Fundamentals of Financial Management (Concise 6th Edition)

500 Part 6 Working Capital Management, Forecasting, and Multinational Financial Management

15-12 ACCRUALS !ACCRUED LIABILITIES"

As we discussed in Chapter 3,! rms generally pay employees on a weekly, biweekly,

or monthly basis; so the balance sheet typically shows some accrued wages. Simi-

larly, the! rm’s own estimated income taxes, Social Security and income taxes

withheld from employee payrolls, and sales taxes collected are generally paid on a

weekly, monthly, or quarterly basis. Therefore, the balance sheet typically shows

some accrued wages and taxes, which we refer to as accruals.

Accruals arise automatically from a! rm’s operations; hence, they are

spontaneous funds. For example, if sales grow by 50%, accrued wages and

taxes should also grow by about 50%. Accruals are “free” in the sense that no

interest is paid on them. However,! rms cannot control their accruals because

the timing of wage payments is set by contract or industry custom and tax pay-

ments are set by law. Thus,! rms use all the accruals they can, but they have

little control over their levels.

Accruals

Continually recurring

short-term liabilities,

especially accrued wages

and accrued taxes.

Accruals

Continually recurring

short-term liabilities,

especially accrued wages

and accrued taxes.

Spontaneous Funds

Funds that are generated

spontaneously as the firm

expands.

Spontaneous Funds

Funds that are generated

spontaneously as the firm

expands.

SEL

F^ TEST What types of short-term credit are classi" ed as accrued liabilities?

What is the cost of accrued liabilities? If accruals have such a low cost, why

don’t " rms use them even more?

15-13 USE OF SECURIT Y IN SHORT#TERM FINANCING

Other things held constant, borrowers prefer to use unsecured short-term debt

because the bookkeeping costs associated with secured loans are high. However,

! rms may! nd that they can borrow only if they put up collateral to protect the

lender or that securing the loan enables them to borrow at a lower rate.

Stocks and bonds, equipment, inventory, accounts receivable, land, and build-

ings can be used as collateral. However, few! rms that need loans hold portfolios

of stocks and bonds. Land, buildings, and equipment are good forms of collateral;

but they are generally used to secure long-term loans rather than short-term work-

ing capital loans. Therefore, most secured short-term business loans use accounts

receivable and inventories as collateral.

To understand the use of security, consider the case of a Chicago hardware

dealer who wanted to modernize and expand his store. He requested a $200,000

loan. After examining his! nancial statements, the bank indicated that it would

lend him a maximum of $100,000 on an unsecured basis and that the interest rate

would be 10%. However, the company had about $300,000 of accounts receivable

that could be used as collateral; and with the receivables as security, the bank

agreed to lend the full $200,000 and at the prime rate of 5.25%. Processing costs for

administering the loan were fairly high; but even so, the secured loan was less

expensive than an unsecured loan would have been.^22

Secured Loan

A loan backed by

collateral, often

inventories or accounts

receivable.

Secured Loan

A loan backed by

collateral, often

inventories or accounts

receivable.

(^22) The term asset-based " nancing is often used as a synonym for secured " nancing. In recent years, accounts
receivable have been used as security for long-term bonds, which has permitted corporations to borrow from
lenders such as pension funds rather than being restricted to banks and other traditional short-term lenders.