Chapter 17 Management of Current Liabilities I. Focus of the chapter is on sources of short term credit.

ST lenders can be classified into cash-flow lenders and asset-based lenders. Cash-flow lenders look upon the borrower's future cash flows as the primary source of loan repayment and the borrower's assets as a secondary source of repayment. Assetbased lenders tend to make riskier loans than cash-flow lenders, and as a result, they place much greater emphasis on the value of the borrower's collateral.

II. Trade credit. Whenever a business receives merchandise ordered from a supplier and then is permitted to wait a specified period of time before having to pay, it is receiving trade credit. Trade credit is considered a spontaneous source of financing, because it normally expands as the volume of a company's purchases increases. Credit terms, or terms of sale, specify the conditions under which a business is required to repay the credit that a supplier has extended to it. The credit terms spell out the credit period and cash discount, if any. Forgoing the cash discount results in an opportunity cost. The annual financing cost of forgoing a cash discount is calculated using Equation 17.3:

AFC =

Percentage discount 100 Percentage discount

365 Credit period - Discount

period

(17.3)

Example:

III. Accrued expenses. Accrued expenses such as accrued wages and taxes represent liabilities for services rendered to the firm that have not yet been paid by the firm. As such they are a source of financing and generally constitute an interest-free source of financing.

Deferred income consists of payments received for goods and services that the firm has agreed to deliver at some future date. As such, they are a source of funds.

IV. Short term bank credit Line of credit. A line of credit is an agreement that permits the firm to borrow funds up to a

predetermined limit at any time during the life of the agreement. The annual financing cost of LOC is calculated using equation 17.1:

AFC =

Interest costs + Fees 365 Usable funds Maturity ( days )

(17.1)

Example:

Revolving credit agreement. An LOC does not legally commit the bank to making loans to the firm

under any and all conditions. If the firm desires a guaranteed line of credit, it must negotiate a revolving credit agreement. Under a revolving credit agreement, or revolver, the bank is legally committed to making loans to a company up to the predetermined credit limit specified in the agreement.
AFC = Interest costs + Commitment Usable funds fee 365 Maturity (days)

(17.4)

Example:

Commercial paper. Commercial paper consists of short-term unsecured promissory notes issued by

major corporations. The annual financing cost can be computed as follows:

AFC =

Interest costs + Placement fee 365 Usable funds Maturity (days)

(17.5)

Example:

V. Accounts receivable loans. Accounts receivable are one of the most commonly used forms of collateral for secured short-term borrowing. From the lender's standpoint, accounts receivable represent a desirable form of collateral, because they are relatively liquid and their value is relatively easy to recover if the borrower becomes insolvent. In addition, accounts receivable involve documents representing customer obligations rather than cumbersome physical assets. Offsetting these advantages, however, are potential difficulties. One disadvantage is that the borrower may attempt to defraud the lender by pledging nonexistent accounts. Also, the recovery process in the event of insolvency may be hampered if the customer who owes the receivables returns the merchandise or files a claim alleging that the merchandise is defective. Finally, the administrative costs of processing the receivables can be high, particularly when a firm has a large number of invoices involving small dollar amounts. Nevertheless, many companies use accounts receivable as collateral for short-term financing by either pledging their receivables or factoring them.

Pledging Accounts Receivable The pledging process begins with a loan agreement specifying the procedures and terms under which the

lender will advance funds to the firm. When accounts receivable are pledged, the firm retains title to the receivables and continues to carry them on its balance sheet. However, the pledged status of the firm's receivables should be disclosed in a footnote to the financial statements A firm that has pledged receivables as collateral is required to repay the loan, even if it is unable to collect the pledged receivables. In other words, the borrower assumes the default risk, and the lender has recourse back to the borrower. Both commercial banks and finance companies make loans secured by accounts receivable. Once the pledging agreement has been established, the firm periodically sends the lender a group of invoices along with the loan request. Upon receipt of the customer invoices, the lender investigates the creditworthiness of the accounts to determine which are acceptable as collateral. The percentage of funds that the lender will advance against the collateral depends on the quality of the receivables and the company's financial position. The percentage normally ranges from 50 to 80 percent of the face amount of the receivables pledged. The company then is required to sign a promissory note and a security agreement, after which it receives the funds from the lender. Most receivables loans are made on a nonnotification basis, which means the customer is not notified that the receivable has been pledged by the firm. The customer continues to make payments directly to the firm. Which are forwarded to the lender. To ensure compliance the borrower is usually subject to a periodic audit to ensure the integrity of its receivables and payments The customer payments are used to reduce

the loan balance and eventually repay the loan. Receivables loans can be a continuous source of financing for a company, however, provided that new receivables are pledged to the lender as existing accounts are collected. By periodically sending the lender new receivables, the company can maintain its collateral base and obtain a relatively constant amount of financing. The annual financing cost of a loan in which receivables are pledged as collateral includes both the interest expense on the unpaid balance of the loan and the service fees charged for processing the receivables. Typically, the interest rate ranges from 2 to 5 percentage points over the prime rate, and service

fees are approximately 1 to 2 percent of the amount of the pledged receivables. The services performed by the lender under a pledging agreement can include credit checking, keeping records of the pledged accounts and collections, and monitoring the agreement. This type of financing can be quite expensive for the firm. Example: see page 512 and Table 17.1.

Factoring Accounts Receivable Factoring receivables involves the outright sale of the firm's receivables to a financial institution known

as a factor. When receivables are factored, title to them is transferred to the factor, and the receivables no longer appear on the firms balance sheet. Traditionally, the use of factoring was confined primarily to the apparel, furniture, and textile industries. Most factoring of receivables is done on a nonrecourse basis; in other words, the factor assumes the risk of default.

VI. Inventory loans. Suitability of inventory for extending short term loan depends on the several characteristics: type, physical characteristics, identifiability, liquidity, and marketability of inventory.