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Smart summary working capital management CFA

2015, Study Session # 11, Reading # 39



Working Capital Management
Line Of Credit
Short Term Marketable Investments
Current Ratio

Current Assets
Current Liabilities



Accounts Receivable
Cost of Goods Sold
Short Term Working Capital Portfolios
Bond Equivalent Yield
Days Sales Outstanding
Weighted Avg. Days of Sale Outstanding


Effective WCM ⇒ adequate cash to fund
day to day necessary operations with
company’s assets invested in most
productive way.

Internal Factors

External Factors

Company size & growth
Organizational structure

Banking services

Sophistication of
working capital
Borrowing & investing
position / activities /

New technologies & new

Interest rates

The economy

Insufficient access to cash:
Restructuring by selling of
Reorganization via bankruptcy
Final liquidation.
Excessive investment in cash, may
not be the optimum use of
company resources.
A careful balance is required in

In effective WCM
Adequate cash levels are maintained.
Converting short-term assets into cash.
Controlling outgoing payments to vendors, employees and others.
It is done by investing in:
Short term funds.
Highly liquid securities.
Maintaining credit reserves in bank lines of credit.
Issuing money market instruments like commercial paper.
It requires reliable cash flow forecasts.



Payment for trade,
financing and

Relation with trading partners

To ensure smooth transactions.

Analysis of WCM activities

To formulate appropriate

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Global view
Strong emphasis
on liquidity

2015, Study Session # 11, Reading # 39


2.1 Defining Liquidity Management
2.1.1 Primary Sources of Liquidity
2.1.2 Secondary Sources of Liquidity
2.1.3 Drags & Pulls on Liquidity

Liquidity ⇒ Company’s ability to meet its short term
An asset is liquid if it can be converted into cash, either
by sale or financing, quickly.
Companies with liquidity ⇒ focus is on putting
abundant liquidity into most effective use.
In tight financial situation ⇒ effective liquidity
management required ⇒ ensures solvency.
If liquidity management is not done ⇒ bankruptcy or
possible liquidation.

2.2 Measuring Liquidity

2.1 Defining Liquidity Management
Ability of management to generate cash when needed.
Usually it is associated with short-term assets and liabilities to provide
Long term assets & liabilities can be used to provide liquidity but can
reduce company’s overall financial strength.
Liquidity management challenges ⇒ developing, implementing and
maintaining liquidity policy.
Company must manage key resources that include primary sources and
secondary sources.

2.1.1 Primary Sources of Liquidity
Most readily available source can be held as cash or near-cash securities.
Ready cash balance: available at banks against payment collection,
investment income, liquidation of near cash securities (maturity < 90
days) & other cash flows.
Short- term funds: trade credit, bank lines of credit, shot term investment
Cash flow management: effectiveness of company in cash management,
system of cash collection, cash available to use.
These funds are readily accessible at lower costs.

2.1.2 Secondary Source of Liquidity
May affect company’s normal operations and in some cases alter financial
and operating position.
Sources include:
Negotiating debt contracts: pressure of interest or principal
Liquidating assets.
Filing for bankruptcy protection and re-organization.
Use of such sources may signal deteriorating financial health.
Bankruptcy protection may be considered a liquidity tool.
Under such protection, a company generating operating cash is liquid and
able to continue business operations until restructuring is approved.

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2015, Study Session # 11, Reading # 39
2.1.3 Drags & Pulls on Liquidity

Drag ⇒ when receipts lag

Pull ⇒ disbursements paid quickly

Major drags include
Uncollected receivables
→ outstanding, risk they would not be collected at all
→ Indicated by no. of days receivable and bad debts.
Obsolete inventory
→ Inventory stands than usual
→ Indication of no longer being usable
→ Indicated by slow inventory turnover ratios.
Tight credit
→ Economic condition not favorable
→ Short term debt cost .
Drags controlled by strict credit & collection practices.

Major pulls on payments include
Making payments early
→ Paying vendors before due date results in companies forgo use of funds.
→ Effective payment management means making payment when due, not early.
Reduced credit limit
→ History of late payments can lead to credit limit by suppliers.
→ Can squeeze company’s liquidity.
Limits on short term lines of credit.
→ Liquidity squeeze occur when bank LOC.
→ LOC restrictions can be:
Government mandated, market-related & company specific.
→ Over-banking ⇒ approach common in emerging as well as some developed
markets featuring unsound banking systems whereby companies establish lines
of credit in excess of their needs..
Low liquidity positions:
→ Such situation is faced by a company in a particular industry or with a weaker
financial position.
→ Secured borrowing is done by such companies.
→ Important for such companies to identify such assets for short term borrowings.
Critical to identify drags and pulls on time or before they have arisen.
2.2 Measuring Liquidity

Liquidity ensures creditworthiness ⇒ perceived ability of a borrower to make timely payments.
Creditworthiness chances to obtain credit at ↓ borrowing cost ⇒ better trade credit terms
Liquidity chances of financial distress ⇒ leads to insolvency & bankruptcy (extreme case).
Liquidity ratios ⇒ check company’s ability to meet short-term debt obligations.



profitable opportunities.


!" # $ %

chances to cover CL.

&/ (





%+.# $ %

→ Measures how many times A/R created & collected on avg. in one fiscal period.
- )


) =


%+. %

1 2

→ Measure how many times inventory created / acquired & sold during one fiscal period.
Activity ratios can also be re-arranged to estimate no. of days CA or CL are on hand.
3 . 45 .6
3 . 45 .6 )

) 78 =
. =

3 . 45 .6= . 78 =

%+.* 29


1 2

/0 /:;<
> 2





1 $



Alternate name

No. of days payable
No. of days inventory
No. of days receivables

Days payable outstanding
Avg. inventory period
Days sales outstanding

Avg. days payable
Inventory holding period
Days in receivables

Turnover ratios tell how company is managing its liquid assets.
Ratio analysis must be done against some benchmark not in isolation.
Benchmark could be industry avg. or company’s own track record (past performance) or with peer group.
@ . 8 = . 45 .6 4 )
. + B7 45 .6 4
) 78 6
Measure of time needed to convert raw material into cash from a sale.
Does not account for increased cash flow by deferring payment to suppliers.
3 =

@ . 8 = . 45 .6 4 )
. + . 45 .6 4
) 78 6–
Also called cash conversion cycle.
Cycles cash generating ability.
For many companies cash conversion cycle is a period that requires financing.

. 45 .6 4= . 78 6

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2015, Study Session # 11, Reading # 39


3.1 Forecasting Short-Term Cash Flows

Ensuring net cash positions not negative.
Negative balance is avoided as cost of borrowing is
and unacceptable.
Balance = inflows-outflows.
Managing short term portfolio ⇒ opportunity cost is
considered acceptable.
To manage cash decisions are done on latest
Company’s treasury function uses optimum services
and techniques associated with company’s payment
configuration to manage cash.

3.1.1 Minimum Cash Balance
3.1.2 Identify Typical Cash Flows
3.1.3 Cash Forecasting System

3.2 Monitoring cash uses and levels

3.1 Forecasting Short Term Cash Flows

Necessary task.
Precision in forecasting effectiveness.
Forecast ⇒ precise may not be accurate.
External uncertainty encourages companies to
maintain minimum level of cash as a buffer.
3.1.1 Minimum Cash Balance

Provides financial flexibility or protection.
An opportunity to take advantages from attractive
Size of this buffer depends upon:
Variation of cash inflows & outflows.
Access to liquid sources.
Ability to raise funds with lead time.

3.1.2 Identifying Typical Cash Flows

Cash mangers using cash flow history or organizational financial history must identify cash flow elements and collect data about them
Real cash flows should be reflected.
Elements include ;


Receipts from operations, broken down by
operating unit, departments, etc.

Payables & payroll disbursements, broken down by
operating unit, departments, etc.

Funds transfers from subsidiaries, joint ventures,
third parties.

Funds transfer to subsidiaries.

Maturing investments

Investments made

Debt proceeds (short and long term)

Debt repayments.

Other income items (interest, etc.)

Interest and dividend payments

Tax refunds.

Tax payments.

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2015, Study Session # 11, Reading # 39

3.1.3 Cash Forecasting System

Must be structured as a system to be effective.
Several aspects to be covered.
Importance of aspects varies in between forecast horizon.

Data frequency

Short Tem

Medium Term

Long Term

Daily / weekly for 4-6 weeks
Receipts & disbursements
Simple projections
Very high
Very high
Daily cash management

Monthly for one year
Receipts & disbursements
Projection models and averages
Fairly high
Planning financial transaction

Annually for 3-5 years
Projected financial statements
Statistical models
Not as high
Long-range financial position

3.2 Monitoring Cash Uses and Levels

Financial manager in charge of managing cash position must know cash balance at real
time basis.
Monitoring cash flow ⇒ key aspects of cash forecasting system.
It involves knowing of the transactions information in time to tackle with them.
Information should be gathered from principal users and providers of cash along with
cash projections.
Minimum cash level is estimated in advance and steps are taken to determine the target
balance for each bank.
Target balance is applied to one main account (the bank where company’s transactions
are concentrated).
Large companies have more concentration banks making cash management more
Short term investments and borrowing assist in cash management.
Cyclical companies need to focus more on sources of cash in times when they produce
and stock inventory for peak seasons.
Company’s cash needs are also influenced by long term investment and financial
Predicting cyclical and non-operating activity needs is critical in managing cash.
Setting aside too much cash can be costly while setting aside too little can cause penalty
to raise funds quickly ⇒ either case would be costly; a reliable forecast is necessary.


4.1 Short-Term Investment Instruments

4.2 Strategies

4.3 Evaluating Short Term Funds Management

4.1.1 Computing Yields On Short Term Investments
4.1.2 Investment Risks

4. Investing Short-Term Funds
Temporary store of funds not needed in daily transactions.
Extra working capital portfolio funds must be invested in long term portfolios.
SWCP include: highly liquid, less risky, and shorter maturity securities e.g. U.S
government securities & corporate obligation.
The portfolio changes as cash is needed or more cash is available for investment.

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2015, Study Session # 11, Reading # 39
4.1 Short-Term Investment Instruments
U.S Treasury Bills (T-bills)

Typical maturities
13, 26, and 52 weeks

Federal agency securities

5-30 days

Bank certificates of
deposit (CDs)

14-365 days

Banker’s acceptances

30-180 days

Eurodollar time deposits

1-180 days

Bank sweep services

1 day

Repurchase agreement

1 day +

Commercial paper (CP)

1-270 days

Mutual funds and money
market mutual funds


Tax-advantaged securities

7, 28, 35, 49, and 90

Obligation of U.S government (guaranteed), issued at a
Active secondary market.
Lowest rates for traded securities.
Obligations of U.S federal agencies (e.g., Fannie Mae, Federal
Home Loan Board) issued as interest-bearing.
Slightly higher yields than T-bills.
Bank obligations, issued interest-bearing in $100,000
“Yankee” CDs offer slightly higher yields.
Bank obligations for trade transactions (usually foreign), issued
at a discount.
Investor protected by underlying company and trade flow itself.
Small secondary market.
Time deposit with bank off-shore (outside United States, such as
Can be CDs or straight time deposit (TD).
Interest-bearing investment.
Small secondary market for CDs, but not TDs.
Service offered by banks that essentially provides interest on
checking account balance (usually over a minimum level).
Large numbers of sweeps are for overnight.
Sale of securities with the agreement of the dealer (seller) to
buy them back at a future time.
Typically over-collateralized at 102 percent.
Often done for very short maturities (< 1 week).
Unsecured obligations of corporations and financial institutions,
issued at discount.
Secondary market for large issuers
CP issuers obtain short-term credit ratings
Money market mutual funds commonly used by smaller
Low yields but high liquidity for money market funds; mutual
fund liquidity dependent on underlying securities in fund.
Can be linked with bank sweep arrangement
Preferred stock in many forms including adjustable rate
preferred stocks (ARPs), auction rate preferred stocks, (AURPs),
and convertible adjustable preferred stocks (CAPs).
Dutch auction often used to set rate.
Offer higher yields

Relative amounts to be invested in each type, depends upon the company.

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Virtually no risk

Slight liquidity risk;
insignificant credit risk.
Credit and liquidity risk
(depending on bank’s
Credit and liquidity risk
(depending on bank’s
Credit risk (depending
on bank) very high
liquidity risk for TDs

Credit and liquidity risk
(depending on bank).
Credit and liquidity risk
(depending on dealer)

Credit and liquidity risk
(depending on credit
Credit and liquidity risk
(depending on fund

Credit and liquidity risk
(depending on issuer’s

2015, Study Session # 11, Reading # 39

4.1.1 Computing Yield on Short Term Investments

6 = 4
) 8 – =
ℎ 6 =
Investor pays less than face value but receives face value at maturity e.g. T-bill, banker’s
Interest bearing securities ⇒ investor pays face amount, receives back face amount +
Nominal rate ⇒ rate based on securities face value.
Yield ⇒ actual return if investment held till maturity.


. 85 =

G $ %




⇒ Annualized using 360 days.

5 O ) 8

. 85 =

G $ P



I $


I $



> $



I $

1.1L* 2 1LM



1.1L* 2 1LM



⇒Annualized using 365 days
⇒ also referred to as the investment yield basis.
U.S. T-bill may be quoted on discount basis or BEY.

N 6 6. 85 =

G $ P


G $ P


I $



Q1.1L* 2 1M


⇒ Though BEY is relevant for investment decisions but discount basis is often quoted.

4.1.2 Investment Risk
Type of Risk

Key Attributes

Credit (or default)

Issuer may default
Issuer could be adversely
affected by economy,
Little secondary market

Market (or interest rate)

Price or rate changes
may adversely affect
There is no market to sell
the maturity to, or there
is only a small secondary
Security is difficult or
impossible to (re) sell.
Security must be held to
maturity and cannot be
liquidated until then.
Adverse general market
movement against your


Foreign exchange

Safety Measures
Minimize amount
Keep maturities short
Watch for
“questionable” names
Emphasize government
Keep maturities short
Keep portfolio diverse in
terms of maturity,

Stick with government
Look for good secondary
Keep maturities short.
Hedge regularly.
Keep most in your
currency and domestic
market (avoid foreign

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2015, Study Session # 11, Reading # 39
4.2 Strategies
Short-term investors do not want to take on substantial risk.
Strategies can be active or passive.
⇒ Passive: one or two decision rules for making daily investments.
⇒ Active: constant monitoring may involve matching, mismatching or laddering
Company must have investment guideline policy



Top priority is safety & liquidity.
Less aggressive than active strategies.
Roll over is required
Must be monitored against some benchmark

Matching Strategy

More daily involvement & choice of
Active involvement with more flexible
investment policy and better forecasts.

Mismatching Strategy

Conservative & similar to passive strategies.
Matching is of timing of cash outflows with
investment maturities.

Ladder strategy

Requires reliable cash forecast.
Riskier, requires liquid securities (T-bill) to
meet liquidity needs.
May also be accompanied by derivatives
posing additional risks.

In b/w passive & matching
Schedules maturities so that investments are
distributed equally over the ladder’s term.
Helpful in managing long-term portfolios

4.3 Evaluating Short Term Funds Management
For portfolios that are not large or diversified ⇒ use spread sheet models.
For diversified portfolios ⇒ more expensive treasury workstations.
Investment returns must be expressed on BEY to allow comparability.
Overall portfolio return must be weighted according to the size of the


5.1 Key Elements of Trade Credit
Granting Process

5.2 Managing Customer’s Receipts

5.3.1 Account Receivable Aging

5.3 Evaluating Accounts Receivable

5.3.2 The No. of Days of Receivables.

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2015, Study Session # 11, Reading # 39
5. Managing Accounts Receivable
Accounts receivable management ⇒ granting credit and processing transaction,
monitoring credit balance, measuring performance of credit function.
Efficient processing and disbursement of information to concerned
departments and managers is required.
Ensuring account receivable accounts are current.
Co-ordination with treasury management function.
Preparation of regular performance measurement reports.
Captive finance subsidiary ⇒ wholly owned subsidiary established to provide
financing of the sales of the parent company.
Some companies outsource accounts receivable function while some may invest
in credit insurance.
5.1 Key Elements of Trade Credit Granting Process
Effective credit management policy is required.
Basic guidelines of such policy set boundaries for credit management function.
Credit scoring model is used to classify borrowers according to creditworthiness.
Such models can be used to predict late payers.
Based upon the quality of borrower the credit is granted.

5.2 Managing Customer’s Receipts
Cash collection systems are function of types of customers and the methods
they use.
Nature of business ⇒ nature of customers ⇒ methods of payment.
Common electronic methods:
Direct debit
Electronic funds transfer
POS terminals
If payments do not transfer electronically, lock box system is used.
⇒ Lockbox: customer payments are mailed to a post office box and the banking
institution retrieves and deposits these payments several times a day.
Float factor measures time it takes for checks to clear ⇒ does not measure time
it takes to receive, deposit and clear checks





2L 1

2* >1


no. ofdays.
Cash collection system must accelerate payments & information content
associated with those payments.
Cash concentration involves:
1) Consolidating deposits.
2) Moving funds (b/w company accounts or to outside points).
⇒ Best treatments for consolidating deposits & moving funds for cash
concentration may differ for.
⇒ For moving funds electronic methods are cost effective.
Avg. dailydeposit =

5.3 Evaluating Accounts Receivable Management
Accounts receivable management ⇒ how efficiently receivable converted into
Such measures can be derived from 1) general financing reports and 2) Internal
financial records.

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2015, Study Session # 11, Reading # 39
5.3.1 Accounts Receivable Aging Schedule
Key report used by accounts receivables managers.
It breaks down accounts into categories of days outstanding.
Can be converted into percentage for comparability.

5.3.2 The No. of Days Receivables.
Provides overall picture.
Can be compared with credit management policy to gauge
account collection performance.
Weighted average DSO gives better idea of how long it takes
to collect from customers irrespective of sales level and ∆ in
Aging schedule is used to calculate weighted avg. DSO.
Major drawback of WADSO ⇒ requires more information ⇒
comparability across companies is difficult due to lack of


6.1 Approaches to Managing Levels of Inventory

6.2 Inventory Costs

6.3 Evaluating Inventory Management

6. Managing Inventory
Necessary for working capital management
Careful balance is required;
⇒ more inventories can lead to obsolete inventory and losses
on selling through discount ⇒ liquidity squeeze.
⇒ Fewer inventories (shortage) can lead to lost sales &
company’s inability to avoid price increase by suppliers.
Motive to hold inventory
a) Transaction motive ⇒ need for inventory as a part of
b) Precautionary stocks ⇒ amount maintained to avoid stock
out losses.
c) Speculative motive ⇒ if costs to in future then benefit
can be achieved. Assumption ⇒ storage cost < savings from
in price.

6.1 Approaches to Managing Levels of Inventory
Economic order quantity – reorder point
⇒ Traditional method
⇒ Reliable short term forecast is necessary.
⇒ Based upon expected demand and predictability of demand.
⇒ Safety stock ⇒ cushion beyond anticipated needs, helps when lead time .
⇒ Anticipation stock ⇒ Inventory in excess of anticipated demand
It fluctuates with sales level.
Just-in-time method
⇒ System to minimize in-process inventory.
⇒ Materials ordered when reach re-order level.
⇒ Can reduce inventory level to optimum level if J.I.T method is incorporated
with manufacturing resource planning method.
⇒ Careful planning is required.

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2015, Study Session # 11, Reading # 39
6.2 Inventory Costs
Several components ⇒ represent both opportunity & real costs.
⇒ Ordering cost: depend on orders e.g. setup, labor, freight etc.
⇒ Carrying: financing & holding costs e.g. storage, cost of capital, insurance, taxes etc.
⇒ Stock-out: affected by level of inventory e.g. lost sales, back-order costs etc.
⇒ Policy: cost of gathering data can be “soft” cost e.g. data processing, overtime, training etc.

6.3 Evaluating Inventory Management
Inventory turnover ratio is used along with no. of days of
Comparison can be drawn with other industries or past history.
Can be different due to product mixes.
Knowing the reason for or in inventory turnover is necessary.


7.1 The Economics of Taking a Trade Discount

7.2 Managing Cash Disbursements

7.3 Evaluating Account Payables Management

7. Managing Accounts Payable

Trade credit ⇒ spontaneous form of credit in which purchaser finances its purchases by delaying payments.
⇒ Discount may be given by the supplier for early payment.
⇒ Usually a specific time is given in which discount can be earned.
Inefficient payable management could be costly in terms of real and opportunity cost.
Company must ensure payable practice is organized, consistent and cost-effective.
Factors need to be taken care off while devising guidelines for managing accounts payable include;
⇒ Organization’s centralization / decentralization.
⇒ Number, size & location of vendors
⇒ Trade credit, cost of borrowing.
⇒ Controls of disbursement float (time for clearing a check).
⇒ Inventory management.
⇒ E-commerce and electronic data interchange (electronic supply chain management)
Stretching payables ⇒ extending time to pay dues during grace period provided by suppliers.
Careful balance is required if paying too early is costly and delaying may deteriorate company’s perceived

7.1 The Economics of Taking a Trade Discount

Costoftradecredit = h1 +


discount hlm.mnopqrstqmuoovrwmxuyzt{vmok
− 1
1 − discount

2/10 net 30 ⇒ 2% discount in 10 days & net amount due on 30th day.
Cost of funds during discount period = 0% ⇒ beneficial to pay near to discount period’s end.
Customer’s short term investment rate < calculated rate ⇒ discount offers a better return over company’s short-term borrowing rate.
7.2 Managing Cash Disbursements

Company’s ability to delay funding bank accounts until the day checks clear.
Pay electronically when it is cost effective.

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2015, Study Session # 11, Reading # 39
7.3 Evaluating Account Payables Management
3 . 45 .6= . 78 =


> 2

%+.* 2’ >



Comparison of no. of day’s payable with credit terms is necessary.
Paying early ⇒ costly.
Paying later ⇒ deteriorating relations with suppliers.
In some industries no. of days inventory & no. of days payable are
similar to one another.


8.1 Source of Short-Term Financing

8.2 Short-Term Borrowing Approaches

8.3 Asset-Based Loans

8.4 Computing the Costs of Borrowing

8.1 Source of Short-Term Financing

Panel A: Bank Source
Sources / Type


Uncommitted line

Large corporations

Regular line

All sizes

Overdraft line

Rate Base




Mainly in U.S; limited

Commitment fee

Common everywhere

All sizes

Commitment fee

Mainly outside U.S.

Revolving credit

Larger corporations

Commitment fee +extra

Strongest form (primarily
in U.S.)

Collateralized loan

Small, weak borrowers

Base +


Common everywhere

Discounted receivables

Large companies


Extra fees

More overseas, but some
in U.S.

Banker’s acceptances

International companies

Spread over commercial


Small volume



Prime + +

Service fees

Special industries

Prime (U.S.) or base rate
(other countries), money
market, LIBOR+

Panel B: Nonbank Sources
Sources / Type


Rate Base



Nonbank finance

Small, weak borrowers

Prime + +

Service fees

Weak credits

Commercial paper

Largest corporations

Money market sets rate

Backup line of credit,
commissions +

Lowest rates for shortterm funds

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2015, Study Session # 11, Reading # 39

8.2 Short-Term Borrowing Approaches
Effective strategy must ensure:
⇒ Sufficient capacity to handle peak cash needs.
⇒ Sufficient sources to fund ongoing cash needs.
⇒ Rates are cost effective.
Company should consider
⇒ Their size & credit-worthiness
⇒ Sufficient access
⇒ Flexibility of borrowing options
Both active and passive borrowing strategies exist. (Discussed earlier).

8.3 Asset-Based Loans
Companies with credit quality go for secured loans (asset-based
Often short term assets presents a challenge for the lender due to
uncertainty involved with such assets.
Lenders may have blanket lien ⇒ right over assets if collateral does
not pay, even if it has worth (in some cases).
Factorizing of accounts receivable can be used.
Inventory blanket lien ⇒lender can claim some or all inventory.
Requires company to certify that goods are segregated and sale
proceeds paid to the lender.
Warehouse receipt arrangement ⇒ similar to above but third party
overlooks inventory.
Cost of asset-based loans depends upon length of time it takes to sell
the goods.

8.4 Computing the Costs of Borrowing

Cost =

Interest + CommitmentFee

If amount borrowed includes interest cost e.g. bankers acceptance.

Cost =


3 =
56 = 8

6 .
In case of dealer’s fee & backup costs e.g. commercial paper

Cost =

Interest + Dealer 9 scommission + backupcost
Loanamount − Interest

Cost is usually annualized and compared.

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