Short-term bank funding: credit lines, secured loans and factoring

Why companies need short-term funding

A company pays suppliers and workers before customers pay it. The gap, the cash conversion cycle, has to be financed. Short-term borrowing also lets a firm keep a liquidity buffer and pay suppliers early when they offer a discount.

Non-financial companies get most short-term money from banks. The three standard facilities are uncommitted lines of credit, committed lines of credit and revolving credit agreements (revolvers). Each can be unsecured or secured, depending on the borrower's strength, its credit situation and the local legal system.

Credit lines give the quickest and most flexible access to cash: the company draws when it needs money and repays when cash comes in. Uncommitted lines and revolvers are more common in the United States, while ordinary committed lines dominate elsewhere.

Three kinds of credit line

An uncommitted line lets the company borrow up to a set amount for a maximum term, paying a market reference rate (MRR) plus an issuer-specific spread only on what is outstanding. There is no other fee, which makes it the cheapest and most flexible source in good times. Banks usually grant them unsecured to customers who keep steady deposits with them, so the bank can watch the account and react quickly if balances fall.

The catch is that the bank may refuse any drawdown. Because the bank has made no promise, it holds almost no capital against the line until it is used. When conditions sour, the bank can say no just when other funding is scarce or very expensive. That is why an uncommitted line cannot be a company's primary funding source, and why it is the least reliable form of bank borrowing. For the bank, it is mainly a relationship tool funded from stable deposits.

A committed (regular) line is a formal written promise to lend. It needs more bank capital, so banks keep the term under a year (typically 364 days) to limit the capital charge, and large borrowers often get a syndicate of banks, each taking a fixed share. The line is unsecured, can be repaid early without penalty, and when drawn shows up as a short-term liability such as notes payable. The borrower pays an upfront commitment fee (for example 0.50%) on either the full line or the unused part. The risk left is renewal risk: a heavily drawn borrower whose credit is weakening may not get the line renewed.

A revolver (or operating line) is a multiyear commitment. Lenders protect themselves with covenants that require or forbid certain actions, much like a bond indenture. Rates and commitment fees work as in a regular line, and some revolvers allow a switch into a medium-term loan. Because the promise runs for years, revolvers are the most reliable bank funding.

Think of the three lines as an umbrella you borrow, one you rent for a year, and one you own for several years. The more certain you are of having it when it rains, the more you pay for it.

Secured loans, assignment and factoring

A secured loan, also called an asset-based loan, requires the borrower to pledge collateral: fixed assets, good-quality receivables, inventory or marketable securities. The lender files a security interest (a right to the asset until the loan is repaid), and the lien appears on the borrower's credit record. Firms that are not strong enough to borrow unsecured use this route.

Receivables can raise cash in two ways. Under assignment of accounts receivable, the receivables are collateral for a loan, and the company keeps collecting them. Under factoring, the company sells the receivables to a lender (the factor), usually at a substantial discount, and the factor takes over credit granting and collection.

The size of the factor's discount depends on how creditworthy the customers are and how costly the accounts are to collect. Inventory can also back a loan in several ways.