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Backup Line

Backup Line
BusinessCorporate Finance and AccountingDebtCorporate Debt

What Is a Backup Line?

A backup line is a line of credit (LOC) that safeguards investors if a company defaults on its commercial paper: a type of unsecured, short-term debt instrument issued by corporations normally to finance payroll, accounts payable and inventories, and meet other short-term liabilities.

The company giving the paper pays a bank a fee in exchange for a guarantee that the outstanding money it owes investors will be repaid would it be a good idea for it as of now not have the option to meet its obligations.

How a Backup Line Works

Commercial paper is a cost-viable means of financing since it needn't bother with to be registered with the Securities and Exchange Commission (SEC) — given that it develops before nine months, or 270 days. Like some other type of bond or debt instrument, the issuer offers the paper expecting it will be in a position to pay both interest and principal by maturity.

However, it's not backed by any collateral. Commercial paper is unsecured, meaning on the off chance that the company some way or another goes belly up investors will not get back what they are owed. One strategy for getting around this is to procure a backup line. The company pays a fee to a bank. In exchange, it gets a guarantee that commercial papers will be paid off in the event that it defaults, assisting with consoling and safeguard investors.

Significant

Backup lines can be sorted out to cover either a portion or all of the commercial paper issued by a company.

At the point when the company chooses to issue the commercial paper, it moves toward a bank, portrays the amount of commercial paper wanted, and the strategy and the course of events for paying it off. Taking a gander at the company's credit, the bank can then determine the amount LOC it would guarantee the company, and at what cost.

The company will pay a fee, which acts as a insurance policy on the commercial papers. As such, on the off chance that the company can't deliver on its commitment, the bank will repay the excess investors for what they are owed.

Illustration of a Backup Line

A retail company is seeking short-term funding to finance new inventory for an impending holiday season. The firm necessities $10 million and offers investors $10.1 million in face value of commercial paper in exchange for $10 million in cash, as per winning interest rates.

Investors will buy the paper since they have faith in the company and its magnificent credit. All things considered, there is as yet a risk, though small, that the retailer could default on its guarantee to pay back the commercial paper.

To settle investors' nerves and dispose of this threat, the company chooses to purchase a backup line. However such a move comes at an expense, the retailer is likewise aware that access to this LOC ought to incite investors to demand a lower financial reward for lending it capital.

Limitations of a Backup Line

Backup lines aren't not difficult to acquire or accessible to everybody. Banks aren't probably going to expand this service except if the issuer of commercial paper is reputable and has a robust strategic plan to pay off all the debt inside a fixed (and short) time span.

That assists with making sense of why just companies with magnificent credit will generally issue commercial paper. Companies with more unfortunate debt ratings will presumably battle to find buyers, except if they offer a substantial discount (higher cost) for the debt issue, or some way or another figure out how to persuade a bank to cover its offering, which is likewise prone to come at a huge expense.

Features

  • The issuer pays a bank a fee in exchange for a guarantee that the outstanding money it owes investors will be repaid in full.
  • A backup line is a credit extension (LOC) that safeguards investors if a company defaults on its unsecured commercial paper.
  • Banks aren't probably going to expand this service except if the issuer is reputable and has a robust strategic plan to pay off all the debt inside a fixed (and short) time period.
  • Backup lines can be sorted out to cover either a portion or all of the commercial paper issued by a company.