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liquidating credits, the short-term loanfrequently displaying many of the features of selfliquidationcontinues to account for a significant share of all loans to business firms.
In fact, most business loans cover only a few weeks or months and are usually related
closely to the borrower's need for short-term cash to finance purchases of inventory or
cover production costs, the payment of taxes, interest payments on debt, and dividend
payments to stockholders.
There is concern in the banking and commercial finance industries today that traditional
inventory loans may be on the decline. Thanks to the development of just in time (JIT) and
supply chain management techniques businesses can continuously monitor their inventory
levels and more quickly replace missing items. Reflecting this trend, inventory to-sales
ratios recently have been declining in many industries. Thus, there appears to be less need
for traditional inventory financing and many businesses are experiencing lower inventory
financing costs. In the future, lenders will be forced to develop other services in order to
replace potential losses in inventory-loan revenues as new software-driven tech nology
speeds up ordering and shipment, allowing businesses to get by with leaner in-house stocks
of goods and raw materials.
Working capital loans provide businesses with short-run credit, lasting from a few days to
about one year. Working capital loans are most often used to fund the purchase of inventories
in order to put goods on shelves or to purchase raw materials; thus, they come closest to the
traditional self-liquidating loan described previously.
Frequently the working capital loan is designed to cover seasonal peaks in the business
customer's production levels and credit needs. For example, a clothing manufacturer antici pating heavy demand in the fall for back-to-school clothes and winter wear will require
short-term credit in the late spring and summer to purchase inventories of cloth and hire
additional workers. The manufacturer's lender can set up a line of credit stretching from six
to nine months, permitting that manufacturer to draw upon the credit line as needed over this
period. The amount of the credit line is determined from the manufacturer's esti mate of the
maximum amount of funds that will be needed at any point during the six to nine-month
term of the loan. Such loans are frequently renewed under the provision that the borrower
pay off all or a significant portion of the loan before renewal is granted.
Normally, working capital loans are secured by accounts receivable or by pledges of
inventory and carry a floating interest rate on the amounts actually borrowed against the
approved credit line. A commitment fee is charged on the unused portion of the credit line
and sometimes on the entire amount of funds made available. Compensating deposit
balances may be required from the customer. These include required deposits whose min imum size is based on the size of the credit line (e.g., 1 to 5 percent of the credit line) and
required deposits equal to a stipulated percentage of the total amount of credit actually
used by the customer (e.g., 15 to 20 percent of actual drawings against the line).
Dealers in
securities
Retailer and
Equipment
Financing
Business
lenders
support
installment
purchases of
automobiles
,
home
appliances,
furniture,
business
equipment,
and
other
durable
goods
by
financing
the
receivables
that dealers
selling these
goods take
on
when
they write
installment
contracts to
cover
customer
purchases.
In
turn,
these
contracts
are
reviewed by
lending
institutions
with whom
the dealers
have
established
credit
relationship
s. If they
meet
acceptable
credit
standards,
the
contracts
are
purchased
by lenders
at
an
interest rate
that varies
periods. In
return
for
the loan the
dealer signs
a
security
agreement,
giving the
lending
institution a
lien against
the goods in
the event of
nonpayment
. At the
same time
the
manufacture
r
is
authorized
to
ship
goods to the
dealer and
to bill the
lender
for
their value.
Periodically,
the lender
will send an
agent
to
check
the
goods
on
the dealer's
floor
to
determine
what
is
selling and
what
remains
unsold. As
goods
are
sold,
the
dealer sends
a check to
the lender
for
the
manufacture
r's invoice
amount,
known as a
"pay-assold"
agreement.
If
the
lender's
agent visits
the dealer
and
finds
any
items
sold off for
which
the
lender
___________________________has
not
received
payment
(known
as_"soldout
ofitrust"),_pa
yment will
be
requested_i
mmediately for
those
particular
items. If the
dealer fails
to pay, the
lender may
be forced to
repossess the
remaining
goods and
return some
or all of
them to the
manufacture
r for credit.
Floor
planning
agreements
typically
include
a
loan-loss
reserve, built
up from the
interest
earned
as
borrowers
repay their
loans, and is
reduced
if
any loans are
defaulted.
Once
the
loan-loss
reserve
reaches
a
predetermine
d level, the
dealer
receives
rebates for a
portion
of
the interest
earned
on
the
installment
contracts.
Key URLs
The World Wide Web
provides some guidance
on analyzing and
granting different types
of business loans. For
example, there are sites
on lending to small
businesses at
www.sba.gov/7alenders/
and the ABCs of
Borrowing at www.
howtoadvice.com/
borrowing. To learn
more about asset-based
borrowing and
international lending see
especially
www.factors.net and
jolis.worldbankimflib.
org/external.htm.
Asset-Based Financing
An increasing portion of short-term lending in
recent years has consisted of asset-based
loanscredit secured by the shorter-term assets
of a firm that are expected to roll over into cash in
the future. Key business assets used for many of
these loans are accounts receivable and inventories.
The lender commits funds against a specific
percentage of the book value of outstanding credit
accounts or against inventory. For example, it may
be willing to loan an amount equal to 70 percent of
a firm's current accounts receivable (i.e., all those
credit accounts that are not past due). Alternatively,
it may make a loan for 40 percent of the business
customer's current inventory. As accounts receivable
are collected or inventory is sold, a portion of the
cash proceeds flow to the lending institution to
retire the loan.
In most loans collateralized by accounts
receivable and inventory, the borrower retains title
to the assets pledged, but sometimes title is passed
to the lender, who then assumes the risk that some
of those assets will not pay out as expected. The
most common example of this arrangement is
Key URL
If you would like to
learn more about
syndicated loans, see
especially www.federal
reserve.gov/releases/
snc/default.htm.
dollars in credit for each loan, and to earn fee income (such as facility fees to open a credit "line or
commitment fees to keep a line of credit available for a period of time).
Many syndicated loans are traded in the secondary (resale) market and usually carry an
interest rate based upon the London Interbank Offered Rate (LIBOR) on Eurodollar
deposits. Syndicated loan rates in recent years have generally ranged from 100 to 400 basis
points over LIBOR, while the loans themselves usually have a light to medium credit qual ity grade and may be either short-term or long-term in maturity.
Because of the size and character of SNCs, federal examiners look at these loans care fully, searching for those that appear to be classified creditsthat is, weak loans that are
rated, in the best case, substandard, doubtful if somewhat weaker, or, in the worst case, an
outright loss that must be written off. Interestingly enough, the majority of classified SNCs
are held by nonbank lenders (such as finance and investment companies), which often take
on subinvestment-grade loans in the hope of scoring exceptional returns.
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The 1980s and 1990s ushered in an explosion of loans to finance mergers and acquisitions of
businesses before these loans slowed as the 21st century opened. Among the most noteworthy
of these acquisition credits are LBOsleveraged buyouts of firms by small groups of
investors, often led by managers inside the firm who believe their firm is undervalued in the
marketplace. A targeted company's stock price could be driven higher, it is argued, if its new
owners can bring more aggressive management techniques to bear, including selling off some
assets in order to generate more revenue.
These insider purchases have often been carried out by highly optimistic groups of
investors, willing to borrow heavily (often 90 percent or more of the LBOs are financed by
debt) in the belief that revenues can be raised higher than debt-service costs. Frequently the
optimistic assumptions behind LBOs have turned out to be wrong and many of these loans
have turned delinquent when economic conditions faltered.