Collateral and Terms

Lenders of secured short-term funds prefer collateral that has a duration closely matched to the term of the loan. Current assets are the most desirable short-term-loan collateral because they can normally be converted into cash much sooner than fixed assets. Thus, the short-term lender of secured funds generally accepts only liquid current assets as collateral.

Typically, the lender determines the desirable percentage advance to make against the collateral. This percentage advance constitutes the principal of the secured loan and is normally between 30 and 100 percent of the book value of the collateral. It varies according to the type and liquidity of collateral.

The interest rate that is charged on secured short-term loans is typically higher than the rate on unsecured short-term loans. Lenders do not normally consider secured loans less risky than unsecured loans. In addition, negotiating and administering secured loans is more troublesome for the lender than negotiating and administering unsecured loans. The lender therefore normally requires added compensation in the form of a service charge, a higher interest rate, or both.

Institutions Extending Secured Short-Term Loans

The primary sources of secured short-term loans to businesses are commercial banks and commercial finance companies. Both institutions deal in short-term loans secured primarily by accounts receivable and inventory. We have already described the operations of commercial banks. Commercial finance companies are lending institutions that make only secured loans—both short-term and long-term—to businesses. Unlike banks, finance companies are not permitted to hold deposits.

Only when its unsecured and secured short-term borrowing power from the commercial bank is exhausted will a borrower turn to the commercial finance company for additional secured borrowing. Because the finance company generally ends up with higher-risk borrowers, its interest charges on secured short-term loans are usually higher than those of commercial banks. The leading U.S. commercial finance companies include the CIT Group and General Electric Corporate Financial Services.

Pledging Accounts Receivable

A pledge of accounts receivable is often used to secure a short-term loan. Because accounts receivable are normally quite liquid, they are an attractive form of short-term-loan collateral.

The Pledging Process When a firm requests a loan against accounts receivable, the lender first evaluates the firm’s accounts receivable to determine their desirability as collateral. The lender makes a list of the acceptable accounts, along with the billing dates and amounts. If the borrowing firm requests a loan for a fixed amount, the lender needs to select only enough accounts to secure the funds requested. If the borrower wants the maximum loan available, the lender evaluates all the accounts to select the maximum amount of acceptable collateral.

After selecting the acceptable accounts, the lender normally adjusts the dollar value of these accounts for expected returns on sales and other allowances. If a customer whose account has been pledged returns merchandise or receives some type of allowance, such as a cash discount for early payment, the amount of the collateral is automatically reduced. For protection from such occurrences, the lender normally reduces the value of the acceptable collateral by a fixed percentage.

Next, the percentage to be advanced against the collateral must be determined. The lender evaluates the quality of the acceptable receivables and the expected cost of their liquidation. This percentage represents the principal of the loan and typically ranges between 50 and 90 percent of the face value of acceptable accounts receivable. To protect its interest in the collateral, the lender files a lien, which is a publicly disclosed legal claim on the collateral.

Notification Pledges of accounts receivable are normally made on a nonnotification basis, meaning that a customer whose account has been pledged as collateral is not notified. Under the nonnotification arrangement, the borrower still collects the pledged account receivable, and the lender trusts the borrower to remit these payments as they are received. If a pledge of accounts receivable is made on a notification basis, the customer is notified to remit payment directly to the lender.

Pledging Cost The stated cost of a pledge of accounts receivable is normally 2 to 5 percent above the prime rate. In addition to the stated interest rate, a service charge of up to 3 percent may be levied by the lender to cover its administrative costs. Clearly, pledges of accounts receivable are a high-cost source of short-term financing.

Factoring Accounts Receivable

Factoring accounts receivable involves selling them outright, at a discount, to a financial institution. A factor is a financial institution that specializes in purchasing accounts receivable from businesses. Although it is not the same as obtaining a short-term loan, factoring accounts receivable is similar to borrowing with accounts receivable as collateral.

Factoring Agreement A factoring agreement normally states the exact conditions and procedures for the purchase of an account. The factor, like a lender against a pledge of accounts receivable, chooses accounts for purchase, selecting only those that appear to be acceptable credit risks. Where factoring is to be on a continuing basis, the factor will actually make the firm’s credit decisions because this will guarantee the acceptability of accounts. Factoring is normally done on a notification basis, and the factor receives payment of the account directly from the customer. In addition, most sales of accounts receivable to a factor are made on a nonrecourse basis, meaning that the factor agrees to accept all credit risks. Thus, if a purchased account turns out to be uncollectible, the factor must absorb the loss.

Typically, the factor is not required to pay the firm until the account is collected or until the last day of the credit period, whichever occurs first. The factor sets up an account similar to a bank deposit account for each customer. As payment is received or as due dates arrive, the factor deposits money into the seller’s account, from which the seller is free to make withdrawals as needed.

In many cases, if the firm leaves the money in the account, a surplus will exist on which the factor will pay interest. In other instances, the factor may make advances to the firm against uncollected accounts that are not yet due. These advances represent a negative balance in the firm’s account, on which interest is charged.

Factoring Cost Factoring costs include commissions, interest levied on advances, and interest earned on surpluses. The factor deposits in the firm’s account the book value of the collected or due accounts purchased by the factor, less the commissions. The commissions are typically stated as a 1 to 3 percent discount from the book value of factored accounts receivable. The interest levied on advances is generally 2 to 4 percent above the prime rate. It is levied on the actual amount advanced. The interest paid on surpluses is generally between 0.2 and 0.5 percent per month.

Although its costs may seem high, factoring has certain advantages that make it attractive to many firms. One is the ability it gives the firm to turn accounts receivable immediately into cash without having to worry about repayment. Another advantage is that it ensures a known pattern of cash flows. In addition, if factoring is undertaken on a continuing basis, the firm can eliminate its credit and collection departments.