Businesses use short-term financing called commercial paper, which can be asset-backed and repaid when customers pay. It is cheaper than lines of credit and provides liquidity to economies. However, if issued to non-creditworthy companies, it can lead to a lack of discipline and risk of default.
Nearly every business, large or small, will at some point have difficulty meeting their short-term cash flow needs. It is very common for a business in this situation to use a form of short-term financing known as commercial paper. A commercial paper loan usually matures in three to six months. Sometimes, commercial paper is backed by some type of collateral, in which case it is known as asset-backed commercial paper.
In a typical situation, asset-backed commercial paper is purchased by a business that intends to repay the loan when the credits mature, in other words when customers pay them money they have already committed to pay. If a business needs short-term cash for inventory or payroll, for example, it can purchase an asset-backed commercial paper loan to meet these immediate needs. Then, when the customers’ accounts are past due, the loan is repaid with that money.
While it is also common for businesses to maintain lines of credit with banks, it is often better for the business to use asset-backed commercial paper instead, as it carries a lower interest rate. Lines of credit serve as a kind of safety net, to be used when other, cheaper options are out of stock or unavailable. While commercial paper may be a much-needed lifeline for a business with immediate financial obligations, that’s not the only purpose it serves.
In a broader sense, asset-backed commercial paper helps provide liquidity to an economy, which means the easy availability of cash. Liquidity is very important to the functioning of economies everywhere. It is of great concern when this liquidity is lost, as happened in 2008 when commercial paper suddenly, but briefly, became unavailable as part of a larger economic crisis in the United States.
Institutions that make short-term loans to businesses can in turn issue this debt to investors. When investors buy the right to collect on debt, this investment is what technically constitutes commercial paper, although this term is also used colloquially to refer to the loan itself. The bank that originally issued the loan, if it transfers the debt to third parties, is released from the obligation to collect it. This can lead to the one major drawback of asset-backed commercial paper, that of a potential lack of discipline from lenders. If a loan is issued to a company that is not creditworthy or unable to repay it, the risk of default increases, making investors less likely to buy commercial paper and therefore a lack of liquidity.
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