Self liquidating paper theory
During the busy season when business is booming the company needs to borrow money to finance short-term assets such as inventory and accounts receivable.The company borrows money to buy more materials to take advantage of the increasing demand of the busy season.There are probable contradictions between the objectives of liquidity, safety and profitability when linked to a commercial bank.Efforts have been made by economists to resolve these contradictions by laying down some theories from time to time.
Basically, a borrower takes out a loan used to finance business activities that generate revenue.In simple words a loan to be successful engages a third party. Moulton who insisted that if the commercial banks continue a substantial amount of assets that can be moved to other banks for cash without any loss of material.In this case the consumers are the third party, besides the lender and the borrower. In case of requirement, there is no need to depend on maturities.Then when business slows down the company will have less of a need for borrowed funds to finance short-term assets like inventory accounts – the need for financing will decline as the need for inventory declines. “Analysis for Financial Management”, Mc Graw-Hill Irwin, New York, NY, 2007.At this point, the company will have generated profits from the busy season, and will now be able to use those profits to repay the loans it took out to finance operations during the busy season. See Also: Loan Agreement Collateralized Debt Obligations When is an interest rate not as important in selecting a loan?