Short-Term Financing.....

The main sources of short-term financing are (1) trade credit, (2) commercial bank loans, (3) commercial paper, a specific type of promissory note, and (4) secured loans.....
 

Trade credit

A firm customarily buys its supplies and materials on credit from other firms, recording the debt as an account payable. This trade credit, as it is commonly called, is the largest single category of short-term credit. Credit terms are usually expressed with a discount for prompt payment. Thus, the seller may state that if payment is made within 10 days of the invoice date, a 2 percent cash discount will be allowed. If the cash discount is not taken, payment is due 30 days after the date of invoice. The cost of not taking cash discounts is the price of the credit.
 

Commercial bank loans

Commercial bank lending appears on the balance sheet as notes payable and is second in importance to trade credit as a source of short-term financing. Banks occupy a pivotal position in the short-term and intermediate-term money markets. As a firm’s financing needs grow, banks are called upon to provide additional funds. A single loan obtained from a bank by a business firm is not different in principle from a loan obtained by an individual. The firm signs a conventional promissory note. Repayment is made in a lump sum at maturity or in installments throughout the life of the loan. A line of credit, as distinguished from a single loan, is a formal or informal understanding between the bank and the borrower as to the maximum loan balance the bank will allow at any one time.
 

Commercial paper

Commercial paper, a third source of short-term credit, consists of well-established firms’ promissory notes sold primarily to other businesses, insurance companies, pension funds, and banks. Commercial paper is issued for periods varying from two to six months. The rates on prime commercial paper vary, but they are generally slightly below the rates paid on prime business loans.

A basic limitation of the commercial-paper market is that its resources are limited to the excess liquidity that corporations, the main suppliers of funds, may have at any particular time. Another disadvantage is the impersonality of the dealings; a bank is much more likely to help a good customer weather a storm than is a commercial-paper dealer.
 

Secured loans

Most short-term business loans are unsecured, which means that an established company’s credit rating qualifies it for a loan. It is ordinarily better to borrow on an unsecured basis, but frequently a borrower’s credit rating is not strong enough to justify an unsecured loan. The most common types of collateral used for short-term credit are accounts receivable and inventories.

Financing through accounts receivable can be done either by pledging the receivables or by selling them outright, a process called factoring in the United States. When a receivable is pledged, the borrower retains the risk that the person or firm that owes the receivable will not pay; this risk is typically passed on to the lender when factoring is involved.

When loans are secured by inventory, the lender takes title to them. He may or may not take physical possession of them. Under a field warehousing arrangement, the inventory is under the physical control of a warehouse company, which releases the inventory only on order from the lending institution. Canned goods, lumber, steel, coal, and other standardized products are the types of goods usually covered in field warehouse arrangements.