Question

Commercial paper is often backed by a bank line of credit, which gives the borrower access to cash that can be used (if needed) to pay off the commercial paper at maturity. Please explain how the bank line of credit can reduce firm’s liquidity risk caused by commercial paper.

Answer 1

When a firm needs money then it can have several sources of fund and line of credit is one such source which works like a credit card i.e. there is a withdrawal limit set for the organization by the bank and the money has to be repaid over a specific period of time. The interset will be charged once the cash is withdrawn from the account and will be charged until it is repaid.

So this is generally unsecured loans and can be accessed at any point in time.

This facility comes into use when there are sudden multiple cash outflows from a company or say an increase in variable cost which was not accounted for earlier. So in this type of situation, there might be a cash crunch but the commercial papers are the fixed obligations whose coupon has to be paid. Hence the line of credit helps the company to deal with it.

The line of credit is also considered to be current assets which improves the current ratio and the liquidity of the company.