Advantages and Disadvantages of Short-Term Financing

The three possible financing policies described above were distinguished by the relative amounts of short-term debt used under each policy. The aggressive policy called for the greatest use of short-term debt, while the conservative policy called for the least. Maturity matching fell in between. Although short-term credit is generally riskier than long-term credit, using short-term funds does have some significant advantages. The pros and cons of short-term financing are considered in this section.

Speed

A short-term loan can be obtained much faster than long-term credit. lenders will insist on a more thorough financial examination before extending long-term credit and the loan agreement will have to be spelled out in considerable detail because a lot can happen during the life of a 10 to 20 year loan. Therefore if funds are needed in a hurry the firm should look to the short-term markets.

Flexibility

If its needs for funds are seasonal or cyclical, a firm may not want to commit itself to long-term debt for three reasons: (1) Flotation costs are higher for long-term debt than for short-term credit. (2) Although long-term debt can be repaid early, provided the loan agreement includes a prepayment provision, prepayment penalties can be expensive. Accordingly, if a firm thinks its need for funds will diminish in the near future, it should choose short-term debt. (3) Long-term loan agreements always contain provisions, or covenants, which constrain the firm’s future actions. Short-term credit agreements are generally less restrictive.

Cost of Long-Term Versus Short-Term Debt

The yield curve is normally upward sloping, indicating that interest rates are generally lower on short-term debt. Thus, under normal conditions, interest costs at the time the funds are obtained will be lower if the firm borrows on a short-term rather than a long-term basis.

Risks of Long-Term Versus Short-Term Debt

Even though short-term rates are often lower than long-term rates, short-term credit is riskier for two reasons: (1) If a firm borrows on a long-term basis, its interest costs will be relatively stable over time, but if it uses short-term credit, its interest expense will fluctuate widely, at times going quite high. For example, the rate banks charge large corporations for short-term debt more than tripled over a two-year period in the 1980s, rising from 6.25 to 21 percent. Many firms that had borrowed heavily on a short-term basis simply could not meet their rising interest costs and as a result, bankruptcies hit record levels during that period. (2) If a firm borrows heavily on a short-term basis, a temporary recession may render it unable to repay this debt. If the borrower is in a weak financial position, the lender may not extend the loan, which could force the firm into bankruptcy. Braniff Airlines, which failed during a credit crunch in the 1980s, is an example. Another good example of the riskiness of short-term debt is provided by Transamerica Corporation, a major financial services company. Transamerica’s chairman, Mr. Beckett, described how his company was moving to reduce its dependency on short-term loans whose costs vary with short-term interest rates. According to Beckett, Transamerica had reduced its variable-rate (short-term) loans by about $450 million over a two-year period. We aren’t going to go through the enormous increase in debt expense again that had such a serious impact on earnings, he said. The company’s earnings fell sharply because money rates rose to record highs. We were almost entirely in variable rate debt, he said, but currently about 65 percent is fixed rate and 35 percent variable, We’ve come a long way, and we’ll keep plugging away at it. Transamerica’s earnings were badly depressed by the increase in short-term rates, but other companies were even less fortunate they simply could not pay the rising interest charges and this forced them into bankruptcy.

Alternative Current Asset Financing Policies

Most businesses experience seasonal and/or cyclical fluctuations. For example, construction firms have peaks in the spring and summer, retailers peak around Christmas and the manufacturers who supply both construction companies and retailers follow similar patterns. Similarly, virtually all businesses must build up current assets when the economy is strong. but they than see off inventories and reduce receivables when the economy slacks off. still, current assets rarely drop to zero-companies have some permanent current assets, which are the current assets on hand at the low point of the cycle. Then, as sales increase during the upswing, current assets must be increased and these additional current assets are defined as temporary current assets. The manner in which the permanent and temporary current assets are financed is called the firm’s current asset financing policy.

Maturity Matching, or “Self-Liquidating”, Approach

The maturity matching, or “self-liquidating”, approach calls for matching asset and liability maturities as shown in Panel a of Figure 17-1. This strategy minimizes the risk that the firm will be unable to pay off its maturing obligations. To illustrate, suppose a company borrows on a one year basis and uses the funds obtained to build and equip a plant. Cash flows from the plant (profits plus depreciation) would not be sufficient to pay off the loan at the end of only one year, so the loan would have to be renewed. If for some reason the lender refused to renew the loan, then the company would have problems. Had the plant been financed with long-term debt, however, the required loan payments would have been better matched with cash flows from profits and depreciation, and the problem of renewal would not have arisen.

At the limit, a firm could attempt to match exactly the maturity structure of its assets and liabilities. Inventory expected to be sold in 30-days could be financed with a 30-day bank loan; a machine expected to last for 5-years could be financed with a 5-year loan; a 20-year building could be financed with a 20-year mortgage bond; and so forth. Actually of course, two factors prevent this exact maturity matching: (1) there is uncertainty about the lives of assets, and (2) some common equity must be used and common equity has no maturity. To illustrate the uncertainty factor, a firm might finance inventories with a 30-day loan, expecting to sell the inventories and then use the cash to retire the loan. But if sales were slow, the cash would not be forthcoming, and the use of short-term credit could end up causing a problem. Still if a firm makes an attempt to match asset and liability maturities, we would define this as a moderate current asset financing policy.

Aggressive Approach

Panel b of Figure 17-1 illustrates the situation for a relatively aggressive firm which finances all of its fixed assets with long-term capital and part of its permanent current assets with short-term, nonspontaneous credit. Note that we used the term “relatively” in the title for panel b because there can be different degrees of aggressiveness. For example, the dashed line in panel b could have been drawn below the line designating fixed assets, indicating that all of the permanent current assets and part of the fixed assets were financed with short-term credit; this would be a highly aggressive, extremely nonconservative position and the firm would be very much subject to dangers from rising interest rates as well as to loan renewal problems. However, short-term debt is often cheaper than long-term debt, and some firms are willing to sacrifice safety for the chance of higher profits.

Conservative Approach

Panel c of Figure 17-1 has the dashed line above the line designating permanent current assets indicating that permanent capital is being used to finance all permanent asset requirements and also to meet some of the seasonal needs. In this situation, the firm uses a small amount of short-term, nonspontaneous credit to meet its peak requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the form of marketable securities. The humps above the dashed line represent short-term financing, while the troughs below the dashed line represent short-term security holdings. Panel c represents a very safe, conservative current asset financing policy.

Chrysler, which in 1996 had $8.7 billion of cash and marketable securities, fits the panel c pattern. Its chairman, Robert Eaton, stated that these liquid assets will be needed during the next recession and he cited as evidence the fact that Chrysler had an operating cash deficit of more than $4 billion during the 1991-1992 recession. However, some of Chrysler’s could borrow funds in the future if need be, so the extra $6.7 billion should be redeployed to earn more than the 3 percent after taxes it was getting. The Chrysler example illustrates the fact that there is no clear, precise answer to the question of how much cash and securities a firm should hold.

Influencing Credit Policy

In addition to the factors discussed in previous sections two other points should be made regarding credit policy.

Profit Potential

We have emphasized the costs of granting credit. However, if it is possible to sell on credit and also to impose a carrying charge on the receivables that are outstanding, then credit sales can actually be more profitable than cash sales. This is especially true for consumer durables (autos, appliances, and so on), but it is also true for certain types of industrial equipment. Thus, GM’s General Motors Acceptance Corporation (GMAC) unit, which finances automobiles, is highly profitable, as is Sears’s credit subsidiary. Some encyclopedia companies even lose money of cash sales but more than make up these losses from the carrying charges on their credit sales. Obviously, such companies would rather sell on credit than for cash!

The carrying charges on outstanding credit are generally about 18 percent on a nominal basis: 1.5 percent per month, so 1.5% × 12 = 18%. This is equivalent to an effective annual rate of (1.015)¹² – 1.0 = 19.6%. Having receivables outstanding that earn more than 18 percent is highly profitable unless there are too many bad debt losses.

Legal Considerations

It is illegal under the Robinson Patman Act, for a firm to charge prices that discriminate between customers unless these differential prices are cost-justified. The same holds true for credit it is illegal to offer more favorable credit terms to one customer or class of customers than to another, unless the differences are cost-justified.

Cash Discounts

The last element in the credit policy decision, the use of cash discounts for early payment, is analyzed by balancing the costs and benefits of different cash discounts. For example, a firm might decide to change its credit terms from “net 30”, which means that customers must pay within 30 days to “2/10. net 30”, where a 2 percent discount is given if payment is made in ten days. This change should produce two benefits: (1) It should attract new customers who consider the discount to be a price reduction and (2) the discount should cause a reduction in the days sales outstanding, because some existing customers will pay more promptly in order to get the discount. Offsetting these benefits is the dollar cost of the discounts. The optimal discount percentage is establish at the point where the marginal costs and benefits are exactly offsetting.

If sales are seasonal, a firm may use seasonal dating on discounts. For example Slimware Inc. a swimsuit manufacturer, sells on terms of 2/10, net 30, May I dating. This means that the effective invoice date is May I, even if the sale was made back in January. The discount may be taken up to May 10; otherwise the full amount must be paid on May 30. Slimware produces throughout the year, but retail sales of bathing suits are concentrated in the spring and early summer. By offering seasonal dating, the company induces induces some of its customers to stock up early, saving Slimware some storage costs and also nailing down sales.

Collection Policy

Collection policy refers to the procedures the firm follows to collect past-due accounts. For example, a letter might be sent to customers when a bill is 10 days past due: a more severe letter, followed by a telephone call, would be sent if payment is not received within 30 days and the account would be turned over to a collection agency after 90 days.

The collection process can be expensive in terms of both out-of-pocket expenditures and lost goodwill-customers dislike being turned over to a collection agency. However, at least some firmness is needed to prevent an undue lengthening of the collection period and to minimize outright losses. A balance must be struck between the costs and benefits of different collection policies.

Changes in collection policy influence sales, the collection period and the bad debt loss percentage. All of this should be taken into account when setting the credit policy.

The Credit Period And Standards

A firm’s regular credit terms, which include the credit period and discount, might call for sales on a 2/10. net 30 basis to all “acceptable” customers. Here customers who pay within 10 days would be given a 2 percent discount, and others would be required to pay within 30 days. its credit standards would be applied to determine which customers qualify for the regular credit terms, and the amount of credit available to each customer.

Credit Standards

Credit standards refer to the financial strength and creditworthiness a customer must exhibit in order to qualify for credit. If a customer does not qualify for the regular credit terms, it can still purchase from the firm, but under more restrictive terms. For example, a firm’s regular credit terms might call for payment after 30 days, and these terms might be extended to all qualified customers. The firm’s credit standards would be applied to determine which customers qualified for the regular credit terms and how much credit each should receive. The major factors considers when setting credit standards relate to the likelihood that a given customer will pay slowly or perhaps end up as a bad debt loss.

Setting credit standards requires a measurement of credit quality, which is defined in terms of the probability of a customer’s default. The probability estimate for a given customer is, for the most part, a subjective judgment. Nevertheless, credit evaluation is a well-established practice, and a good credit manager can make reasonably accurate judgments of the probability of default by different classes of customers.

Managing a credit department requires fast, accurate, and up-to-date information. To help get such information, the National Association of Credit Management (a group with 43,000 member firms) persuaded TRW, a large credit reporting agency, to develop a computer-based telecommunications network for the collection, storage, retrieval, and distribution of credit information. A typical business credit report would include the following pieces of information:

1. A summary balance sheet and income statement.
2. A number of key rations, with trend information.
3. Information obtained from the firm’s suppliers telling whether it pays promptly or slowly, and whether it has recently failed to make any payments.
4. A verbal description of the physical condition of the firm’s operations.
5. A verbal description of the backgrounds of the firm’s owners, including any previous bankruptcies, lawsuits divorce settlement problems, and the like.
6. A summary rating, ranging from A for the best credit risks down to F for those that are deemed likely to default.

Although a great deal of credit information is available, it must still be processed in a judgmental manner. Computerized information systems can assist in making better credit decisions, but in the final analysis, most credit decisions are really exercises in information judgment.

Credit Policy

The success or failure of a business depends primarily on the demand for its products as a rule, the higher its sales, the larger its profits and the higher its stock price. Sales, in turn, depend on a number of factors, some exogenous but others under the firm’s control. The major controllable determinants of demand are sales prices, product quality, advertising and the firm’s credit policy. Credit policy in turn, consists of these four variables.

1.    Credit period, which is the length of time buyers are given to pay for their purchases.

2.    Credit standards, which refer to the required financial strength of acceptable credit customers.

3.    Collection policy, which is measured by its toughness or laxity in attempting to collect on      slow-paying accounts.

4.    Discounts given for early payment, including the discount percentage and how rapidly payment must be made to qualify for the discount.

                  

The credit manager is responsible for administering the firm’s credit policy. However, because of the pervasive importance of credit, the credit policy itself is normally established by the executive committee, which usually consists of the president plus the vice-presidents of finance, marketing and production.