RDP 2013-13: Inventory Investment in Australia and the Global Financial Crisis 3. Short-term Business Finance in Australia

Firms typically need liquidity to finance their daily operations, such as purchasing supplies, paying workers, and producing output. Demand for inventories in the manufacturing, wholesale trade and retail trade industries (which I will broadly define as the ‘goods distribution sector’) is generally very short-term in focus because firms in the sector often face significant short-term fluctuations in sales and production.

Inventory investment is typically financed through a combination of short-term internal and external finance due to its short-term nature and a desire by firms to match the maturities of their assets and liabilities (Graham and Harvey 2001). Short-term internal finance includes firms' cash flows and stocks of cash and securities that can be easily liquidated. Short-term external finance can be divided into intermediated credit provided by financial institutions and trade credit provided by suppliers.

Short-term intermediated credit can be further separated into revolving (or ‘open-end’) credit and term (or ‘closed-end’) credit. Revolving business credit is the most common form of short-term intermediated debt and typically has the following characteristics:

  • for a fee, the lender commits to provide credit up to an agreed limit to the borrower
  • the borrower can borrow any amount up to the authorised limit
  • any repayments made by the borrower (other than interest and charges) reduce the extent of used credit and increase the amount of unused credit available.

A revolving credit loan allows a borrower to draw down, repay and re-borrow funds (up to a maximum limit). Examples of revolving business credit include bank overdrafts, lines of credit, and credit cards. Revolving credit is ‘open-ended’ because the length of the loan is not fixed, even if the length of the facility is finite, while a term loan is ‘closed-ended’ because it is drawn during a short commitment period and then repaid by a fixed date. Revolving credit lines are particularly suited to financing short-term production and inventory investment given their flexibility and convenience (Berger and Udell 1998).

Revolving credit lines typically have variable interest rates, and the loan rate is linked to a short-term rate such as the cash rate or the 90-day bank bill rate. Interest on a revolving credit line is calculated based on the outstanding principal balance. In other words, just like a personal credit card, interest is accrued and charged based on the amount of credit used rather than the amount that is available. A borrowing firm is also typically charged an annual fee on the unused portion of the credit facility (in some cases, fees are charged on the total facility).

Trade credit is the other common form of short-term external finance. Trade credit (or ‘business-to-business lending’) comprises short-term loans extended by suppliers to their customers. Under a trade credit agreement, a loan is automatically created when the customer delays payment of their bills to the suppliers. Trade credit is particularly popular as a method of short-term business finance in industries that are vertically integrated via supply chains. For example, manufacturers can have a comparative advantage over financial intermediaries in supplying short-term funds to wholesalers and retailers because they have an inherent interest to insure their customers against liquidity shocks that might endanger their own survival (Petersen and Rajan 1997).

For the median listed company in the Australian goods distribution sector, short-term debt and trade credit have accounted for about 6 per cent and 20 per cent of total liabilities, respectively, over the past decade. However, this understates the importance of revolving credit as a method of short-term financing because the balance sheet estimate only measures the used portion of revolving credit lines, rather than the total amount of credit committed, and hence available, to firms. Australian goods distribution firms only use a fraction of their committed credit lines, on average, such that total credit lines have represented nearly 60 per cent of total liabilities over the past decade.