November 27, 2014

Working Capital Finance - USA

This article  introduces the five major forms of debt used to finance working capital. The purpose of this information is to provide insight into the different ways in which debt for working capital can be structured and prepare finance professonals  to choose and structure  debt best suited to a firm’s financial situation and needs.

Line of Credit

A line of credit is an open-ended loan with a borrowing limit that the business can draw against or repay at any time during the loan period. This arrangement allows a company flexibility to borrow funds when the need arises for the exact amount required. Interest is paid only on the amount borrowed, typically on a monthly basis. A line of credit can be either unsecured, if no specific collateral is pledged for repayment, or secured by specific assets such as accounts receivable or inventory.

The standard term for a line of credit is 1 year with renewal subject to the lender’s annual review and approval. Lenders usually require full repayment of the line of credit during the annual loan period
and prior to its renewal. This repayment is sometimes referred to as the annual cleanup.

Lenders require a fee for providing the line of credit, based on the line’s credit limit, which is paid whether or not the firm uses the line. This fee, usually in the range of 25 to 100 basis points, covers the bank’s costs for underwriting and setting up the loan account in the event that a firm does not use the line and the bank earns no interest income. A second cost is the requirement for a borrower to maintain a compensating balance account with the bank. Under this arrangement, a borrower must have a deposit account with a minimum balance equal to a percentage of the line of credit, perhaps 10% to 20%. If a firm normally maintains this
balance in its cash accounts, then no additional costs are imposed by this requirement. However, when a firm must increase its bank deposits to meet the compensating balance requirement, then it is incurring an additional cost. In effect, the compensating balance reduces the business’s net loan proceeds and increases its effective interest rate.

 Like most loans, the lending terms for a line of credit include financial covenants or minimal financial standards that the borrower must meet. Typical financial covenants include a minimum current ratio, a minimum net worth, and a maximum debt-to-equity ratio. The advantages of a line of credit is that it allows a company to minimize the principal borrowed and the resulting interest payments.

With full repayment required each year and annual extensions subject to lender approval, a line of credit cannot finance medium-term or long-term working capital investments.

Accounts Receivable Financing

Loans secured by accounts receivable are a common form of debt used to finance working capital.
Under accounts receivable debt, the maximum loan amount is tied to a percentage of the borrower’s accounts receivable.  The firm must use customer payments on these receivables to reduce the loan balance. The borrowing ratio depends on the credit quality of the firm’s customers and the age of the accounts receivable. A firm with financially strong customers should be able to obtain a loan equal to 80% of its accounts receivable. With weaker credit customers, the loan may be limited to 50% to 60% of accounts
receivable. Lenders may exclude receivables beyond a certain age (e.g., 60 or 90 days) in the base used to calculate the loan limit.

Since accounts receivable are pledged as collateral, when a firm does not repay the loan, the lender will collect the receivables directly from the customer and apply it to loan payments. The bank receives
a copy of all invoices along with an assignment that gives it the legal right to collect payment and apply it to the loan. In some accounts receivable loans, customers make payments directly to a bank-controlled account (a lock box).

Firms gain several benefits with accounts receivable financing arrangements. Borrowing capacity grows automatically as sales grow. This automatic matching of credit increases to sales growth provides a ready means to finance expanded sales, which is especially valuable to fast-growing firms. Accounts receivable financing allows small businesses with creditworthy customers to use the stronger credit of their customers to
help borrow funds.


Factoring entails the sale of accounts receivable to another firm, called the factor, who then collects payment from the customer. Through factoring, a business can shift the effort and costs of collection and the risk of nonpayment to a third party. In a factoring arrangement, a company and the factor work out a credit limit and average collection period for each customer. As the company makes new sales to a customer, it provides an invoice to the factor. The customer pays the factor directly, and the factor then pays the company based on the agreed upon average collection period, less a slight discount
that covers the factor’s collection costs and credit risk.

A factor may advance payment for a large share of the invoice, typically 70% to 80%, providing the
company with immediate cash flow from sales. In this case, the factor charges an interest rate on this advance and then deducts the advance amount from its final payment to the firm when an invoice is collected

Factoring saves the cost of establishing and administering its own collection system. Second, a factor can often collect accounts receivable at a lower cost than a small business, due to economies of scale, and transfer some of these savings to the company. Third, factoring is a form of collection insurance that provides an enterprise with more predictable cash flow from sales. On the other hand, factoring costs may be higher than a direct loan,.The business loses control over the collection  part of the customer relationship, which may affect overall customer relations, especially when the factor’s collection practices differ from those of the company.

Inventory Financing

Inventory financing is a secured loan with inventory as collateral.  Firms with an inventory of standardized goods with predictable prices, such as automobiles or appliances, will be more successful at securing
inventory financing than businesses with a large amount of work in process or highly seasonal or perishable goods. Loan amounts also vary with the quality of the inventory pledged as collateral, usually ranging from 50% to 80%. For most businesses, inventory loans yield loan proceeds at a lower share of pledged assets than accounts receivable financing. When inventory is a large share of a firm’s current assets, however, inventory financing has to be sought to finance working capital.

Lenders need to control the inventory pledged as collateral to ensure that it is not sold before their loan is repaid. Two primary methods are used to obtain this control: (1) warehouse storage; and (2) direct assignment by product serial or identification numbers.  Under one warehouse arrangement, pledged inventory is stored in a public warehouse and controlled by an independent party (the warehouse operator). A warehouse receipt is issued when the inventory is stored, and the goods are released only upon
the instructions of the receipt-holder. When the inventory is pledged, the lender has control of the receipt and can prevent release of the goods until the loan is repaid. A field warehouse, can also be established. Here, an independent public warehouse company assumes control over the pledged inventory at the
firm’s site.  Direct assignment by serial number is a simpler method to control inventory used for manufactured goods that are tagged with a unique serial number. The lender receives an assignment or trust
receipt for the pledged inventory that lists all serial numbers for the collateral. The company houses and controls its inventory and can arrange for product sales. However, a release of the assignment or return of the trust receipt is required before the collateral is delivered and ownership transferred to the buyer. This release occurs with partial or full loan repayment.

While inventory financing involves higher transaction and administrative costs than other loan instruments, it is an important financing tool for companies with large inventory assets.

Term Loan

Term loans can finance medium-term noncyclical working capital. A term loan is a form of medium-term debt in which principal is repaid over several years, typically in 3 to 7 years. Since lenders prefer not to bear interest rate risk, term loans usually have a floating interest rate set between the prime rate and prime plus 300 basis points, depending on the borrower’s credit risk.
Term loans have a fixed repayment schedule that can take several forms. Level principal payments over the loan term are most common. In this case, the company pays the same principal amount each month plus interest on the outstanding loan balance. A second option is a level loan payment in which the total payment amount is the same every month but the share allocated to interest and principle varies with each payment. Finally, some term loans are partially amortizing and have a balloon payment at maturity. Term loans can be either unsecured or secured; a business with a strong balance sheet and a good profit and cash flow history might obtain an unsecured term loan, but many small firms will be required to pledge assets. Moreover,
since loan repayment extends over several years, lenders include financial covenants in their loan agreements to guard against deterioration in the firm’s financial position over the loan term. Typical financial covenants
include minimum net worth, minimum net working capital (or current ratio), and maximum debt-to-equity ratios. Finally, lenders often require the borrower to maintain a compensating balance account equal to 10% to 20% of the loan amount.

To be rewritten once again.

MBA Core Management Knowledge - One Year Revision Schedule

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