by Merlin Hernandez

 

Businesses need to keep current with capital markets since they remain a major source of investment funds for capital formation and working capital and have some of the highest returns on investments. Larger businesses use the funds generated from issuing stock in an IPO to finance long term capital expenditures like new equipment, projects, acquisitions or new technology. For companies that are not publicly traded, as well as small businesses, the use of marketable securities is important in building collateral for business loans from financial intermediaries. Choosing the right securities in which to invest, and determining the best risk-return trade-off in order to support the goals of the company is part of the measure of effective management.

Managers also need to be mindful that the share price on the stock exchange is directly related to demonstrated operational efficiencies as evidenced by annual corporate financial statements. This also supports consumer and credit market confidence – an appreciating stock is an indication of a healthy prognosis and worth consideration in decisions about where to place the investment dollar. For smaller businesses, CDs and Treasuries are also extremely liquid though they may yield lower returns. The advantage is that they remain low risk.  Bond markets are particularly useful for short term financing like working capital – meeting inventory needs and receivables within the next year. 

Commercial paper has been a cheap way to raise capital by corporations with strong credit. With slightly higher return rates than T-Bills, and minimum credit risk, commercial paper has been regarded as a safe asset. The mortgage crisis of 2007 where mortgage-backed securities fell significantly in value changed the perception of commercial paper as low risk. The lesson might be that heavy reliance on commercial paper as an investment/financing instrument can flip the portfolio risk from low to high. A good strategy when investing in commercial paper might be that investors should spread their risk with a diversified portfolio, and perhaps restrict investment to blue chip issues. Short term T-Bills can form part of a contingency plan.

 In terms of short term loans in the current economic climate, the maturity matching approach can leverage a firm’s risk of default on a loan portfolio by using T-Bills that mature at the same time as the loan term. This offers protection from default but if receivables can cover the loan as expected, returns from the T-Bills can become part of the company’s liquidity cushion. What I am saying is that when loans are cheap as they currently are, firms can aggressively take advantage of the climate to access working capital while using asset reserves for investment and liquidity cushion. This would be a combination of aggressive and maturity matching approaches to working capital financing.

A multi-purpose revolving line of credit is one of the most useful resources for businesses of any size and can serve both short and long term needs. It is a valuable source of working capital that can be applied to receivables, payroll and marketing expenses, and occasional cash flow shortages. Many times a bank will extend a line of credit to a firm based on receivables as the only collateral. They may look at AR and cash flows only in making the decision. This might however be specific to industries like fashion, toys, school supplies, the gift trade etc. – with their high seasonal demand and cash flow spikes. The bank would hedge its risk by only extending such a facility to clients in good standing or those with a cash flow history that demonstrates a high probability of meeting their payments.

For small businesses, trade credit is perhaps the most obvious and flexible form of short term financing. On the demand side, trade credit remains one of the most common modes of short term financing for businesses with working capital or credit challenges seeking better cash flow management. It can be seen as an interest-free line of credit.  The terms of trade credit are supposed to benefit a supplier as well through an increase in short term sales, moving inventory that would soon be out-of-date, or to reward valuable customers – credit terms function as a form of sales promotion.

The value of trade credit can be analyzed in terms of opportunity cost. The Time Value of Money increases an amount of money as a result of interest earned and is an opportunity cost attached to the deferment of a payment obligation. Small firms may not have an in-depth understanding of APR/APY terms or true rates of return. They tend to measure the benefits of credit terms by the length of the collection period. Payables are often prioritized by due dates and cash availability and a longer payment period is seen as an advantage. Perhaps there should be no difference but in practicality, there might be, especially as the opportunity costs attached to a small payable may be almost negligible in relation to the convenience of the longer term.

The fact that there are no interest penalties attached to a trade credit arrangement is motivation for the customer to defer payment in favor of immediate liquidity needs, which may include a short term investment, the gains of which could give an amount greater than the trade credit payment. The longer the collection term, the more attractive the arrangement might be. An added advantage is that deferment, even beyond the collection term, lowers the financing costs due to an extended period at no additional cost.

Related articles on this blog

• Financing a Small Business
• Decision Making

• Diversifying a Small Business

 

 

Advertisements