608 CHAPTER 16 Working Capital Management
abandon attractive growth opportunities. The key features of bank loans are discussed
in the following paragraphs.Maturity
Although banks do make longer-term loans, the bulk of their lending is on a short-term
basis —about two-thirds of all bank loans mature in a year or less. Bank loans to busi-
nesses are frequently written as 90-day notes, so the loan must be repaid or renewed at
the end of 90 days. Of course, if a borrower’s financial position has deteriorated, the
bank may refuse to renew the loan. This can mean serious trouble for the borrower.Promissory Note
When a bank loan is approved, the agreement is executed by signing a promissory
note. The note specifies (1) the amount borrowed; (2) the interest rate; (3) the repay-
ment schedule, which can call for either a lump sum or a series of installments; (4) any
collateral that might have to be put up as security for the loan; and (5) any other terms
and conditions to which the bank and the borrower have agreed. When the note is
signed, the bank credits the borrower’s checking account with the funds, so on the
borrower’s balance sheet both cash and notes payable increase.Compensating Balances
Banks sometimes require borrowers to maintain an average demand deposit (checking
account) balance equal to from 10 to 20 percent of the face amount of the loan. This
is called a compensating balance,and such balances raise the effective interest rate
on the loans. For example, if a firm needs $80,000 to pay off outstanding obligations,
but if it must maintain a 20 percent compensating balance, then it must borrow
$100,000 to obtain a usable $80,000. If the stated annual interest rate is 8 percent, the
effective cost is actually 10 percent: $8,000 interest divided by $80,000 of usable funds
equals 10 percent.^15
As we noted earlier in the chapter, recent surveys indicate that compensating bal-
ances are much less common now than 20 years ago. In fact, compensating balances
are now illegal in many states. Despite this trend, some small banks in states where
compensating balances are legal still require their customers to maintain compensat-
ing balances.Informal Line of Credit
A line of credit is an informal agreement between a bank and a borrower indicating
the maximum credit the bank will extend to the borrower. For example, on December 31,
a bank loan officer might indicate to a financial manager that the bank regards the firm
as being “good” for up to $80,000 during the forthcoming year, provided the bor-
rower’s financial condition does not deteriorate. If on January 10 the financial man-
ager signs a promissory note for $15,000 for 90 days, this would be called “taking
down” $15,000 of the total line of credit. This amount would be credited to the firm’s
checking account at the bank, and before repayment of the $15,000, the firm could
borrow additional amounts up to a total of $80,000 outstanding at any one time.(^15) Note, however, that the compensating balance may be set as a minimum monthlyaverage,and if the firm
would maintain this average anyway, the compensating balance requirement would not raise the effective in-
terest rate. Also, note that theseloancompensating balances are added to any compensating balances that the
firm’s bank may require forservices performed,such as clearing checks.