In this section the focus of the chapter turns from short-term investing to short-term borrowing. Topics covered include short-term borrowing alternatives, as well as methods for calculating the effective costs of lines of credit and commercial paper.
Short-term debt instruments mature within one year and are generally used by firms to finance current assets such as accounts receivable and inventory. There are a number of alternatives to short-term debt issuance, including trade financing, intercompany loans, and the sale of receivables. These are all potential sources of liquidity funding that should be considered as part of a company’s short-term funding strategy, and are summarized below.
- Trade Credit
- Intercompany Loans
- Selling of Receivables
- Supply Chain Finance
- Commercial Bank Credit
- The all-in rate of interest
- Commitment fees, which can be on both used and unused balances
- Upfront and arranger fees on loan syndications, which are applied on initial setup and on renewal
- Single Payment Notes
- Repurchase Agreements
- Commercial Paper Issuance
- Asset-Based Borrowing
Trade credit arises when a customer receives goods or services but payment is not made to the supplier until a later date. Trade credit is the primary source of short-term financing used by many firms, since trade credit lets a buyer use the supplier’s goods or services while simultaneously using the cash it otherwise would have had to pay in advance or upon delivery. Trade credit provides a tangible economic benefit as a source of financing because the buyer may avoid liquidating investments or incurring debt over the credit period. A firm that pays its suppliers before the invoice’s due date (assuming no discount for early payment) may be forgoing an inexpensive source of short-term financing.
Intercompany lending may provide a low-cost source of funds. Multiple units of a firm—often, but not necessarily, separate subsidiaries of a multinational firm located in different countries—may borrow and lend among themselves through an in-house bank or other internal borrowing mechanism. Termed intercompany lending, these arrangements are formal and usually involve promissory notes or a memorandum of understanding. They are normally priced at market rates, or “arm’s length” rates, to comply with tax and regulatory requirements. An internal lender can generally apply lower margins than external banks, as they have access to better information on their subsidiaries’ credit quality. In addition, the parent company, or group as a whole, will often have better access to capital at better rates than individual group entities. Borrowers therefore benefit from a lower cost of funds, while the lender will typically generate a higher return than if the surplus cash was placed in money market instruments.
Many laws and regulations affect domestic and cross-border intercompany lending.20 For example, the length of time that intercompany loans are outstanding can affect whether the repayment of principal is treated as a return of capital or a dividend, for tax purposes. This can mean intercompany loans have to be settled on a regular basis; otherwise, they may be considered equity by the relevant tax authorities. There are also significant issues pertaining to transfer pricing (which necessitates the use of market rates) and capitalization requirements. Many jurisdictions examine these loan programs very closely, and even minor compliance problems can result in large fines. As a result, policies and documentation related to intercompany lending transactions should be comprehensive and designed based on advice from legal, audit, and tax professionals to avoid possible problems.
Receivables may be sold or discounted to raise cash in two ways. First, receivables may be sold at a discount from face value to a third party called a factor, which then collects on the receivables. This process is referred to as factoring. Second, receivables can be securitized. Through securitization, a firm issues debt securities backed by a pool of receivables. Receivables that are suitable for debt securitization have a predictable cash flow stream adequate to retire the issue and a historical record of low losses. There is more detail on techniques available to finance receivables, including securitization, in Chapter 10, Introduction to Working Capital.
In supply chain finance, a supplier receives loans based upon the credit rating and financial capabilities of its customer (i.e., the buying firm). Supply chain finance is typically arranged for by the buying firm rather than the supplier and allows the buying firm to extend its payables while providing lower-cost financing for its supplier. For example, suppose that a customer has historically paid suppliers 30 days after the receipt of invoices. Using supply chain finance, the firm may negotiate longer payment terms of 90 days. The new payment terms will increase the buyer’s accounts payable, but it will also increase the suppliers’ accounts receivable. Using supply chain finance, invoices are approved by the buyer when received. Suppliers may wait the full 90 days and receive the full amount of the invoice. Suppliers also have the option to receive a discounted amount prior to maturity. The primary advantage for the suppliers is that the invoices are discounted at a rate tied to the buyer’s cost of capital. This rate may be much lower than the supplier’s cost of capital, providing relatively low-cost financing for the supplier’s accounts receivable.
Bank borrowings represent an important source of working capital for most firms, especially middle-market and smaller firms. Larger, publicly traded firms often find bank credit attractive because banks can customize debt structures and use information not disclosed to the public to justify underwriting the debt.
Bank loans are offered on a secured or unsecured basis. Security, provided in the form of collateral or guarantees, may be used to obtain more favorable rates by some borrowers or to make credit available to businesses that cannot access unsecured credit facilities. In addition, a lender’s use of private information may reduce borrowing costs.
The sections below describe the most common forms of bank credit. These include loan syndications and participations, as well as lines of credit. Note that loans and credit arrangements are often referred to as credit facilities.
For organizations requiring large credit facilities, banks may extend those facilities through loan syndications and participations.
In a loan syndication, multiple financial institutions share the funding of a single credit facility. The syndicate, or group of lenders, is led by an agent who acts as the intermediary between the firm and the syndicate to negotiate credit terms and documentation, make advances and collect payments on the loan, and disseminate information. The agent usually receives an annual fee for handling these tasks. All syndicate members share common documentation, but each lender has a promissory note, making it a direct lending relationship. The individual lenders in the syndicate are usually able to sell their shares with or without consent from the borrower.
In a loan participation, a financial institution purchases an interest in another lender’s credit facility. The purchaser is called a participant, and the seller is the lead institution. The participant does not have a separate note and has only an indirect relationship with the borrower. A participation agreement specifies the participant’s and lead institution’s rights and obligations. In the case of a blind participation, the participation is not disclosed to the borrower, and the participant may not contact the borrower directly or disclose the participant’s role in the credit facility.
The rationale for these arrangements is that they allow banks to offer larger loans than they could on their own, due to capital requirements, and to expand their loan portfolio beyond their usual market, creating a more diversified mix of loans. It is important for treasury professionals whose organizations have loans under syndication or participation arrangements to understand the structure of the arrangements since it will affect how they interact with the lenders.
i. Overview
A line of credit is an agreement in which the lender gives the borrower access to funds up to a maximum amount over a specific period of time. Lines of credit are usually revolving (see discussion below), meaning the borrower may borrow, repay, and borrow funds again up to the established limit during the commitment period. A line of credit can provide short-term financing, back up a commercial paper program, or provide temporary liquidity. Swing and bridge (or bridging) loans are specifically designed to provide short-term funding until longer-term financing can be arranged.
ii. Conditions and Covenants
Requirements and conditions frequently associated with lines of credit include “cleanup” periods, credit sub-limits, covenants, and material adverse change (MAC) clauses. To ensure that a line is used for temporary financing, a lender may require a period of 30 to 60 consecutive days with no outstanding borrowing on the line (i.e., a cleanup period). This requirement is used mostly for middle-market and small firms to ensure that they do not use short-term financing for needs more appropriately met by long-term sources. A lender also may establish sub-limits under the line for specific uses such as letter of credit issuance or drafts under banker’s acceptances. Covenants used in short-term lending typically focus on maintaining certain minimum liquidity or coverage ratios, or maximum debt ratios. Finally, a MAC clause allows the lender to prohibit further funding or even declare the loan in default if there has been an adverse change in the borrower’s credit profile.
Ensuring sound internal reporting protocols and implementing improvements in cash forecasting help the firm remain compliant with the loan covenants. While reporting is normally a requirement of any covenant, it is also an important management tool. It is much easier to negotiate problems with covenant violations before they actually occur rather than after the fact. Since covenants typically apply to an entire organization, timely and accurate reporting from subsidiaries is an essential part of this issue.
iii. Types of Lines
Lines of credit are secured or unsecured, and uncommitted or committed. Secured lines require the borrower to pledge some form of collateral, most often current assets such as receivables or inventory. Unsecured lines do not require any collateral as part of the borrowing arrangement. The availability under some secured lines is limited by a borrowing base (sometimes referred to as the loan value) that is negotiated as a percentage of the value of the collateral securing the line.
An uncommitted line is an agreement with a lender in which the lender offers to make funds available in the future but is not obligated to provide a specific amount. Usually, an uncommitted line is made available for a one-year period. However, funding may be refused at the lender’s discretion or canceled outright, usually due to changes in the financial condition of the borrower. Hence, an uncommitted line is often called a discretionary line of credit. There is typically no fee for an uncommitted line unless funds are actually borrowed.
By contrast, a committed line usually involves a formal loan agreement that specifies the terms and conditions of the credit facility. It also typically requires compensation in the form of balances or fees because the lender is obligated to provide funding up to the credit limit stipulated in the agreement so long as the borrower is not in default. A commitment fee may be assessed based on the total amount or unused portion of the commitment. Typically, payment is made quarterly with varying fees, depending upon the company’s creditworthiness, the stated purpose of the line, and the commitment term. Some committed lines have an incremental, or accordion, feature, which allows the borrower to increase the amount borrowed up to a pre-agreed limit.
One of the most common types of credit lines is a revolving credit agreement, also known as a revolver. This is a committed line of credit, as opposed to an uncommitted line of credit, that is established for a specified period of time, often on a multiyear basis. Revolving credit lines are formal, contractual commitments with loan agreements, including covenants. Usually, there is a commitment fee on the unused portion, as well as a fee for use of the borrowing facility (which is calculated on a daily or overnight basis). Though often used for short-term borrowing, the commitment term typically ranges from two to five years and may be followed by a period in which the principal is repaid systematically. If more than one year remains on a multiyear revolver, accounting guidelines typically allow balances on this agreement to be carried as a long-term liability on the borrower’s balance sheet.
Revolvers contain all the characteristics of committed lines. In addition, revolvers often feature short-term, fixed-rate funding options that offer fixed-rate loans for specified periods with penalties imposed for prepayment. An example is a funding option for 90-day advances fixed at a rate equal to some preestablished spread over a specified reference interest rate. The amount of the spread varies depending on the credit risk. Some revolvers also have a multicurrency drawdown capability, allowing the borrower to fund borrowing requirements in different currencies from the same facility.
Another type of credit line is referred to as a guidance line or operating risk exposure limit. Guidance lines are used by banks to accommodate the credit exposure created from operating activities, such as automated clearinghouse (ACH) operations, daylight overdrafts,21 returned deposits, and foreign exchange exposure. Banks initiate this type of line, rather than the customer, in order to determine the overall level of exposure the bank has relative to all of the activities (borrowing and non-borrowing) that the customer has with the bank. Often, the bank will not disclose this type of line or credit limit. It is important, however, that treasury professionals ask about and actively manage any exposure limits to avoid potential problems with their firm’s ability to send wires or ACH credits from its accounts or to obtain additional borrowing. This is especially true during periods of high growth or acquisitions, which may stretch or break limits that are not being managed. It is also important to note that while the guidance line is typically treated by the bank as a credit exposure that impacts overall lending to a specific customer, it does not represent any commitment on the part of the bank to lend funds to the organization in question.
In many jurisdictions, banks provide companies with overdraft facilities, which are a type of credit line and a more formal version of the guidance line. An overdraft permits a company to maintain a negative balance on a demand deposit account on an overnight basis (or longer). Overdrafts are usually repayable on demand and can typically be pre-authorized up to a specified limit on payment of a fee. Banks may charge interest on any negative balance and/or apply a daily fee whenever the overdraft facility is used. Some jurisdictions prohibit the use of overdraft facilities.
iv. Pricing
Pricing for a line of credit is usually negotiable. The lender may take into account various aspects of the overall lender/borrower relationship in pricing the facility. There are three basic cost components for lines of credit:
The all-in rate consists of a base rate, such as SOFR, LIBOR (until its replacement), the US prime rate, or the Fed funds rate (all discussed later in this chapter), plus a spread that is added to, or occasionally subtracted from, the base rate. Rates on lines are normally variable and adjust immediately to changes in the base rate. While the actual rate on the loan will vary with the market, it is not unusual for a credit agreement to have a floor rate, which provides a bottom limit on how low the total interest rate can go.
The total interest paid is calculated as the all-in rate times the loan balance outstanding at any given time. Since both the rates and the loan balance can vary daily, the daily interest expense will also change. Annual (or period) interest is the total of the daily interest charges during the year (or period). Total fees paid include all commitment fees, placement fees, and any issuance costs. The impact of these rates and fees on loan pricing is covered later in this chapter.
Single payment notes are usually granted for a short period of time (e.g., a 60-day note) and specific purpose, with both the principal and interest amounts paid at maturity. Because of the limited duration and precise maturity of a single payment note, a specific cash flow event is frequently identified as the repayment source at the time the funds are advanced.
A repurchase agreement, or repo, is another source of short-term funds. With a repo, securities are sold, providing the seller with cash until the securities are repurchased. Repos let firms tap into the liquidity of their investment portfolio without having to permanently dispose of their short-term investments. An equivalent transaction may be structured by using a single payment note secured by marketable securities.
This section focuses on the use of commercial paper (CP) as a source of short-term financing. CP is unsecured promissory notes of highly rated corporations, financial institutions, or sovereigns. The specific characteristics of CP programs vary by country and are driven by the relevant local securities registration requirements. These requirements set maximum maturity dates and, typically, minimum issuance amounts that allow issued CP to be exempt from registration.
In the United States, there are two types of CP programs, named after the sections in the Securities Act of 1933 that provide exemptions from registration of CP with the Securities and Exchange Commission (SEC). An issuer under a 3(a)(3) program can issue CP up to 270 days in minimum amounts of $100,000. The proceeds of 3(a)(3) CP may only be used for working capital purposes. An issuer under a 4(2) program can issue CP up to 397 days in minimum amounts of $250,000. There is no restriction on how the proceeds of 4(2) CP may be used, including for construction expenditures or acquisitions. In practice, most outstanding CP has a maturity less than 30 days, but issuers continually roll over the CP into a new issue at maturity.
Characteristics of 3(a)(3) and 4(2) CP programs are outlined in Exhibit 13.4.
CP programs are rated by the major credit rating agencies, which normally require each program to have a liquidity backup in the event the market would not be available to issue or reissue CP for any reason. Typical backup facilities include a revolving credit facility or a letter of credit issued by a highly rated bank. Although common, not every CP issuer has to have a backup. Some firms with high liquidity and a strong credit rating are able to issue CP based solely on their own resources. CP can be issued directly by firms (i.e., sold directly to investors), but most CP is placed through dealers (selected by the issuer) who market the CP to investors for a nominal fee.
CP is sold at a discount, meaning the interest paid by the issuer on the CP is deducted from the CP’s face value when determining the proceeds that are available for use by the issuing firm. The discount rate on most CP, including USD-denominated CP, is calculated on a 360-day basis; however, the discount rate on CP issued in some currencies, including GBP, HKD, and SGD, is calculated on a 365-day basis. Other costs associated with a CP program include the dealer fees, backup credit facility fees, rating agency charges, and any credit enhancement costs.
Because of the effort and high fixed costs involved in establishing a CP program, CP financing is desirable only when ongoing funding needs are large. Firms with the highest credit rating rarely issue CP for amounts below $50 million, although individual issues under an overall program may be for smaller amounts. In addition, firms without excellent credit ratings often find commercial bank credit more attractive than CP because banks have more flexibility in structuring credit (e.g., covenants, rate adjustments, and collateral) to mitigate risk and therefore lower costs to the borrower.
Commercial finance companies and some commercial banks specialize in asset-based lending. Asset-based lines of credit in the working capital area are typically secured by accounts receivable or inventory, and can support temporary financing needs. Because accounts receivable and inventory are among a company’s most liquid assets, their use as security for asset-based financing may restrict the borrower’s ability to arrange other borrowing, including unsecured bank loans.
A loan or other borrowing arrangement represents an investment by the counterparty (i.e., the lender or investor). Consequently, the factors that influence investment yield are the determinants of credit pricing. Pricing and fees on loans increase with default risk, price risk, liquidity, and length of maturity. A discussion of how these factors impact loan pricing via interest rates is provided in the following section of this chapter. Factors that enter into borrowing costs yet do not impact an investor’s yields include dealer and placement fees, rating agency fees, credit enhancement fees, and backup credit costs.
It should be noted that borrowing costs are commonly discussed in terms of basis points (typically abbreviated as bps). One basis point is equal to a one-hundredth of 1%, which is 0.0001 or 0.01%. Thus, 50 bps is equivalent to 0.0050 or 0.50%.
In this section, the costs associated with CP and credit lines are covered, along with formulas and calculations for these sources.
- Annual Cost for CP Issuance
- Annual Cost for a Line of Credit
The all-in or total costs to issue CP include the interest rate implied in the discount, a dealer fee, and a fee for credit enhancement in the form of a backup or standby line of credit.
Assume that a firm issues $50,000,000 of US CP (and therefore uses a 360-day year for CP calculations) with a 20-day maturity at a discount of 0.396%. To calculate the annualized cost of the paper, begin by finding the amount of usable funds, which is the face amount of the CP less the discount:
Assume that the annualized dealer fee is 0.12% (12 basis points) and the cost of a backup line of credit is 0.25% (25 basis points). The amount of the dealer fee and the amount of the backup line of credit fee are calculated as follows:
As a final step in determining the annual cost of the CP issuance, the periodic interest rate must be annualized based on the number of times in a year that CP could be issued, assuming similar terms. When annualizing the cost of CP, note that a 365-day year is assumed. A general equation for this calculation appears below:
The annualized cost of 0.78% applies to the issuer of the CP. However, the buyer’s or investor’s yield is based on how much is gained in relation to the amount of funds that are not usable because they are tied up in the investment. In this example, the nominal, or annual, yield to the investor (calculated on a 365-day basis) is:
The investor’s yield is lower than the borrower’s cost because the investor does not receive the dealer fee or the backup line of credit fee paid by the borrower.
A line of credit lender will typically charge interest on funds borrowed and charge a commitment fee on the line on an annual basis. While there may be other fees, they tend to be one-time charges rather than recurrent annual fees. Interest is charged on the used portion of the line. The commitment fee may be charged on the entire line or just its unused portion. The overall interest rate on the credit line is determined by the total interest paid on the line’s used portion and the amount paid for the commitment fee relative to the average used portion of the credit line over the borrowing period. In the example that follows, the commitment fee applies to the unused portion of the credit line.
Assume that a firm expects to use $1,600,000 of short-term borrowings, but it wants to establish a $3,000,000 credit line to ensure adequate reserve borrowing capacity. A lender offers the firm LIBOR plus a risk premium of 2.50%. The lender requires a commitment fee of 0.30% (30 basis points) on the unused portion of the line. LIBOR at the time of the loan is 0.70%. The rate on the used portion of the line is LIBOR plus 2.50%, or 3.20% (the all-in rate). Begin by calculating all interest and fees paid:
20 Intercompany lending can be quite complex due to laws and regulations such as anti-hybrid rules, the US GILTI (global intangible low-taxed income) minimum tax, and the 30% limit on net interest expense (at every level of the legal structure) when calculating EBITDA (earnings before interest, taxes, depreciation, and amortization) for tax purposes.
21 A daylight overdraft occurs when a customer’s available account balance becomes negative during the day, but the needed funds are deposited or become available before the end of the business day. This may happen when a bank allows a customer to initiate wires or submit ACH payment files against funds that will be deposited or become available later in the day.