a companys
line of credit be completely paid off for at least one month each year. This is to
prevent the company from using the bank for permanent financing. Of course,
banks are essentially matching their assets and liabilities as well. The difference
is that a banks assets are its loans which it matches to its sources of financing
while firms match their financing to their assets. Since a banks financing source
is predominantly short-term deposits, it wants its loan portfolio to be
predominantly short-term as well.

Life insurance companies and pension funds, on the other hand, have
liabilities that are many years in the future. They would prefer to make longer
term loans so that there isnt the need to reinvest the money every year.

COMPONENTS OF WORKING CAPITAL

Cash

Cash is probably the least productive asset you can have. Not only does it
not earn anything, it actually loses purchasing power as a consequence of

inflation. So why do firms hold cash? The three Keynsian motives for holding
cash balances are

Transactions motive to conduct day-to-day business of paying for

purchases, labor, etc.
Precautionary motive to cover unexpected expenditures. If the
delivery truck breaks down, it must be repaired or replaced if you want
to stay in business.
Speculative motive unusually good opportunities occasionally arise. If
you have the money available, you can take advantage of these
opportunities.
While cash is necessary to cover the transactions motive, the
precautionary and speculative motives can be covered with the near money (or
near cash) of marketable securities.

In order to maximize your cash balances, you can do one of two things;
either accelerate the inflow of funds (ask for an advance on your salary) or delay
the outflow of funds (postpone paying the phone bill until next month). But why
would we want to maximize our cash holdings if it is the least productive asset?
Because idle cash, either sitting in a checking account or tied-up in accounts
receivable is extremely costly.

For example, suppose we have a client who owes us payment of

$5,000,000 that is due. The opportunity cost of not collecting is the interest we
could earn on the money.

$5,000,000
2%

Receivable due
Treasury bill rate

$ 100,000

Annual interest

$100,000/365 days = $274 per day

Can you invest money for one day? Absolutely. In fact, for a large enough
amount of money, someone will meet you at the bank on Sunday in order to
accept your deposit.
This also illustrates the concept of float. Bank float is the period of time
between when a check is written to pay an obligation and when the funds are
actually deducted from your checking account. Within a city, it is common
practice to have a local check clearing system where banks meet each day to
exchange checks written on one anothers accounts. When the bank where a
check is deposited is in a different city from the bank on which the check is
drawn, the deposited check first goes to the regional Federal Reserve Bank,
(Dallas in the case of Texas), and is then forwarded to the issuing bank. This
adds a day or two to the float period. If the check is drawn on a bank account in
another Federal Reserve District, then another day or so is added as the local
Fed must forward the check to the Fed in the issuing banks district which then
forwards the check to the bank. Exxon used to pay suppliers west of the
Mississippi river with checks written on a small bank in North Carolina, while
suppliers east of the Mississippi were paid with checks on a small bank in
Arizona. One days worth of float to the U.S. government is worth over $1 billion
(which is one reason government employees now get paid on the first of the
following month rather than the last day of the month).

Most of us have probably played the float on at least one occasion (and
probably gotten caught!) It should be noted, however, that using float to cover
up a deficit (i.e., hot check) is illegal.
Another means of extending the float is through the use of drafts. A draft
is like a check, but must be returned to the issuer for verification prior being
deposited. This, again, adds 2-3 days to the float period. Insurance companies

are most noted for using drafts within the U.S. The type of draft that insurance
companies use is known as sight drafts since they are paid upon presentation.
Time drafts are those which are payable upon a specific future date. Time drafts
are an important financing instrument in international trade and will be discussed
later.
While bank float and drafts delay the outflow of funds, cash balances can
also be increased by speeding up the inflow of funds. The primary means of
accomplishing this is through the use of a lock-box system. A lock-box is a post
office box in a local city where payments from customers in the area are sent.
The lock-box is cleared daily and the checks are deposited in a local bank and
then wired to the companys main bank account. Referred to as concentration
banking, it cuts 2-3 days off of the time it takes the checks to cross several
states and allows funds to be concentrated in one bank for investment in shortterm securities. The larger amount of funds that can be invested yields higher
interest rates and lower transactions costs.

The local bank will offer the lock-box system if a local office is not available
or does not want to devote the personnel to tend to the system. Banks,
however, charge for the services that they provide through either a direct service
charge, or by requiring that a minimum compensating balance be maintained. A
compensating balance is one that does not pay any interest. The minimum
balance can be either an absolute minimum or an average minimum.

The clearing of checks can also be accelerated through the use of the
Federal Reserve Banks Automated Clearing House (ACH) system which is
governed by the National Automated Clearing House Association (NACHA).
Companies can do this through the use of a check scanner which converts the
paper check into an electronic check that can be processed from a computer.
Generally referred to as Electronic Check Processing, this is essentially the
same as what occurs with direct deposit of payroll checks.

Marketable Securities

Marketable securities are a way of holding cash but with the attribute of
earning interest. Market securities have three characteristics:

1. Short-term maturity (less than one year, or money market instruments

2. High marketability
3. Virtually no risk of default
Several types of marketable securities exist, the major ones being

U.S. Treasury bills

Treasury bills are auctioned every Monday by the government. Most
have maturities of 91 or 181 days, although some 9-month (270
days) and 12-month (360 days) bills are sold. The t-bills, generally
with a face value of $10,000 each, are sold at a discount to the
highest bidders. The difference between the amount paid and the
face value at maturity represents the interest that is earned.

Anticipation notes
Anticipation notes are issued by municipalities and school districts.
Since their revenues come from tax sources, the notes are in
anticipation of future tax receipts.

Commercial paper

Commercial paper is the promissory notes of a major national firms.

Most of the firms that issue commercial paper sell it directly to
investors (insurance companies, money market funds, pension
funds) although sometimes it will be sold through investment
bankers. Commercial paper is a substitute for bank debt, but at a
rate of interest that is one-fourth to on-half of a percent higher than tbills (currently about 4.3%) but significantly less than what banks
would charge (prime is currently about 8.5%).

Bankers Acceptances
A bankers acceptance is a time draft that evolves from international
export/import financing. An exporter is paid by a time draft issued by
a foreign bank. Since the draft is not payable until some future date
(1-3 months, typically) the company that receives it will often sell it to
its local bank at a discount. The local bank bundles the discounted
drafts (bankers acceptances) and then resells them in the money
markets.

Accounts Receivable

Accounts receivable are generated when a firm offers credit to its

customers. The first thing that needs to be addressed when establishing a credit
policy is to set the standards by which a firm is judged in determining whether or
not credit will be extended. There is whats known as the 5 Cs of credit:

1. Character the willingness of the borrower to repay the obligation

2. Capacity the capability of the borrower to earn the money to repay the
obligation

3. Capital sufficient assets available to support operations (as opposed

to a firm that is undercapitalized). Sometimes capital is interpreted to
mean equity capital; i.e., to make sure the owners of the firm have
sufficient money at stake to give them proper incentive to repay the loan
and not let the company go bankrupt.
4. Collateral assets to support the loan which can be liquidated if default
occurs
5. Conditions current and future anticipated conditions of the firm and the
industry.
Once the credit standards have been set, the terms of credit need to be
established. When must the customer pay? If they pay early, will they receive a
discount? If they pay late, do they get charged a penalty?

While the whole purpose of extending credit is to increase sales and, thus,
gross profits, the expected increase in gross profits must be compared with the
costs associated with extending credit to customers. These costs include

The time value of money tied up in accounts receivable

Bad debts that occur
Credit checks (to minimize bad debts)
Collection costs
Discounts for early payment (reduces revenues)
Clerical costs associated with maintaining a credit department

Competitors will respond very quickly to a change in price. How many

times have we seen the claims that We will meet or beat any advertised price?
A change in credit policy, on the other hand, is a more subtle means of
competing for customers and one that the competition will not necessarily
respond to. In fact, many firms base their business on easy credit. How many
times have we seen the advertisements where they tell us Good credit? Bad
credit? No credit? We dont care! Of course, these firms will have larger bad

debt expenses and larger financing costs, etc. Obviously, they will also need to
have higher prices (higher gross profit margins) in order to cover these costs.

Inventories

Inventories (raw materials, work-in-process, finished goods) make up a

large portion of most firms current assets, and for many, total assets. As such,
the extent to which a firm efficiently manages its inventories can have a large
influence on its profitability. Thus, keeping abreast of inventory policy is critical
to the profitability (and value) of the firm.

Several factors influence the amount of inventory that a firm maintains.

The most important of these include

Level of sales typically, the more sales a firm has, the more inventory
it holds
Length of time and technical nature of the production process The
longer it takes to produce finished goods inventories from raw materials,
the larger the amount of finished goods that a firm will typically hold (a
safety stock). Also, if the production process is highly technical,
requiring that retooling be performed prior to each production run in
order to assure that production is meeting specifications, larger amounts
of inventory will be produced with each production run in order to
minimize the set-up costs associated with retooling.
Durability vs. Perishability If an inventory item is highly perishable,
such as fresh vegetables, a small amount will be held. Similarly,
fashions of clothes and car styles are perishable and will result in
smaller inventories than durable goods such as tools and hardware.

 Costs Cost of holding inventories as well as costs of obtaining

inventories will influence inventory sizes.
Inventory costs can be broken down into three major categories:

A.

Ordering Costs
1.
Fixed costs stocking, clerical
2.
Shipping costs often fixed
3.
Missed quantity discounts an opportunity cost

B.

Carrying Costs
1.
Time value of money tied-up in inventories
2.
Warehousing costs
3.
Insurance
4.
Handling
5.
Obsolescence, breakage, shrinkage

C.

Stock-out Costs
1.
Lost sales
2.
Loss of goodwill
3.
Special shipping costs

Ideally, we want to balance these costs against each other so that our total
costs are minimized.

Short-term Sources of Financing

Trade Credit

The major source of short-term financing for firms is that of trade credit.
While it is an account payable on our balance sheet, it is an account receivable
on the balance sheet of our supplier.

The terms of credit can vary quite a bit:

1. Cash on Delivery (i.e., no credit)

2. Net amount due within a certain period of time
3. Net amount with a discount if paid within a certain period of time, net
amount within another period.
For example, 2/10 net 30 means that if you pay within the first ten days,
you can deduct 2% from the bill; otherwise the full amount of the bill is due
within 30 days. Discounts are offered by suppliers to keep their A/R balances
down and minimize the funds that are tied-up.

Not taking the discount can be a very expensive means of financing. For
example, suppose we do not pay within the first ten days. Then, if we pay on
the thirtieth day, we have paid 2% (approximately) for an additional twenty days
use of the funds (the first ten days were free anyway). Since there are 18
twenty-day periods in a year, this is approximately

2% * 18 = 36%

Actually, the cost is a little higher since we are paying 2% on top of the 98% we
would otherwise have to pay:

2% 360days
*
36. 7%
98% 20days

Of course, if you miss payment by day 10 for taking the discount, dont pay the
full amount of day 11 or you have paid

2%*360 = 720%

Do banks charge 36% interest on loans? Not in Texas or most states. It is a

violation of the usury laws. Then why do many companies forego the discounts
if the cost is so high? It is the only source of funding that they can get. To
reduce the effective cost, firms will often stretch payment out past the due date.
Of course, this subjects the firm to risk of its credit being completely cut off by
the supplier and possibly damages the credit reputation since other suppliers will
often request references before extending credit themselves.

Some firms will offer post-dated billing, typically in a seasonal industry.

For example, if a manufacturers primary sales are to retailers for the Christmas
season they may encourage retailers to order in June and July rather than
waiting until September. The encouragement is that if an order is placed in June
or July, the manufacturer will not bill them until September and even then regular
credit terms will apply. The advantage here is that it allows the manufacturer to
smoothe out sale and thus production. The manufacturer can then save on
overtime with employees as well as not incur many of the carrying costs
associated with holding the inventories since the retailer takes possession and
ownership earlier.

Commercial Banks

The second major source of short-term financing for firms is commercial

banks. A firm wants to establish a close relationship with its bank and obtain a
line of credit. In order to get a credit line, you will want to show them your
income statements, balance sheets, financial ratios, etc. The bank will then
allow a certain amount of credit with a set rate of interest (usually prime plus).
This can be renegotiated every year. In fact, commercial banks bread and
butter is their business accounts and they are very competitive with one another
in trying to attract corporate clients. The amount of the credit line is typically tied
to the amount of accounts receivable that the firm has and sometimes to the
amount of inventories that it holds.

Another type of credit line is referred to as a revolving line of credit. With a

revolving line of credit, the bank provides a written agreement guaranteeing
loans up to a certain amount. The firm will pay a normal rate of interest on the
amounts of funds that it borrows plus a commitment fee of one-half to one
percent on any unborrowed funds. Unlike a regular line of credit which can be
changed, a revolving line of credit guarantees that the bank will always make the
amount available if needed. Additionally, a revolving line of credit will often be
extended jointly by several banks when the amounts used are larger than a
single bank can (or wants to) handle alone.

Types of Loans

Loans come in a variety of shapes. A simple loan requires that the firm
maintain a non-interest-bearing account at the bank. While compensating
balances are not used as much as they have been in the past, they are still
encountered frequently.

Suppose a bank offers a one-year loan for $100,000 at an 8% rate of

interest with a compensating balance of 20%. Then,

$100,000 loan
Less:

20,000 compensating balance

$ 80,000 net proceeds

At the end of one year, the firm repays the bank $88,000. $8,000 is interest on
the loan and the other $80,000 (with the $20,000 in the compensating balance
for a total of $100,000) is the principal. Thus, the firm has effectively paid
$8,000 interest on the use of $80,000 for an annual rate of interest of 10%.

Alternatively, the bank may offer a discounted loan where the interest is
deducted up-front. Using our same example,

$100,000 loan
Less:

8,000 interest
$ 92,000 net proceeds

At the end of the year, the firm repays the $100,000 of principal (since the
interest was paid up-front). Effectively, the firm paid $8,000 of interest for the
use of $92,000 of funds for a rate of interest of 8.7% on the loan.

Of course, your banker is there to help you and may express concern that
the need to come up with $100,000 at the end of the year could be difficult.
He/she may suggest, instead, an interest add-on loan where the amount of
interest is added to the principal and then repaid in a series of installments. Our
example loan would then required that monthly payments of $9,000 be made
($100,000 principal + $8,000 interest = $108,000/12 months = $9,000 per
month).

$100,000

Average
Owed

12 months

As an approximation, the amount of the loan that was outstanding during

the year was, on average, only $50,000. The $8,000 of interest thus represents
an approximately 16% rate of interest on the average amount of the loan.

More precisely, this loan appears as

100,000

1 - - - - - - - - - - - - - - - - - 11

(9,000) - - - - - - - - - - - - - - (9,000)

12

(9,000)

Of course, if you were the bank, the cash flows would be the same, only
the signs would be reversed. So as a bank officer, how would you determine the
rate of interest that you were earning on this investment?

The true cost of debt of any loan is the internal rate of return between what
you receive and what you have to pay back. Suppose we use our calculators
and determine the IRR of this interest add-on loan. We determine that the IRR
is 1.2%. But remember that his is 1.2% per month. Using simple interest,
1.2%*12 = 14.4% annual rate of interest.

Security for Bank Loans

Banks like some sort of collateral for loans to ensure repayment of the
loan, at least in part. The preferred collateral for bank loans is accounts
receivable. The reason, of course, is that collecting money is what banks do.
Typically, a bank will loan up to 75-80% of the receivables that are not over 60
days. There are two ways to obtain financing with receivables:

Pledging of Accounts Receivable This is the most common form. A

lender will loan up to 80% of the amount of the invoice. Upon
payment, the borrower has pledged to use the proceeds to reduce
the amount of the loan. If the customer does not pay the invoice, the
borrower is still obligated to repay the loan.
Factoring of Accounts Receivable The receivable is sold to a factoring
institution. Typically, this is used prior to making a sale on credit.
The seller will go to a factor who will run a credit check on the
potential buyer. If the buyer has a good credit rating, the factor will
give the go-ahead to sell on credit and then buy the receivable (at a
discount) from the seller. The buyer is notified in writing to pay the
factor directly for the receivable. Then, if the invoice is not paid, it is
up to the factor to collect from the buyer and the factor takes the risk
of bad debt. Sometimes, the factor may withhold 10% from the seller
to make them share in the risk of non-payment. Then, when
payment is received, the 10% reserve will be refunded to the seller.
The use of factoring is considerably more expensive than the pledging of
accounts receivable. This is due to the fact that, in addition to lending money for
a period of 30-90 days, the factor also must run a credit check, incur the cost of
collection, and undertake the risk of nonpayment.
Banks will also use inventories as collateral for short-term loans. A blanket
lien (or floating lien) is one that covers all inventories. Even then, the lender will
only loan 40-50% of the cost of those goods. This is because, if default occurs,
the lender will have to hire someone to sell the inventories as well as
substantially discounting them in order to liquidate the inventories.

A warehouse receipts loan is where a third party holds the inventory as

collateral for the lender. A warehouse receipts loan is most commonly used in
the canning industry or where production of inventory is seasonal. For example,
the cotton season runs from June to October. Denim jeans, on the other hand,
are purchased year-round. Thus, a denim manufacturer might buy cotton in
June and produce denim but not have enough for the estimated annual demand.
The producer could then go to a bank and borrow against the bolts of denim that
have been produced. These bolts of denim would then be stored in a public
warehouse as collateral and funds would be made available for the producer to
purchase more cotton and produce more denim. As inventories are sold, the
loan could be paid down, in which case the lender would notify the public
warehousing company to release X number of bolts of denim to the producer
and the process reverses itself.
If the inventories are too bulky to transport to a public warehouse, a field
warehouse arrangement may be set up where the public warehousing company
goes to the producers place of business and physically segregates the
inventories that are being held as collateral for the lender. Only the public
warehousing company would have access to the collateral and would only
release it upon notification by the lender.

Securities Loans
A borrower can pledge their inventories of securities of another company
(bonds, notes payable) as collateral for a loan as well. Thus, if you hold a note
payable from a creditworthy firm, many lenders will loan money against it. (This
is similar, in a sense, to what happens with a margin purchase.)
In short, if a firm has assets of virtually any kind, it can use them as
collateral for short-term loans to meet its short-term cash needs.