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MGT602 - Entrepreneurship - Lecture Handout 33

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PRO FORMA SOURCES AND USES OF FUNDS

COMMERCIAL BANKS

Commercial banks are the most frequently used source of short-term funds.

  1. This is debt financing and requires some collateral, some asset with value.
  2. This collateral can be business assets, personal assets, or the assets of the cosigner of the note.

Types of Bank Loans

1.Accounts receivable loans.

  1. Accounts receivable provide a good basis for a loan, especially if the customer base is creditworthy.
  2. A bank may finance up to 80% of the value of the accounts receivable.
  3. A factoring arrangement can be developed whereby the factor (bank) actually buys the accounts and collects the money.
  4. If any of the receivables are not collectible, the factor sustains the loss, not the business.
  5. The cost of factoring is higher than the cost of securing a loan against the accounts receivable.

2.Inventory loans.

  1. Inventory is often a basis for a loan, particularly when inventory is liquid and can be sold easily.
  2. Finished goods inventory can be financed up to 50% of value.
  3. Trust receipts are a type of inventory loan used to finance floor plans of retailers such as auto dealers.
  4. The bank advances a large percentage of the invoice price of the goods and is paid a pro rate basis as the inventory is sold.

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MGT604 - Management of Financial Institutions - Lecture Handout 30

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Related Content: MGT604 - VU Lectures, Handouts, PPT Slides, Assignments, Quizzes, Papers & Books of Management of Financial Institutions

Letter of Credit and International Trade

A letter of credit is a document issued mostly by a financial institution which usually provides an irrevocable payment undertaking (it can also be revocable, confirmed, unconfirmed, transferable or others e.g. back to back: revolving but is most commonly irrevocable/confirmed) to a beneficiary against complying documents as stated in the Letter of Credit. Letter of Credit is abbreviated as an LC or L/C, and often is referred to as a documentary credit, abbreviated as DC or D/C, documentary letter of credit, or simply as credit (as in the UCP 500 and UCP 600). Once the beneficiary or a presenting bank acting on its behalf, makes a presentation to the issuing bank or confirming bank, if any, within the expiry date of the LC, comprising documents complying with the terms and conditions of the LC, the applicable UCP and international standard banking practice, the issuing bank or confirming bank, if any, is obliged to honor irrespective of any instructions from the applicant to the contrary. In other words, the obligation to honor (usually payment) is shifted from the applicant to the issuing bank or confirming bank, if any. Non-banks can also issue letters of credit however parties must balance potential risks.

The LC can also be the source of payment for a transaction, meaning that an exporter will get paid by redeeming the letter of credit. Letters of credit are used nowadays primarily in international trade transactions of significant value, for deals between a supplier in one country and a wholesale customer in another. They are also used in the land development
process to ensure that approved public facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Since nowadays almost all letters of credit are irrevocable, (i.e.
cannot be amended or cancelled without prior agreement of the beneficiary, the issuing bank, and the confirming bank, if any). However, the applicant is not a party to the letter of credit. In executing a transaction, letters of credit incorporate functions common to giros and Traveler's cheque. Typically, the documents a beneficiary has to present in order to avail him of the credit are commercial invoice, bill of lading, insurance documents. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped.

Read more: MGT604 - Management of Financial Institutions - Lecture Handout 30

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