16.3 Secured Sources of Short-Term Loans

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When a firm has exhausted its sources of unsecured short-term financing, it may be able to obtain additional short-term loans on a secured basis. Secured short-term financing has specific assets pledged as collateral. The collateral commonly takes the form of an asset, such as accounts receivable or inventory. The lender obtains a security interest in the collateral through the execution of a security agreement with the borrower that specifies the collateral held against the loan. In addition, the terms of the loan against which the security is held form part of the security agreement. A copy of the security agreement is filed in a public office within the state, usually a county or state court. Filing provides subsequent lenders with information about which assets of a prospective borrower are unavailable for use as collateral. The filing requirement protects the lender by legally establishing the lender’s security interest.

secured short-term financing

Short-term financing (loan) that has specific assets pledged as collateral.

security agreement

The agreement between the borrower and the lender that specifies the collateral held against a secured loan.

CHARACTERISTICS OF SECURED SHORT-TERM LOANS

Although many people believe that holding collateral as security reduces the risk that a loan will default, lenders do not usually view loans in this way. Lenders recognize that holding collateral can reduce losses if the borrower defaults, but the presence of collateral has no impact on the risk of default. A lender requires collateral to ensure recovery of some portion of the loan in the event of default. What the lender wants above all, however, is to be repaid as scheduled. In general, lenders prefer to make less risky loans at lower rates of interest than to be in a position in which they must liquidate collateral.

Collateral and Terms

Lenders of secured short-term funds prefer collateral that has a duration closely matched to the term of the loan. Current assets are the most desirable short-term-loan collateral because they can normally be converted into cash much sooner than fixed assets. Thus, the short-term lender of secured funds generally accepts only liquid current assets as collateral.

Typically, the lender determines the desirable percentage advance to make against the collateral. This percentage advance constitutes the principal of the secured loan and is normally between 30 and 100 percent of the book value of the collateral. It varies according to the type and liquidity of collateral.

percentage advance

The percentage of the book value of the collateral that constitutes the principal of a secured loan.

The interest rate that is charged on secured short-term loans is typically higher than the rate on unsecured short-term loans. Lenders do not normally consider secured loans less risky than unsecured loans. In addition, negotiating and administering secured loans is more troublesome for the lender than negotiating and administering unsecured loans. The lender therefore normally requires added compensation in the form of a service charge, a higher interest rate, or both.

Institutions Extending Secured Short-Term Loans

The primary sources of secured short-term loans to businesses are commercial banks and commercial finance companies. Both institutions deal in short-term loans secured primarily by accounts receivable and inventory. We have already described the operations of commercial banks. Commercial finance companies are lending institutions that make only secured loans—both short-term and long-term—to businesses. Unlike banks, finance companies are not permitted to hold deposits.

commercial finance companies

Lending institutions that make only secured loans—both short-term and long-term—to businesses.

Only when its unsecured and secured short-term borrowing power from the commercial bank is exhausted will a borrower turn to the commercial finance company for additional secured borrowing. Because the finance company generally ends up with higher-risk borrowers, its interest charges on secured short-term loans are usually higher than those of commercial banks. The leading U.S. commercial finance companies include the CIT Group and General Electric Corporate Financial Services.

USE OF ACCOUNTS RECEIVABLE AS COLLATERAL

Two commonly used means of obtaining short-term financing with accounts receivable are pledging accounts receivable and factoring accounts receivable. Actually, only a pledge of accounts receivable creates a secured short-term loan; factoring really entails the sale of accounts receivable at a discount. Although factoring is not actually a form of secured short-term borrowing, it does involve the use of accounts receivable to obtain needed short-term funds.

Pledging Accounts Receivable

pledge of accounts receivable is often used to secure a short-term loan. Because accounts receivable are normally quite liquid, they are an attractive form of short-term-loan collateral.

pledge of accounts receivable

The use of a firm’s accounts receivable as security, or collateral, to obtain a short-term loan.

The Pledging Process When a firm requests a loan against accounts receivable, the lender first evaluates the firm’s accounts receivable to determine their desirability as collateral. The lender makes a list of the acceptable accounts, along with the billing dates and amounts. If the borrowing firm requests a loan for a fixed amount, the lender needs to select only enough accounts to secure the funds requested. If the borrower wants the maximum loan available, the lender evaluates all the accounts to select the maximum amount of acceptable collateral.

After selecting the acceptable accounts, the lender normally adjusts the dollar value of these accounts for expected returns on sales and other allowances. If a customer whose account has been pledged returns merchandise or receives some type of allowance, such as a cash discount for early payment, the amount of the collateral is automatically reduced. For protection from such occurrences, the lender normally reduces the value of the acceptable collateral by a fixed percentage.

Next, the percentage to be advanced against the collateral must be determined. The lender evaluates the quality of the acceptable receivables and the expected cost of their liquidation. This percentage represents the principal of the loan and typically ranges between 50 and 90 percent of the face value of acceptable accounts receivable. To protect its interest in the collateral, the lender files a lien, which is a publicly disclosed legal claim on the collateral.

lien

A publicly disclosed legal claim on loan collateral.

Notification Pledges of accounts receivable are normally made on a nonnotification basis, meaning that a customer whose account has been pledged as collateral is not notified. Under the nonnotification arrangement, the borrower still collects the pledged account receivable, and the lender trusts the borrower to remit these payments as they are received. If a pledge of accounts receivable is made on a notification basis, the customer is notified to remit payment directly to the lender.

nonnotification basis

The basis on which a borrower, having pledged an account receivable, continues to collect the account payments without notifying the account customer.

notification basis

The basis on which an account customer whose account has been pledged (or factored) is notified to remit payment directly to the lender (or factor).

Matter of fact

Receivables Trading

Founded in 2007, the Receivables Exchange is an online marketplace where organizations such as hedge funds and commercial banks looking for short-term investments can bid on receivables pledged by small, medium-sized, and large companies from a wide range of industries. Companies that need cash put their receivables up for auction on the Receivables Exchange, and investors bid on them. In its first few years of operation, the Receivables Exchange provided funding of more than $1 billion to companies selling their receivables. The Receivables Exchange attracted the attention of the NYSE Euronext, which purchased a minority stake in the company in 2011.

Pledging Cost The stated cost of a pledge of accounts receivable is normally 2 to 5 percent above the prime rate. In addition to the stated interest rate, a service charge of up to 3 percent may be levied by the lender to cover its administrative costs. Clearly, pledges of accounts receivable are a high-cost source of short-term financing.

 

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