Secured Loans

Banks and other finance companies often require security for a short-term loan just as they do for a long-term loan. Security for short-term loans usually consists of accounts receivable, inventories, or both.

Accounts Receivable Financing Accounts receivable financing involves either assigning receivables or factoring receivables. Under assignment, the lender has the receivables as security, but the borrower is still responsible if a receivable can't be collected. With conventional factoring, the receivable is discounted and sold to the lender (the factor). Once it is sold, collection is the factor's problem, and the factor assumes the full risk of default on bad accounts. With maturity factoring, the factor forwards the money on an agreed-upon future date.

Factors play a particularly important role in the retail industry. Retailers in the clothing business, for example, must buy large amounts of new clothes at the beginning of the season. Because this is typically a long time before they have sold anything, they wait to pay their suppliers, sometimes 30 to 60 days. If an apparel maker can't wait that long, it turns to factors, who buy the receivables and take over collection. In fact, the garment industry accounts for about 80 percent of all factoring in the United States.

Factoring is important elsewhere. For example, when Compaq Computer announced its fourth-quarter financial results ending in January 1998, analysts were surprised to

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CHAPTER 19 Short-Term Finance and Planning 661

learn that the firm had factored $1.1 billion in receivables during the period. Some investors worried that this was Compaq's way of hiding excess inventory in the distribution channel by forcing dealers to buy so it wouldn't show up on Compaq's books. For its part, Compaq pointed out that it factored receivables because it could earn a "positive carry" by earning more on the money it got than the rate it paid in factoring its receivables.

Cost of Factoring

For the year just ended, LuLu's Pies had an average of $50,000 in accounts receivable. Credit sales were $500,000. LuLu's factors its receivables by discounting them 3 percent, in other words, by selling them for 97 cents on the dollar. What is the effective interest rate on this source of short-term financing?

To determine the interest rate, we first have to know the accounts receivable, or average collection, period. During the year, LuLu's turned over its receivables $500,000/50,000 = 10 times. The average collection period is therefore 365/10 = 36.5 days.

The interest paid here is a form of discount interest (discussed in Chapter 6). In this case, LuLu's is paying 3 cents in interest on every 97 cents of financing. The interest rate per 36.5 days is thus .03/.97 = 3.09%. The APR is 10 X 3.09% = 30.9%, but the effective annual rate

Factoring is a relatively expensive source of money in this case.

We should note that, if the factor takes on the risk of default by a buyer, then the factor is providing insurance as well as immediate cash. More generally, the factor essentially takes over the firm's credit operations. This can result in a significant saving. The interest rate we calculated is therefore overstated, particularly if default is a significant possibility.

Ross et al.: Fundamentals VII. Short-Term Financial 1S. Short-Term Finance of Corporate Finance, Sixth Planning and Management and Planning Edition, Alternate Edition

Inventory Loans Inventory loans, short-term loans to purchase inventory, come in inventory loan three basic forms: blanket inventory liens, trust receipts, and field warehouse financing: A secured short-tei-m loan to purchase

1. Blanket inventory lien. A blanket lien gives the lender a lien against all the inventory. borrower's inventories (the blanket "covers" everything).

2. Trust receipt. A trust receipt is a device by which the borrower holds specific inventory in "trust" for the lender. Automobile dealer financing, for example, is done by use of trust receipts. This type of secured financing is also called floor planning, in reference to inventory on the showroom floor. However, it is somewhat cumbersome to use trust receipts for, say, wheat grain.

3. Field warehouse financing. In field warehouse financing, a public warehouse company (an independent company that specializes in inventory management) acts as a control agent to supervise the inventory for the lender.

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