Management of Short-Term Liabilities

In our cash budgeting example, we showed how our hypothetical firm is going to need to arrange a small amount of short-term borrowing to cover its cash shortfall in the fourth quarter. (Arguably, the firm is going to have a cash short-fall because of an investment in new manufacturing equipment, which would be a candidate for a long-term financing solution). However, because the firm generates significant cash from operations, a short-term borrowing alternative to cover its cash shortfall in one quarter may be its cheapest alternative. 

Operating loans: The most common way to cover a short-term cash deficit is to secure an operating loan. Operating loans usually give the firm the ability to borrow up until a specified amount over a given period (usually one year). A typical operating loan is a line of credit. These may be unsecured, or secured against an asset owned by the firm (collateral). Unsecured lines of credit are typically only granted to corporations with excellent credit ratings, because the credit agreement is only backed by projections of future cash flows.

Letter of credit: A letter of credit is an agreement by a bank assuring payment to a seller of goods and services. As long as the seller performs the duties of the underlying contract (ie. the goods arrive as promised to a buyer), the seller will receive payment from the financial institution. This assures the seller that they will be paid, regardless of whether the buyer fails to pay. This way, it transfers the risk of non-payment from the seller to the financial institution. Letters of credit are commonly used in international trade when the seller of goods is in one country and the buyer is in another. 

Secured loans: For corporations without excellent credit ratings, banks usually require some kind of security for a loan. Security for short-term loans usually involve short-term assets such as accounts receivable or inventory. Accounts receivable can either be assigned (the lender has a lien on the receivables and recourse against the borrower) or factored (the accounts receivables are sold without recourse). Short-term loans that use inventory as collateral include blanket inventory liens (a lien against all the borrower's inventory), trust receipts (the inventory is held in trust for the lender, and proceeds from the sale of inventory are immedetialy remitted to the lender), and field warehouse financing (a public warehouse company supervises the inventory for the lender). 

Commercial paper: Commercial paper is short-term notes issued by large corporations with excellent credit ratings. Commercial paper differs from bonds in that they typically have a maturity of 30 to 90 day (but possibly up to one year). Bankers acceptances are a variation of commercial paper where banks gaurantee the principle and interest payments on a corporation's commerical paper, while charging the corportation a "stamping fee," typically between 0.20 and 0.75 percent. 

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