Short-term financing may be used to meet seasonal and temporary fluctuations in a company’s funds position as well as to meet permanent needs of the business. For example, short-term financing may be used to provide extra net working capital, finance current assets, or provide interim financing for a long-term project. Two of among important sources of short-term financing are bank loans and receivable financing. The merits of the different alternative sources of such those two short-term financing are usually considered carefully before a firm borrows money.
Through extensive case examples, this post provides guideline what steps, calculations and analysis are needed to be performed to decide if a company should use a bank loans financing or receivable factoring. For faster page load, this post is broken down into three pages (use the page navigation at the bottom of the post:
Page-1. Bank Loans Financing Page-2. Receivable Factoring Page-3. Bank Loan Vs Factoring Decision
Generally speaking, there are at least nine factors bearing upon the selection of any types of short-term financing (including bank loans and factoring), they are:
- Effect on credit rating – Some sources of short-term financing may negatively affect the firm’s credit rating.
- Risk – The firm must consider the reliability of the source of funds for future borrowing.
- Restrictions – Certain lenders may impose restrictions, such as requiring a minimum level of net working capital.
- Flexibility – Certain lenders are more willing than others to work with the borrower, for example, to periodically adjust the amount of funds needed.
- Expected money market conditions.
- The inflation rate.
- Corporate profitability and liquidity positions.
- The stability of the firm’s operations.
To be eligible for a bank loan, a company must have sufficient equity and good liquidity. When a short-term bank loan is taken, the debtor usually signs a note, which is a written statement that the borrower agrees to repay the loan at the due date. A note payable may be paid at maturity or in installments.
Bank loans are not spontaneous financing as is trade credit. Borrowers must apply for loans, and lenders must grant them. Without additional funds, a firm may have to restrict its plans; therefore, as a company’s need for funds changes, it alters its borrowings from banks. One example is a self-liquidating (seasonal) loan which is used to pay for a temporary increase in accounts receivable or inventory. As soon as the assets realize cash, the loan is repaid.
Loans, of course, earn interest, and the prime interest rate is the lowest interest rate applied to short-term loans from a bank. Banks charge only their most creditworthy clients the prime rate; other borrowers are charged higher interest rates.
Bank financing may take any of the following four forms:
1. Unsecured Loans – Most short-term unsecured loans are self-liquidating. This kind of loan is recommended for use by companies with excellent credit ratings for financing projects that have quick cash flows. They are appropriate when the firm must have immediate cash and can either repay the loan in the near future or quickly obtain longer-term financing. The disadvantages of this kind of loan are that, because it is made for the short term, it carries a higher interest rate than a secured loan and payment in a lump sum is required.
2. Secured Loans – If a borrower’s credit rating is deficient, the bank may lend money only on a secured basis, that is, with some form of collateral behind the loan. Collateral may take many forms including inventory, accounts receivable, or fixed assets. In some cases, even though the company is able to obtain an unsecured loan, it may still give collateral in exchange for a lowest interest rate.
3. Lines of Credit – Under a line of credit, the bank agrees to lend money to the borrower on a recurring basis up to a specified amount. Credit lines are typically established for a 1-year period and may be renewed annually. Construction companies often use such an arrangement because they usually receive only minimal payments from their clients during construction, being compensated primarily at the end of a job.
The advantages of a line of credit for a company are the easy and immediate access to funds during tight money market conditions and the ability to borrow only as much as needed and repay immediately when cash is available. The disadvantages relate to the collateral requirements and the additional financial information that must be presented to the bank. Also, the bank may place restrictions upon the company, such as ceiling on capital expenditures or the maintenance of a minimum level of working capital. Further, the bank will charge a commitment fee on the amount of the unused credit line.
When a company borrows under a line of credit, it may be required to maintain a deposit with the bank that does not earn interest. This deposit is referred to as a compensating balance and is stated as a percentage of the loan. The compensating balance effectively increases the cost of the loan. A compensating balance may also be placed on the unused portion of a line of credit, in which case the interest rate would be reduced. For Example, a company borrows $200,000 and is required to keep a 12 percent compensating balance. It also has an unused line of credit in the amount of $100,000, for which a 10 percent compensating balance is required. the maximum balance that the business must maintain is ($200,000 x 0.12) + ($100,000 x 0.10) = $24,000 + $10,000 = $34,000. The bank may test a borrower’s financial capability by requiring the borrower to ‘‘clean up,’’ that is, repay the loan for a brief time during the year (e.g., for 1 month). A company that is unstable to repay a short-term loan should probably finance with long-term funds. The payment shows the bank that the loan is actually seasonal rather than permanent financing.
4. Installment Loans – An installment loan requires monthly payments. When the principal on the loan decreases sufficiently, refinancing can take place at lower interest rates. The advantage of this kind of loan is that it may be tailored to satisfy a company’s seasonal financing needs.
Computation of Interest of a Bank Loan
Interest on a loan may be paid either at maturity (ordinary interest) or in advance (discounting the loan). When interest is paid in advance, the proceeds from the loan are reduced and the effective (true) interest cost is increased. Here are two examples:
Example-1: XYZ Company borrows $30,000 at 16 percent interest per annum and repays the loan 1 year hence. The interest paid is $30,000 x 0.16 = $4,800. The effective interest rate is 16 percent. How if the note is discounted? The proceeds of this loan are smaller than the previous one:
Proceeds = principal – interest = $30,000 – $4,800 = $25,200
The true interest rate for this discounted loan is:
Effective interest rate = interest / proceeds = $4,800 / $25,000 = 19%
Example-2: ABC Bank will give a company a 1-year loan at an interest rate of 20 percent payable at maturity, while DEF Bank will lend on a discount basis at a 19 percent interest rate. Which bank charges the lowest effective rate?
ABC Bank = 20%
DEF Bank = 19% / 81% = 23.5%
Result: The loan from ABC Bank has the better interest rate.
When a loan has a compensating balance requirement associated with it, the proceeds received by the borrower are decreased by the amount of the balance. The compensating balance will increase the effective interest rate. See the following three examples:
Example-1: The effective interest rate associated with a 1-year, $600,000 loan that has a nominal interest rate of 19 percent, with interest due at maturity and requiring a 15 percent compensating balance is computed as follows:
Effective interest rate (with compensating balance) =
(interest rate x principal) / (proceeds, % x principal) =
(0.19 x $600,000) / [(1.00 – 0.15) x $600,000] =
$114,000 / $510,000 = 22.4%
Example-2: Assume the same facts as in above first example, except that the loan is discounted. The effective interest rate is:
Effective interest rate (with discount) =
(interest rate x principal) / [(proceeds, % x principal) – interest] =
(0.19 x $600,000) / [(0.85 x $600,000) – $114,000] =
$114,000 / $396,000 = 28.8%
Example-3: XYZ Company has a line of credit in the amount of $400,000 from its bank, but it must maintain a compensating balance of 13 percent on outstanding loans and a compensating balance of 10 percent on the unused credit. The interest rate on the loan is 18 percent. The company borrows $275,000. What is the effective interest rate on the loan?
First, you need to count the required compensating balance, here it is:
0.13 x $275,000 = $35,750
0.10 x 125,000 = $12,500
Second, calculate effective interest rate (with line of credit):
[interest rate (on loan) x principal)] / principal – compensating balance =
(0.18 x $275,000) / ($275,000 – $48,250) = $49,500 / $226,750 = 21.8%
On an installment loan, the effective interest rate computation is more involved. Assuming a 1-year loan is to be paid in equal monthly installments, the effective rate must be based on the average amount outstanding for the year. The interest to be paid is computed on the face amount of the loan. Here are two good examples:
Example-1: A company borrows $40,000 at an interest rate of 10 percent to be paid in 12 monthly installments. The average loan balance is $40,000 / 2 = $20,000. The effective interest rate is $4,000 / $20,000 = 20%.
Example-2: Assume the same facts as in the above first example, except that the loan is discounted. The interest of $4,000 is deducted in advance so the proceeds received are $40,000 – $4,000 = $36,000. The average loan balance is $36,000/2=$18,000. The effective interest rate is $4,000 / $18,000 = 22.2%.