Week 5 Team Problem

Role in the Cash Conversion Cycle

The average payment period is the final component of the cash conversion cycle introduced in Chapter 15. The average payment period has two parts: (1) the time from the purchase of raw materials until the firm mails the payment and (2) payment float time (the time it takes after the firm mails its payment until the supplier has withdrawn spendable funds from the firm’s account). In Chapter 15, we discussed issues related to payment float time. Here we discuss the firm’s management of the time that elapses between its purchase of raw materials and its mailing payment to the supplier. This activity is accounts payable management.

When the seller of goods charges no interest and offers no discount to the buyer for early payment, the buyer’s goal is to pay as slowly as possible without damaging its credit rating. In other words, accounts should be paid on the last day possible, given the supplier’s stated credit terms. For example, if the terms are net 30, the account should be paid 30 days from the beginning of the credit period, which is typically either the date of invoice or the end of the month (EOM) in which the purchase was made. This timing allows for the maximum use of an interest-free loan from the supplier and will not damage the firm’s credit rating (because the account is paid within the stated credit terms). In addition, some firms offer an explicit or implicit “grace period” that extends a few days beyond the stated payment date; if taking advantage of that grace period does no harm to the buyer’s relationship with the seller, the buyer will typically take advantage of the grace period.

Example 16.1

In 2013, Brown-Forman Corporation (BF), manufacturer of alcoholic beverage brands such as Jack Daniels, had annual revenue of $3.8 billion, cost of revenue of $1.8 billion, and accounts payable of $468 million. BF had an average age of inventory (AAI) of 168 days, an average collection period (ACP) of 55 days, and an average payment period (APP) of 136 days (BF’s purchases were $1.3 billion). Thus, the cash conversion cycle for BF was 87 days (168 + 55 − 136).

The resources BF had invested in this cash conversion cycle (assuming a 365-day year) were

Based on BF’s APP and average accounts payable, the daily accounts payable generated by BF is about $3.5 million ($0.48 billion ÷ 136). If BF were to increase its average payment period by 5 days, its accounts payable would increase by about $17.5 million (5 × $3.5 million). As a result, BF’s cash conversion cycle would decrease by 5 days, and the firm would reduce its investment in operations by $17.5 million. Clearly, if this action did not damage BF’s credit rating, it would be in the company’s best interest.

Analyzing Credit Terms

The credit terms that a firm is offered by its suppliers enable it to delay payments for its purchases. Because the supplier’s cost of having its money tied up in merchandise after it is sold is probably reflected in the purchase price, the purchaser is already indirectly paying for this benefit. Sometimes a supplier will offer a cash discount for early payment. In that case, the purchaser should carefully analyze credit terms to determine the best time to repay the supplier. The purchaser must weigh the benefits of paying the supplier as late as possible against the costs of passing up the discount for early payment.

Taking the Cash Discount If a firm intends to take a cash discount, it should pay on the last day of the discount period. There is no added benefit from paying earlier than that date.

Giving Up the Cash Discount If the firm chooses to give up the cash discount, it should pay on the final day of the credit period. There is an implicit cost associated with giving up a cash discount. The cost of giving up a cash discount is the implied rate of interest paid to delay payment of an account payable for an additional number of days. In other words, when a firm gives up a discount, it pays a higher cost for the goods that it orders. The higher cost that the firm pays is like interest on a loan, and the length of this loan is the number of additional days that the purchaser can delay payment to the seller. This cost can be illustrated by a simple example. The example assumes that payment will be made on the last possible day (either the final day of the cash discount period or the final day of the credit period).

Example 16.3

My Finance Lab Solution Video

In Example 16.2, we saw that Lawrence Industries could take the cash discount on its February 27 purchase by paying $980 on March 10. If Lawrence gives up the cash discount, it can pay on March 30. To keep its money for an extra 20 days, the firm must pay an extra $20, or $1,000 rather than $980. In other words, if the firm pays on March 30, it will pay $980 (what it could have paid on March 10) plus $20. The extra $20 is like interest on a loan, and in this case the $980 is like the loan principal. Lawrence Industries owes $980 to its supplier on March 10, but the supplier is willing to accept $980 plus $20 in interest on March 30. Figure 16.1 shows the payment options that are open to the company.

To calculate the implied interest rate associated with giving up the cash discount, we simply treat $980 as the loan principal, $20 as the interest, and 20 days (the time from March 10 to March 30) as the term of the loan. Again, the tradeoff that Lawrence faces is that it can pay $980 on March 10 or $980 plus $20 in interest 20 days later on March 30. Therefore, the interest rate that Lawrence is paying by giving up the discount is 2.04% ($20 ÷ $980). Keep in mind that the 2.04% interest rate applies to a 20-day loan. To calculate an annualized interest rate, we multiply the interest rate on this transaction times the number of 20-day periods during a year. The general expression for calculating the annual percentage cost of giving up a cash discount can be expressed as¹

(16.1)

1. Equation 16.1 and the related discussions are based on the assumption that only one discount is offered. In the event that multiple discounts are offered, calculation of the cost of giving up the discount must be made for each alternative.

where

Substituting the values for CD (2%) and N (20 days) into Equation 16.1 results in an annualized cost of giving up the cash discount of 37.24% [(2% ÷ 98%) × (365 ÷ 20)].

A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of Equation 16.1:

(16.2)

The smaller the cash discount, the closer the approximation to the actual cost of giving it up. Using this approximation, the cost of giving up the cash discount for Lawrence Industries is 36.5% [2% × (365 ÷ 20)].

Using the Cost of Giving Up a Cash Discount in Decision Making The financial manager must determine whether it is advisable to take a cash discount. A primary consideration influencing this decision is the cost of other short-term sources of funding. When a firm can obtain financing from a bank or other institution at a lower cost than the implicit interest rate offered by its suppliers, the firm is better off borrowing from the bank and taking the discount offered by the supplier.

The example shows that the cost of giving up a cash discount is relevant when one is evaluating a single supplier’s credit terms in light of certain bank borrowing costs. However, other factors relative to payment strategies may also need to be considered. For example, some firms, particularly small firms and poorly managed firms, routinely give up all discounts because they either lack alternative sources of unsecured short-term financing or fail to recognize the implicit costs of their actions.

Effects of Stretching Accounts Payable

A strategy that is often employed by a firm is stretching accounts payable, that is, paying bills as late as possible without damaging its credit rating. Such a strategy can reduce the cost of giving up a cash discount.

Although stretching accounts payable may be financially attractive, it raises an important ethical issue: It may cause the firm to violate the agreement it entered into with its supplier when it purchased merchandise. Clearly, a supplier would not look kindly on a customer who regularly and purposely postponed paying for purchases.

accruals

Liabilities for services received for which payment has yet to be made.

in practice focus on ETHICS: Accruals Management

On June 2, 2010, Diebold, Inc., agreed to pay a $25 million fine to settle accounting fraud charges brought by the U.S. Securities and Exchange Commission (SEC). According to the SEC, the management of the Ohio-based manufacturer of ATMs, bank security systems, and electronic voting machines regularly received reports comparing the company’s earnings to analyst forecasts. When earnings were below forecasts, management identified opportunities, some of which amounted to accounting fraud, to close the gap.

“Diebold’s financial executives borrowed from many different chapters of the deceptive accounting playbook to fraudulently boost the company’s bottom line,” SEC Enforcement Director Robert Khuzami said in a statement. “When executives disregard their professional obligations to investors, both they and their companies face significant legal consequences.”^a

A number of the SEC’s claims focused on premature revenue recognition. For example, Diebold was charged with improper use of “bill and hold” transactions. Under generally accepted accounting principles, revenue is typically recognized after a product is shipped. However, in some cases, sellers can recognize revenue before shipment for certain bill and hold transactions. The SEC claimed that Diebold improperly used bill and hold accounting to record revenue prematurely.

The SEC also claimed that Diebold manipulated various accounting accruals. Diebold was accused of understating liabilities tied to its Long Term Incentive Plan, commissions to be paid to sales personnel, and incentives to be paid to service personnel. Diebold temporarily reduced a liability account set up for payment of customer rebates. The company was also accused of overstating the value of inventory and improper inventory write-ups.

Each of these activities allowed Diebold to inflate the company’s financial performance. According to the SEC’s complaint, Diebold’s fraudulent activities misstated reported pretax earnings by at least $127 million between 2002 and 2007. Two years prior to the settlement, Diebold restated earnings for the period covered by the charges.

The clawback provision of the 2002 Sarbanes-Oxley antifraud law requires executives to repay compensation they receive while their company misled shareholders. Diebold’s former CEO, Walden O’Dell, agreed to return $470,000 in cash, plus stock and options. The SEC is currently pursuing a lawsuit against two other former Diebold executives for their part in the matter.

 Why might financial managers still be tempted to manage earnings when a clawback is a legitimate possibility?

Example 16.7

Tenney Company, a large janitorial service company, currently pays its employees at the end of each work week. The weekly payroll totals $400,000. If the firm were to extend the pay period so as to pay its employees 1 week later throughout an entire year, the employees would in effect be lending the firm $400,000 for a year. If the firm could earn 10% annually on invested funds, such a strategy would be worth $40,000 per year (0.10 × $400,000).

 REVIEW QUESTIONS

short-term, self-liquidating loan

An unsecured short-term loan in which the use to which the borrowed money is put provides the mechanism through which the loan is repaid.

Loan Interest Rates

The interest rate on a bank loan can be a fixed or a floating rate, and the interest rate is often based on the prime rate of interest. The prime rate of interest (prime rate) is the lowest rate of interest charged by leading banks on business loans to their most important business borrowers. The prime rate fluctuates with changing supply-and-demand relationships for short-term funds. Banks generally determine the rate to be charged to various borrowers by adding a premium to the prime rate to adjust it for the borrower’s “riskiness.” The premium may amount to 4 percent or more, although many unsecured short-term loans carry premiums of less than 2 percent.

Fixed- and Floating-Rate Loans Loans can have either fixed or floating interest rates. On a fixed-rate loan, the rate of interest is determined at a set increment above the prime rate on the date of the loan and remains unvarying at that fixed rate until maturity. On a floating-rate loan, the increment above the prime rate is initially established, and the rate of interest is allowed to “float,” or vary, above prime as the prime rate varies until maturity. Generally, the increment above the prime rate will be lower on a floating-rate loan than on a fixed-rate loan of equivalent risk because the lender bears less risk with a floating-rate loan. Most short-term business loans are floating-rate loans.

Method of Computing Interest Once the nominal (or stated) annual rate is established, the method of computing interest is determined. Interest can be paid either when a loan matures or in advance. If interest is paid at maturity, the effective (or true) annual rate—the actual rate of interest paid—for an assumed 1-year period is equal to

(16.3)

Most bank loans to businesses require the interest payment at maturity.

When interest is paid in advance, it is deducted from the loan so that the borrower actually receives less money than is requested (and less than they must repay). Loans on which interest is paid in advance are called discount loans. The effective annual rate for a discount loan, assuming a 1-year period, is calculated as

(16.4)

Paying interest in advance raises the effective annual rate above the stated annual rate.

Single-Payment Notes

A single-payment note can be obtained from a commercial bank by a creditworthy business borrower. This type of loan is usually a one-time loan made to a borrower who needs funds for a specific purpose for a short period. The resulting instrument is a note, signed by the borrower, that states the terms of the loan, including the length of the loan and the interest rate. This type of short-term note generally has a maturity of 30 days to 9 months or more. The interest charged is usually tied in some way to the prime rate of interest.

Example 16.9

Gordon Manufacturing, a producer of rotary mower blades, recently borrowed $100,000 from each of two banks, bank A and bank B. The loans were incurred on the same day, when the prime rate of interest was 6%. Each loan involved a 90-day note with interest to be paid at the end of 90 days. The interest rate was set at % above the prime rate on bank A’s fixed-rate note. Over the 90-day period, the rate of interest on this note will remain at % (6% prime rate + % increment) regardless of fluctuations in the prime rate. The total interest cost on this loan is $1.849 [$100,000 × (, × 90 ÷ 365)], which means that the 90-day rate on this loan is 1.85% ($1,849 ÷ $100,000).

Assuming that the loan from bank A is rolled over each 90 days throughout the year under the same terms and circumstances, we can find its effective annual interest rate, or EAR, by using Equation 5.10. Because the loan costs 1.85% for 90 days, it is necessary to compound (1 + 0.0185) for 4.06 periods in the year (that is, 365 ÷ 90) and then subtract 1:

The effective annual rate of interest on the fixed-rate, 90-day note is 7.73%.

Bank B set the interest rate at 1% above the prime rate on its floating-rate note. The rate charged over the 90 days will vary directly with the prime rate. Initially, the rate will be 7% (6% + 1%), but when the prime rate changes, so will the rate of interest on the note. For instance, if after 30 days the prime rate rises to 6.5% and after another 30 days it drops to 6.25%, the firm will be paying 0.575% for the first 30 days (7% × 30 ÷ 365), 0.616% for the next 30 days (7.5% × 30 ÷ 365), and 0.596% for the last 30 days (7.25% × 30 ÷ 365). Its total interest cost will be $1,787 [$100,000 × (0.575% + 0.616% + 0.596%)], resulting in a 90-day rate of 1.79% ($1,787 ÷ $100,000).

Again, assuming the loan is rolled over each 90 days throughout the year under the same terms and circumstances, its effective annual rate is 7.46%:

Clearly, in this case the floating-rate loan would have been less expensive than the fixed-rate loan because of its generally lower effective annual rate.

Personal Finance Example 16.10

Megan Schwartz has been approved by Clinton National Bank for a 180-day loan of $30,000 that will allow her to make the down payment and close the loan on her new condo. She needs the funds to bridge the time until the sale of her current condo, from which she expects to receive $42,000.

Clinton National offered Megan the following two financing options for the $30,000 loan: (1) a fixed-rate loan at 2% above the prime rate or (2) a variable-rate loan at 1% above the prime rate. Currently, the prime rate of interest is 8%, and the consensus forecast of a group of mortgage economists for changes in the prime rate over the next 180 days is as follows:

• 60 days from today the prime rate will rise by 1%.
• 90 days from today the prime rate will rise another %.
• 150 days from today the prime rate will drop by 1%.

Using the forecast prime rate changes, Megan wishes to determine the lowest interest-cost loan for the next 6 months.

• Fixed-Rate Loan: Total interest cost over 180 days
  
• Variable-Rate Loan: The applicable interest rate would begin at 9% (8% + 1%) and remain there for 60 days. Then the applicable rate would rise to 10% (9% + 1%) for the next 30 days and then to 10.50% (10% + 0.50%) for the next 60 days. Finally, the applicable rate would drop to 9.50% (10.50% − 1%) for the final 30 days.

Total interest cost over 180 days

Because the estimated total interest cost on the variable-rate loan of $1,442 is less than the total interest cost of $1,480 on the fixed-rate loan, Megan should take the variable-rate loan. By doing so, she will save about $38 ($1,480 − $1,442) in interest cost over the 180 days.

Lines of Credit

A line of credit is an agreement between a commercial bank and a business, specifying the amount of unsecured short-term borrowing that the bank will make available to the firm over a given period of time. It is similar to the agreement under which issuers of bank credit cards, such as MasterCard, Visa, and Discover, extend preapproved credit to cardholders. A line-of-credit agreement is typically made for a period of 1 year and often places certain constraints on the borrower. It is not a guaranteed loan; rather, it indicates that if the bank has sufficient funds available, it will allow the borrower to owe it up to a certain amount of money. The amount of a line of credit is the maximum amount the firm can owe the bank at any point in time.

When applying for a line of credit, the borrower may be required to submit such documents as its cash budget, pro forma income statement, pro forma balance sheet, and recent financial statements. If the bank finds the customer acceptable, the line of credit will be extended. The major attraction of a line of credit from the bank’s point of view is that it eliminates the need to examine the creditworthiness of a customer each time it borrows money within the year.

Interest Rates The interest rate on a line of credit is normally stated as a floating rate: the prime rate plus a premium. If the prime rate changes, the interest rate charged on new as well as outstanding borrowing automatically changes. The amount a borrower is charged in excess of the prime rate depends on its creditworthiness. The more creditworthy the borrower, the lower the premium (interest increment) above prime and vice versa.

Operating-Change Restrictions In a line-of-credit agreement, a bank may impose operating-change restrictions, which give it the right to revoke the line if any major changes occur in the firm’s financial condition or operations. The firm is usually required to submit up-to-date, and preferably audited, financial statements for periodic review. In addition, the bank typically needs to be informed of shifts in key managerial personnel or in the firm’s operations before changes take place. Such changes may affect the future success and debt-paying ability of the firm and thus could alter its credit status. If the bank does not agree with the proposed changes and the firm makes them anyway, the bank has the right to revoke the line of credit.

Compensating Balances To ensure that the borrower will be a “good customer,” many short-term unsecured bank loans—single-payment notes and lines of credit—require the borrower to maintain, in a checking account, a compensating balance equal to a certain percentage of the amount borrowed. Banks frequently require compensating balances of 10 to 20 percent. A compensating balance not only forces the borrower to be a good customer of the bank but may also raise the interest cost to the borrower.

Annual Cleanups To ensure that money lent under a line-of-credit agreement is actually being used to finance seasonal needs, many banks require an annual cleanup. In these cases, the borrower must have a loan balance of zero—that is, owe the bank nothing—for a certain number of days during the year. Insisting that the borrower carry a zero loan balance for a certain period ensures that short-term loans do not turn into long-term loans.

All the characteristics of a line-of-credit agreement are negotiable to some extent. Today, banks bid competitively to attract large, well-known firms. A prospective borrower should attempt to negotiate a line of credit with the most favorable interest rate, for an optimal amount of funds, and with a minimum of restrictions. Borrowers today frequently pay fees to lenders instead of maintaining deposit balances as compensation for loans and other services. The lender attempts to get a good return with maximum safety. Negotiations should produce a line of credit that is suitable to both borrower and lender.

Revolving Credit Agreements

A revolving credit agreement is nothing more than a guaranteed line of credit. It is guaranteed in the sense that the commercial bank assures the borrower that a specified amount of funds will be made available regardless of the scarcity of money. The interest rate and other requirements are similar to those for a line of credit. It is not uncommon for a revolving credit agreement to be for a period greater than 1 year.² Because the bank guarantees the availability of funds, a commitment fee is normally charged on a revolving credit agreement. This fee often applies to the average unused balance of the borrower’s credit line. It is normally about 0.5 percent of the average unused portion of the line.

2. Many authors classify the revolving credit agreement as a form of intermediate-term financing, defined as having a maturity of 1 to 7 years, but we do not use the intermediate-term financing classification; only short-term and long-term classifications are made. Because many revolving credit agreements are for more than 1 year, they can be classified as a form of long-term financing; however, they are discussed here because of their similarity to line-of-credit agreements.

commercial paper

A form of financing consisting of short-term, unsecured promissory notes issued by firms with a high credit standing.

Interest on Commercial Paper

Commercial paper is sold at a discount from its par, or face, value. The size of the discount and the length of time to maturity determine the interest paid by the issuer of commercial paper. The actual interest earned by the purchaser is determined by certain calculations, illustrated by the following example.

An interesting characteristic of commercial paper is that its interest cost is normally 2 percent to 4 percent below the prime rate. In other words, firms are able to raise funds more cheaply by selling commercial paper than by borrowing from a commercial bank. The reason is that many suppliers of short-term funds do not have the option, as banks do, of making low-risk business loans at the prime rate. They can invest safely only in marketable securities such as Treasury bills and commercial paper.

Although the stated interest cost of borrowing through the sale of commercial paper is normally lower than the prime rate, the overall cost of commercial paper may not be less than that of a bank loan. Additional costs include various fees and flotation costs. Also, even if it is slightly more expensive to borrow from a commercial bank, it may at times be advisable to do so to establish a good working relationship with a bank. This strategy ensures that when money is tight, funds can be obtained promptly and at a reasonable interest rate.

International Transactions

The important difference between international and domestic transactions is that payments are often made or received in a foreign currency. Not only must a U.S. company pay the costs of doing business in the foreign exchange market, but it also is exposed to exchange rate risk. A U.S.-based company that exports goods and has accounts receivable denominated in a foreign currency faces the risk that the U.S. dollar will appreciate in value relative to the foreign currency. The risk to a U.S. importer with foreign-currency-denominated accounts payable is that the dollar will depreciate. Although exchange rate risk can often be hedged by using currency forward, futures, or options markets, doing so is costly and is not possible for all foreign currencies.

Typical international transactions are large in size and have long maturity dates. Therefore, companies that are involved in international trade generally have to finance larger dollar amounts for longer time periods than companies that operate domestically. Furthermore, because foreign companies are rarely well known in the United States, some financial institutions are reluctant to lend to U.S. exporters or importers, particularly smaller firms.

Financing International Trade

Several specialized techniques have evolved for financing international trade. Perhaps the most important financing vehicle is the letter of credit, a letter written by a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. The letter of credit essentially substitutes the bank’s reputation and creditworthiness for that of its commercial customer. A U.S. exporter is more willing to sell goods to a foreign buyer if the transaction is covered by a letter of credit issued by a well-known bank in the buyer’s home country.

Firms that do business in foreign countries on an ongoing basis often finance their operations, at least in part, in the local market. A company that has an assembly plant in Mexico, for example, might choose to finance its purchases of Mexican goods and services with peso funds borrowed from a Mexican bank. This practice not only minimizes exchange rate risk but also improves the company’s business ties to the host community. Multinational companies, however, sometimes finance their international transactions through dollar-denominated loans from international banks. The Eurocurrency loan markets allow creditworthy borrowers to obtain financing on attractive terms.

Transactions between Subsidiaries

Much international trade involves transactions between corporate subsidiaries. A U.S. company might, for example, manufacture one part in an Asian plant and another part in the United States, assemble the product in Brazil, and sell it in Europe. The shipment of goods back and forth between subsidiaries creates accounts receivable and accounts payable, but the parent company has considerable discretion about how and when payments are made. In particular, the parent can minimize foreign exchange fees and other transaction costs by “netting” what affiliates owe each other and paying only the net amount due rather than having both subsidiaries pay each other the gross amounts due.

Collateral and Terms

Lenders of secured short-term funds prefer collateral that has a duration closely matched to the term of the loan. Current assets are the most desirable short-term-loan collateral because they can normally be converted into cash much sooner than fixed assets. Thus, the short-term lender of secured funds generally accepts only liquid current assets as collateral.

Typically, the lender determines the desirable percentage advance to make against the collateral. This percentage advance constitutes the principal of the secured loan and is normally between 30 and 100 percent of the book value of the collateral. It varies according to the type and liquidity of collateral.

The interest rate that is charged on secured short-term loans is typically higher than the rate on unsecured short-term loans. Lenders do not normally consider secured loans less risky than unsecured loans. In addition, negotiating and administering secured loans is more troublesome for the lender than negotiating and administering unsecured loans. The lender therefore normally requires added compensation in the form of a service charge, a higher interest rate, or both.

Institutions Extending Secured Short-Term Loans

The primary sources of secured short-term loans to businesses are commercial banks and commercial finance companies. Both institutions deal in short-term loans secured primarily by accounts receivable and inventory. We have already described the operations of commercial banks. Commercial finance companies are lending institutions that make only secured loans—both short-term and long-term—to businesses. Unlike banks, finance companies are not permitted to hold deposits.

Only when its unsecured and secured short-term borrowing power from the commercial bank is exhausted will a borrower turn to the commercial finance company for additional secured borrowing. Because the finance company generally ends up with higher-risk borrowers, its interest charges on secured short-term loans are usually higher than those of commercial banks. The leading U.S. commercial finance companies include the CIT Group and General Electric Corporate Financial Services.

Pledging Accounts Receivable

A pledge of accounts receivable is often used to secure a short-term loan. Because accounts receivable are normally quite liquid, they are an attractive form of short-term-loan collateral.

The Pledging Process When a firm requests a loan against accounts receivable, the lender first evaluates the firm’s accounts receivable to determine their desirability as collateral. The lender makes a list of the acceptable accounts, along with the billing dates and amounts. If the borrowing firm requests a loan for a fixed amount, the lender needs to select only enough accounts to secure the funds requested. If the borrower wants the maximum loan available, the lender evaluates all the accounts to select the maximum amount of acceptable collateral.

After selecting the acceptable accounts, the lender normally adjusts the dollar value of these accounts for expected returns on sales and other allowances. If a customer whose account has been pledged returns merchandise or receives some type of allowance, such as a cash discount for early payment, the amount of the collateral is automatically reduced. For protection from such occurrences, the lender normally reduces the value of the acceptable collateral by a fixed percentage.

Next, the percentage to be advanced against the collateral must be determined. The lender evaluates the quality of the acceptable receivables and the expected cost of their liquidation. This percentage represents the principal of the loan and typically ranges between 50 and 90 percent of the face value of acceptable accounts receivable. To protect its interest in the collateral, the lender files a lien, which is a publicly disclosed legal claim on the collateral.

Notification Pledges of accounts receivable are normally made on a nonnotification basis, meaning that a customer whose account has been pledged as collateral is not notified. Under the nonnotification arrangement, the borrower still collects the pledged account receivable, and the lender trusts the borrower to remit these payments as they are received. If a pledge of accounts receivable is made on a notification basis, the customer is notified to remit payment directly to the lender.

Pledging Cost The stated cost of a pledge of accounts receivable is normally 2 to 5 percent above the prime rate. In addition to the stated interest rate, a service charge of up to 3 percent may be levied by the lender to cover its administrative costs. Clearly, pledges of accounts receivable are a high-cost source of short-term financing.

Factoring Accounts Receivable

Factoring accounts receivable involves selling them outright, at a discount, to a financial institution. A factor is a financial institution that specializes in purchasing accounts receivable from businesses. Although it is not the same as obtaining a short-term loan, factoring accounts receivable is similar to borrowing with accounts receivable as collateral.

Factoring Agreement A factoring agreement normally states the exact conditions and procedures for the purchase of an account. The factor, like a lender against a pledge of accounts receivable, chooses accounts for purchase, selecting only those that appear to be acceptable credit risks. Where factoring is to be on a continuing basis, the factor will actually make the firm’s credit decisions because this will guarantee the acceptability of accounts. Factoring is normally done on a notification basis, and the factor receives payment of the account directly from the customer. In addition, most sales of accounts receivable to a factor are made on a nonrecourse basis, meaning that the factor agrees to accept all credit risks. Thus, if a purchased account turns out to be uncollectible, the factor must absorb the loss.

Typically, the factor is not required to pay the firm until the account is collected or until the last day of the credit period, whichever occurs first. The factor sets up an account similar to a bank deposit account for each customer. As payment is received or as due dates arrive, the factor deposits money into the seller’s account, from which the seller is free to make withdrawals as needed.

In many cases, if the firm leaves the money in the account, a surplus will exist on which the factor will pay interest. In other instances, the factor may make advances to the firm against uncollected accounts that are not yet due. These advances represent a negative balance in the firm’s account, on which interest is charged.

Factoring Cost Factoring costs include commissions, interest levied on advances, and interest earned on surpluses. The factor deposits in the firm’s account the book value of the collected or due accounts purchased by the factor, less the commissions. The commissions are typically stated as a 1 to 3 percent discount from the book value of factored accounts receivable. The interest levied on advances is generally 2 to 4 percent above the prime rate. It is levied on the actual amount advanced. The interest paid on surpluses is generally between 0.2 and 0.5 percent per month.

Although its costs may seem high, factoring has certain advantages that make it attractive to many firms. One is the ability it gives the firm to turn accounts receivable immediately into cash without having to worry about repayment. Another advantage is that it ensures a known pattern of cash flows. In addition, if factoring is undertaken on a continuing basis, the firm can eliminate its credit and collection departments.

Floating Inventory Liens

A lender may be willing to secure a loan under a floating inventory lien, which is a claim on inventory in general. This arrangement is most attractive when the firm has a stable level of inventory that consists of a diversified group of relatively inexpensive merchandise. Inventories of items such as auto tires, screws and bolts, and shoes are candidates for floating-lien loans. Because it is difficult for a lender to verify the presence of the inventory, the lender generally advances less than 50 percent of the book value of the average inventory. The interest charge on a floating lien is 3 to 5 percent above the prime rate. Commercial banks often require floating liens as extra security on what would otherwise be an unsecured loan. Floating-lien inventory loans may also be available from commercial finance companies.

Trust Receipt Inventory Loans

A trust receipt inventory loan often can be made against relatively expensive automotive, consumer durable, and industrial goods that can be identified by serial number. Under this agreement, the borrower keeps the inventory, and the lender may advance 80 to 100 percent of its cost. The lender files a lien on all the items financed. The borrower is free to sell the merchandise but is trusted to remit the amount lent, along with accrued interest, to the lender immediately after the sale. The lender then releases the lien on the item. The lender makes periodic checks of the borrower’s inventory to make sure that the required collateral remains in the hands of the borrower. The interest charge to the borrower is normally 2 percent or more above the prime rate.

Trust receipt loans are often made by manufacturers’ wholly owned financing subsidiaries, known as captive finance companies, to their customers. Captive finance companies are especially popular in industries that manufacture consumer durable goods because they provide the manufacturer with a useful sales tool. For example, General Motors Acceptance Corporation, the financing subsidiary of General Motors, grants these types of loans to its dealers. Trust receipt loans are also available through commercial banks and commercial finance companies.

Warehouse Receipt Loans

A warehouse receipt loan is an arrangement whereby the lender, which may be a commercial bank or finance company, receives control of the pledged inventory collateral, which is stored by a designated agent on the lender’s behalf. After selecting acceptable collateral, the lender hires a warehousing company to act as its agent and take possession of the inventory.

Two types of warehousing arrangements are possible. A terminal warehouse is a central warehouse that is used to store the merchandise of various customers. The lender normally uses such a warehouse when the inventory is easily transported and can be delivered to the warehouse relatively inexpensively. Under a field warehouse arrangement, the lender hires a field-warehousing company to set up a warehouse on the borrower’s premises or to lease part of the borrower’s warehouse to store the pledged collateral. Regardless of the type of warehouse, the warehousing company places a guard over the inventory. Only on written approval of the lender can any portion of the secured inventory be released by the warehousing company.

The actual lending agreement specifically states the requirements for the release of inventory. As with other secured loans, the lender accepts only collateral that it believes to be readily marketable and advances only a portion—generally 75 to 90 percent—of the collateral’s value. The specific costs of warehouse receipt loans are generally higher than those of any other secured lending arrangements because of the need to hire and pay a warehousing company to guard and supervise the collateral. The basic interest charged on warehouse receipt loans is higher than that charged on unsecured loans, generally ranging from 3 to 5 percent above the prime rate. In addition to the interest charge, the borrower must absorb the costs of warehousing by paying the warehouse fee, which is generally between 1 and 3 percent of the amount of the loan. The borrower is normally also required to pay the insurance costs on the warehoused merchandise.

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