9.5 Some Short-term Sources of Funds

The following are common means by which the firm will (horizontally) finance the gap in its cash flow:

Short-term Bank Line of Credit

In order to open up an “LOC,” a corporation must apply for a line with its commercial bankers. Once approved, the LOC works much like a credit card. In order to borrow money, the corporations imply writes a check and funds are provided. When the corporation is able to pay back the funds borrowed, it simply writes a check back to the bank. Naturally, the firm will pay interest on the money borrowed and the bank will often demand collateral such as inventory to secure the line. LOCs are usually short-term, often up to just one year in term at which time all borrowings must be repaid. The firm may also renew the credit line.

The lending institution will often require “compensating balances.” For example, let’s say a firm borrows $1,000,000 and the bank requires a 10% balance. This means that the firm must always have on deposit in its account $100,000 which bears no interest. This raises the interest cost of any loans. Additionally, the bank may require an upfront fee in order to open the account. This fee is not unfair, as the bank incurs an opportunity cost in keeping sufficient  liquid funds available for the customer to access.

Bank Note

A bank note although short-term, is unlike an LOC, in that the borrower receives the entire principal at the time the loan is closed and pays a fixed rate of interest until the loan matures in a year or less. The note may sometimes be collateralized.

Commercial Paper

Commercial Paper is generally an unsecured promissory note issued in the Money Market. It is not considered a Security, as stocks and bonds are, and thus is not subject to the laws governing new Security Issues (Initial Public Offerings or “IPOs”) as per the Security Act of 1933. On the most reputable corporation can issue Commercial Paper because its credibility relies virtually on credit reputation alone.

In order to gain access to the money market, a corporation who needs liquid funds for as little as one day, will contact a money market dealer it knows and indicate the firm’s needs. The dealer will then find buyers, or lenders, to purchase the “paper.” Remarkably, these transactions are backed by trust alone. Interestingly, except for one large default in 1969, there have been scare defaults over its entire history.

The money market is an institutional market with very large minimums. Small investors can gain access to the money markets via money market savings accounts at a savings institution or via money market mutual funds.


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Corporate Finance Copyright © 2023 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

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