Set out where firms can raise short-term funds
The idea
Short-term funding runs from the informal to the negotiated. Trade credit from suppliers is the most common and looks free until the discount forgone is annualised. A committed bank line of credit provides certainty for a fee; an uncommitted line does not and can be withdrawn precisely when it is needed. Commercial paper is unsecured short-term debt issued directly to investors and is available only to strong credits, at rates below bank borrowing. Secured borrowing against receivables or inventory costs more but is open to weaker companies, because the lender's recourse does not depend on the borrower's standing alone.
Formulas
Cost of forgoing a trade discount
cost = [1 + d ÷ (1 − d)]^(365 ÷ (N − t)) − 1
- d
- the discount for early payment
- N
- the day the full amount is due
- t
- the last day the discount can be taken
For 2/10 net 30 the effective annual cost is about 44.6%, far above most bank rates, so take the discount unless cash is very short.
A practice question
What is commercial paper?
- Short-term unsecured debt sold to investors - correct
- Long-term debt secured on assetsWhy not: Commercial paper is short-dated (in the US, up to 270 days) and unsecured.
- A bank's promise to lend on demandWhy not: That describes a committed line of credit. Commercial paper is sold to investors rather than funded by a bank.
Commercial paper is a short-term IOU that a company sells directly to investors instead of borrowing from a bank. Short-term means it is repaid within a short period, in the US up to 270 days. Unsecured means no asset is pledged as backup, so only strong, well-rated companies can use it. It is often cheaper than a bank loan. For example, a firm needing $50 million for 60 days to stock up for a busy season can issue commercial paper rather than draw on a bank line.
A harder one
How does a committed line of credit differ from an uncommitted one?
- A committed line has no fee, whereas an uncommitted one charges a fee on the unused amountWhy not: Reversed. A commitment fee, usually charged on the unused amount, is what a committed line costs because the bank is obliged to lend.
- A committed line obliges the bank to lend, for a fee; an uncommitted one does not - correct
- A committed line funds long-term investment, while an uncommitted one funds working capitalWhy not: Both are short-term facilities. What separates them is whether the bank is obliged to lend.
A line of credit is an agreed borrowing limit a company can draw on when needed. With a committed line, the bank must lend when asked, and the company pays a fee, usually on the unused amount, for that certainty. With an uncommitted line, the bank can say no. Idea: the fee buys certainty. For example, a firm with a $20 million committed line can still borrow in a credit squeeze, while the bank can simply decline an uncommitted request, often exactly when cash is needed.
The hardest tier
Why might a company with a weak credit rating borrow against its receivables despite the higher cost?
- Pledging receivables keeps the debt off the balance sheetWhy not: A loan secured on receivables is still a liability. Only a true sale of the receivables can remove them, and that is a different transaction.
- Receivables lenders waive covenants on such facilitiesWhy not: Such facilities come with their own conditions, often including tight reporting on the collateral.
- The lender relies on the receivables, not the company's own credit - correct
Borrowing against receivables means pledging the money customers owe you as backup for a loan. The lender then mainly checks how likely those customers are to pay, not how healthy the borrower is. That is why a weakly rated firm can still borrow this way, even though it costs more. For example, $10 million of receivables owed by strong customers might support an 80% loan: $10 million x 0.80 = $8 million. The debt still stays on the balance sheet as a liability.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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