USE OF INVENTORY AS COLLATERAL

Inventory is generally second to accounts receivable in desirability as short-term loan collateral. Inventory normally has a market value that is greater than its book value, which is used to establish its value as collateral. A lender whose loan is secured with inventory will probably be able to sell that inventory for at least book value if the borrower defaults on its obligations.

The most important characteristic of inventory being evaluated as loan collateral is marketability. A warehouse of perishable items, such as fresh peaches, may be quite marketable, but if the cost of storing and selling the peaches is high, they may not be desirable collateral. Specialized items, such as moon-roving vehicles, are also not desirable collateral because finding a buyer for them could be difficult. When evaluating inventory as possible loan collateral, the lender looks for items with very stable market prices that have ready markets and that lack undesirable physical properties.

Floating Inventory Liens

A lender may be willing to secure a loan under a floating inventory lien, which is a claim on inventory in general. This arrangement is most attractive when the firm has a stable level of inventory that consists of a diversified group of relatively inexpensive merchandise. Inventories of items such as auto tires, screws and bolts, and shoes are candidates for floating-lien loans. Because it is difficult for a lender to verify the presence of the inventory, the lender generally advances less than 50 percent of the book value of the average inventory. The interest charge on a floating lien is 3 to 5 percent above the prime rate. Commercial banks often require floating liens as extra security on what would otherwise be an unsecured loan. Floating-lien inventory loans may also be available from commercial finance companies.

floating inventory lien

A secured short-term loan against inventory under which the lender’s claim is on the borrower’s inventory in general.

Trust Receipt Inventory Loans

trust receipt inventory loan often can be made against relatively expensive automotive, consumer durable, and industrial goods that can be identified by serial number. Under this agreement, the borrower keeps the inventory, and the lender may advance 80 to 100 percent of its cost. The lender files a lien on all the items financed. The borrower is free to sell the merchandise but is trusted to remit the amount lent, along with accrued interest, to the lender immediately after the sale. The lender then releases the lien on the item. The lender makes periodic checks of the borrower’s inventory to make sure that the required collateral remains in the hands of the borrower. The interest charge to the borrower is normally 2 percent or more above the prime rate.

trust receipt inventory loan

A secured short-term loan against inventory under which the lender advances 80 to 100 percent of the cost of the borrower’s relatively expensive inventory items in exchange for the borrower’s promise to repay the lender, with accrued interest, immediately after the sale of each item of collateral.

Trust receipt loans are often made by manufacturers’ wholly owned financing subsidiaries, known as captive finance companies, to their customers. Captive finance companies are especially popular in industries that manufacture consumer durable goods because they provide the manufacturer with a useful sales tool. For example, General Motors Acceptance Corporation, the financing subsidiary of General Motors, grants these types of loans to its dealers. Trust receipt loans are also available through commercial banks and commercial finance companies.

Warehouse Receipt Loans

warehouse receipt loan is an arrangement whereby the lender, which may be a commercial bank or finance company, receives control of the pledged inventory collateral, which is stored by a designated agent on the lender’s behalf. After selecting acceptable collateral, the lender hires a warehousing company to act as its agent and take possession of the inventory.

warehouse receipt loan

A secured short-term loan against inventory under which the lender receives control of the pledged inventory collateral, which is stored by a designated warehousing company on the lender’s behalf.

Two types of warehousing arrangements are possible. A terminal warehouse is a central warehouse that is used to store the merchandise of various customers. The lender normally uses such a warehouse when the inventory is easily transported and can be delivered to the warehouse relatively inexpensively. Under a field warehouse arrangement, the lender hires a field-warehousing company to set up a warehouse on the borrower’s premises or to lease part of the borrower’s warehouse to store the pledged collateral. Regardless of the type of warehouse, the warehousing company places a guard over the inventory. Only on written approval of the lender can any portion of the secured inventory be released by the warehousing company.

The actual lending agreement specifically states the requirements for the release of inventory. As with other secured loans, the lender accepts only collateral that it believes to be readily marketable and advances only a portion—generally 75 to 90 percent—of the collateral’s value. The specific costs of warehouse receipt loans are generally higher than those of any other secured lending arrangements because of the need to hire and pay a warehousing company to guard and supervise the collateral. The basic interest charged on warehouse receipt loans is higher than that charged on unsecured loans, generally ranging from 3 to 5 percent above the prime rate. In addition to the interest charge, the borrower must absorb the costs of warehousing by paying the warehouse fee, which is generally between 1 and 3 percent of the amount of the loan. The borrower is normally also required to pay the insurance costs on the warehoused merchandise.

 REVIEW QUESTIONS

16–11Are secured short-term loans viewed as more risky or less risky than unsecured short-term loans? Why?

16–12In general, what interest rates and fees are levied on secured short-term loans? Why are these rates generally higher than the rates on unsecured short-term loans?

16–13Describe and compare the basic features of the following methods of using accounts receivable to obtain short-term financing: (a) pledging accounts receivable and (b) factoring accounts receivable. Be sure to mention the institutions that offer each of them.

16–14For the following methods of using inventory as short-term loan collateral, describe the basic features of each, and compare their use: (a) floating lien, (b) trust receipt loan, and (c) warehouse receipt loan.

Summary

FOCUS ON VALUE

Current liabilities represent an important and generally inexpensive source of financing for a firm. The level of short-term (current liabilities) financing employed by a firm affects its profitability and risk. Accounts payable and accruals are spontaneous liabilities that should be carefully managed because they represent free financing. Notes payable, which represent negotiated short-term financing, should be obtained at the lowest cost under the best possible terms. Large, well-known firms can obtain unsecured short-term financing through the sale of commercial paper. On a secured basis, the firm can obtain loans from banks or commercial finance companies, using either accounts receivable or inventory as collateral.

The financial manager must obtain the right quantity and form of current liabilities financing to provide the lowest-cost funds with the least risk. Such a strategy should positively contribute to the firm’s goal of maximizing the stock price.

REVIEW OF LEARNING GOALS

LG 1 Review accounts payable, the key components of credit terms, and the procedures for analyzing those terms. The major spontaneous source of short-term financing is accounts payable. They are the primary source of short-term funds. Credit terms may differ with respect to the credit period, cash discount, cash discount period, and beginning of the credit period. Cash discounts should be given up only when a firm in need of short-term funds must pay an interest rate on borrowing that is greater than the cost of giving up the cash discount.

LG 2 Understand the effects of stretching accounts payable on their cost and the use of accruals. Stretching accounts payable can lower the cost of giving up a cash discount. Accruals, which result primarily from wage and tax obligations, are virtually free.

LG 3 Describe interest rates and the basic types of unsecured bank sources of short-term loans. Banks are the major source of unsecured short-term loans to businesses. The interest rate on these loans is tied to the prime rate of interest by a risk premium and may be fixed or floating. It should be evaluated by using the effective annual rate. Whether interest is paid when the loan matures or in advance affects the rate. Bank loans may take the form of a single-payment note, a line of credit, or a revolving credit agreement.

LG 4 Discuss the basic features of commercial paper and the key aspects of international short-term loans. Commercial paper is an unsecured IOU issued by firms with a high credit standing. International sales and purchases expose firms to exchange rate risk. Such transactions are larger and of longer maturity than domestic transactions, and they can be financed by using a letter of credit, by borrowing in the local market, or through dollar-denominated loans from international banks. On transactions between subsidiaries, “netting” can be used to minimize foreign exchange fees and other transaction costs.

LG 5 Explain the characteristics of secured short-term loans and the use of accounts receivable as short-term-loan collateral. Secured short-term loans are those for which the lender requires collateral, which are usually current assets such as accounts receivable or inventory. Only a percentage of the book value of acceptable collateral is advanced by the lender. These loans are more expensive than unsecured loans. Commercial banks and commercial finance companies make secured short-term loans. Both pledging and factoring involve the use of accounts receivable to obtain needed short-term funds.

LG 6 Describe the various ways in which inventory can be used as short-term-loan collateral. Inventory can be used as short-term-loan collateral under a floating lien, a trust receipt arrangement, or a warehouse receipt loan.

Opener-in-Review

In the chapter opener, you learned about FastPay, a company that lends to online ad publishers based on advertising receivables. Suppose that you are running a business that relies on online ad revenues. It typically takes 60 days to collect from your customers and convert receivables into cash. FastPay offers you $150,000 in cash in exchange for the right to collect $155,000 in receivables from a particular customer. You have a bank line of credit that allows you to borrow on a short-term basis at an annual interest rate of 7 percent. Should you borrow on the credit line or accept the offer from FastPay?

Self-Test Problem

(Solutions in Appendix)

LG 1 LG 2

ST16–1Cash discount decisions The credit terms for each of three suppliers are shown in the following table. (Note: Assume a 365-day year.)

Supplier Credit terms
X 1/10 net 55 EOM
Y 2/10 net 30 EOM
Z 2/20 net 60 EOM
  • a. Determine the approximate cost of giving up the cash discount from each supplier.
  • b. Assuming that the firm needs short-term financing, indicate whether it would be better to give up the cash discount or take the discount and borrow from a bank at 15% annual interest. Evaluate each supplier separately using your findings in part a.
  • c. Now assume that the firm could stretch its accounts payable (net period only) by 20 days from supplier Z. What impact, if any, would that have on your answer in part b relative to this supplier?
 

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