Self Liquidating Loans

In view of high exposure to risk for a comparatively low return, commercial banks have understandably tried to find ways to protect themselves. Until very recently, this effort led them to lend only short-term funds and only in the form of self-liquidating loans – that is, they loaned money only for specific purposes and operations that would produce adequate cash flows to retire the debt quickly. The perfect example of such a selfliquidating situation is a working-capital loan made to a manufacturer or retailer that has a marked seasonal sales pattern. For example, retail sales of a toy manufacturer’s product peak just before Christmas each year. The manufacturer’s own sales peak probably comes in August; however, when retailers and toy distributors are building up their inventories for the buying season, to meet this demand, the manufacturer must schedule a high level of production from May through July. In May of each year, therefore, the company takes out a loan from its bank to provide added working capital to finance the build up in inventory. By September, heavy sales draw down the inventory to normal levels. Most of these sales, however, are made on terms of net 30 days, giving the company a large accounts receivable balance, but little cash. Finally, by early November, the customers pay their accounts, and collections of accounts receivable provide enough cash flow to retire the bank loan. Thus, the loan is self-liquidating in six months. This is a classic bank lending situation. The bank knows before it makes the loan exactly how long the funds will be needed. The relatively short life of the loan increases the bank’s liquidity. By making a fairly large number of predictable, short-term loans, a bank feels comfortable lending the highest proportion of its funds that regulations permit. In other words, it will want to lend up to its loan limit, or be fully loaned. If a bank finds little demand for self-liquidating, seasonal loans, it may be forced to lend in longer term, less predictable situations. Caution would probably lead this bank to keep a higher proportion of its funds in marketable securities to preserve its overall liquidity. This traditional scenario has been transformed by important changes in bank practices during recent years. Commercial banks no longer stress the self-liquidating requirement as strongly as they once did. As the suppliers of short-term financing have become more competitive, banks have become more willing to provide longer term funds in the form of term loans. These new practices are creating an increasingly flexible source of short-term and intermediate-term funds for business organizations.