Short-Term Bank Credit - Financial Management

Commercial banks are an important source of both secured and unsecured short-term credit. In terms of the aggregate amount of short -term financing they provide to business firms, they rank second behind trade credit. Although trade credit is a primary source of spontaneous short-term financing, bank loans represent the major source of negotiated short -term funds.

A major purpose of short-term bank loans is to meet the firm’s seasonal needs for funds—such as financing the buildup of inventories and receivables. Bank loans used for this purpose are regarded as self -liquidating, because sale of the inventories and collection of the receivables are expected to generate sufficient cash flows to permit the firm to repay the loan prior to the next seasonal buildup.

When a firm obtains a short-term bank loan, it normally signs a promissory note specifying the amount of the loan, the interest rate being charged, and the due date. The loan agreement may also contain various protective covenants. Short-term bank loans appear on the balance sheet under notes payable.

The interest rate charged on a bank loan is usually related to the prime rate, which is the rate banks historically have charged on loans made to their most creditworthy, or prime, business customers. The prime rate fluctuates over time with changes in the supply of and demand for loanable funds. During the past 25 years, for instance, the prime rate ranged from as low as 4.0 percent to as high as 21.5 percent. In recent years many large, highly profitable companies have been able to borrow at less than the prime rate. Subprime borrowing is partially the result of increased competition among large banks and other suppliers of short -term financing for especially creditworthy borrowers.

As an alternative to borrowing funds in the United States, large, well -established multinational corporations can borrow short -term funds in the Eurodollar market. The interest rate in the Eurodollar market is usually related to the London Interbank Offer Rate, or LIBOR. LIBOR is the interest rate at which banks in the Eurocurrency market lend to each other. For example, large, well -established multinational corporations usually can borrow at about 0.5 percentage points over LIBOR. Because LIBOR is frequently about 1.5 or more percentage points below U.S. bank prime rates, large companies can often borrow in the Eurodollar market at subprime rates. For example, in June 2004, the LIBOR rate was 1.36 percent, compared to an average prime rate of 4.00 percent. However, the LIBOR rate tends to be more volatile over time than the prime rate. Short-term bank financing is available under three different arrangements:

  • Single loans (notes)
  • Lines of credit
  • Revolving credit agreements

Single Loans (Notes)

Businesses frequently need funds for short time periods to finance a particular undertaking. In such a case, they may request a bank loan. This type of loan is often referred to as a note. The length of this type of loan can range from 30 days to one year, with most being for 30 to 90 days.

The interest rate a bank charges on an individual loan at a given point in time depends on a number of factors, including the borrower’s creditworthiness relative to prime (lowest) credit risks. The interest rate often includes a premium of 1 to 2 or more percentage points above the prime rate, depending on how the bank officer perceives the borrower’s overall business and financial risk. If the borrower is in a weak financial position and has overall risk that is thought to be too high, the bank may refuse to make an unsecured loan, regardless of the interest rate.When making the loan decision, the loan officer also considers the size of the checking account balance the company maintains at the bank, the amount of other business it does with the bank, and the rates that competitive banks are charging on similar loans.

The annual financing cost of a bank loan is also a function of when the borrower must pay the interest and whether the bank requires the borrower to maintain a compensating balance. Interest Payments If the interest on a note is paid at maturity, the annual financing cost is equal to the stated annual interest rate. In the case of a discounted loan, however, the bank deducts the interest at the time the loan is made, and thus the borrower does not receive the full loan amount. In other words, the borrower pays interest on funds it does not receive, and the annual financing cost of the loan is greater than the stated annual interest rate.For example, suppose the Edgewood Flower and Gift Shop receives a 6-month (183 day) $5,000 discounted loan at a stated annual interest rate of 8 percent. The firm pays $201 interest in advance (0.08 *$5,000 *183/365) and receives only $4,799 ($5,000 *$201). Using Equation 16.8, the annual financing cost is calculated as follows:

AFC = $201/$4,799 * 365/183 = 0.084 or 8.4%

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Financial Management Topics