Borrowers often assume that because they have made all their payments in a timely manner, renewing their line of credit will be as easy as it has been in the past. However, this is not the case, says Kenneth R. Cookson, attorney with Kegler, Brown, Hill & Ritter.
“The lending environment is different now and the conditions that allowed some borrowers to run the lines up to the maximum amount and simply pay the interest have passed,” says Cookson. “While in earlier years, it was almost automatic that timely payment of the monthly interest alone would make renewal easy, today, being a ‘loyal customer’ is nearly irrelevant to the renewal process.”
Smart Business spoke with Cookson about the lending environment and how changing conditions have affected it.
What challenges are banks currently facing?
In the post-Great Recession regulatory environment, banks are facing a combination of focused regulations and declining values in real estate portfolios and borrowers. They have pressure on their capital requirements and reserve requirements. When a loan is classified as less than perfect, there has to be a reserve established from a bank’s capital to offset the portion of the loan that is in jeopardy, which can eat into capital reserves quickly.
Banks are being subjected to a loan-by-loan analysis by regulators and they are trying to get ahead of that by going through their own portfolios to figure out which loans are speculative and which are not.
Further, a bank may feel regulatory pressure when it has a high concentration of loans in one industry with similar borrowers, so it may hedge its risk. The borrower may be surprised that the line of credit is not extended because the business has made payments on time, but the bank may feel that it is too exposed in that particular area.
How are banks coping with these regulatory requirements?
They are certainly increasing their lending standards. The ratio of loan-to-value has come down, particularly in the real estate market, where a 70 percent loan-to-value ratio is not an unusual request. When you couple that with a decline in real estate values, it really amplifies the state of the conditions and the difficulties for both lenders and borrowers.
What is happening to borrowers?
Borrowers, in many cases, are being caught unaware. They have had a line of credit with a bank for many years and don’t deal with a commercial banker very often. They will send in financial statements annually, the revolver is generally renewed and the rate goes up or down according to market conditions.
Now, bankers are having trouble renewing those lines of credit and are reducing them, or imposing other requirements that have not been enforced previously, such as not allowing borrowers to take out the maximum on their line and just pay the interest for a full year. The borrowers express surprise, asking, ‘Why shouldn’t making timely payments make the renewal of that loan automatic?’
The answer begins with the regulatory requirements on banks and concentration issues, the value of the portfolio of the collateral supporting the loan, an increase in loan-to-value ratios and cash flows.
If it is a real estate loan or one backed by accounts receivable, and the value of either or both has gone down, leading to the appropriate ratios established in the loan document to not be in line, the loan could be classified downward. Borrowers need to understand a bank’s regulation reviews, internal reviews and lending policies, and be prepared for that.
What can borrowers do to help themselves through this?
Borrowers should make sure that their financial statements are current, accurate and complete. Look at your internal records and make sure that your accounts receivable are all good, and if they are not, work to discover the problems before the bank does.
Also, know your business plan and what your five or 10 largest customers are doing. If you learn that of your two lines of business, only one is profitable, you should shift your resources to the more profitable of the two.
Companies can get weighed down by the history of their operations and not take a critical look at their business model, business plan, customer array and pricing policies. Examine your business model as if you were starting fresh.
There is no shortage of examples of businesses that hypothetically have grown but their profits have not gone up proportionally. Increasing sales doesn’t necessarily mean higher profits because of other factors, such as margins and collectability issues. You have to scrub the numbers to see what you are doing right. You may have to cut back sales to better serve customers at higher margins in order to make more money.
How can banks and borrowers each adjust during this period of transition?
You have to assume that we are going to come out of this Great Recession and that the economy will be back in growth mode. This takes patience and understanding from both lenders and borrowers.
Lenders want to make loans. They need to lend money because that is how they get a return on the capital that has been invested. And borrowers need to be granted loans in order to make that happen.
Kenneth R. Cookson is an attorney at Kegler, Brown, Hill & Ritter. Reach him at (614) 462-5445 or email@example.com.
Insights Legal Affairs is brought to you by Kegler, Brown, Hill & Ritter Co., LPA
Many businesses, at one time or another, have cash flow deficiencies. These can stem from a large account falling behind in payments to a seasonal increase/decrease in sales, among other reasons.
Even if a company manages its cash flow appropriately today, no one can predict the circumstances the company may find itself in a few months from now. The best thing to do is to conserve capital for these unexpected events, but the second best thing is to obtain working capital line of credit.
“A company does not need to anticipate cash flow issues to apply for a line of credit,” says Al DeFlaviis, chief lending officer at First State Bank. “Instead, think of it as an insurance policy that doesn’t need to be paid until you need it. But the time to talk to your bank about a line of credit is before you experience a working capital deficiency.”
A line of credit gives a company the opportunity to borrow on a short-term basis for payroll, to take advantage of inventory discounts and to pay other fixed overhead expenses that are due prior to accounts receivable collections.
Smart Business spoke with DeFlaviis about how to use a line of credit to meet your company’s needs for working capital.
How does a line of credit work?
Interest is charged on the outstanding balance, not on the unused portion of the line. Interest rates are almost always variable and are tied to an index such as the prime rate or LIBOR indices. Once you have established a line of credit, your company can usually advance and repay the line as often as necessary. Lines of credit are usually renewed annually at a time when the your company’s annual financial statements have been completed.
How can a business determine what its line of credit should be?
To begin the process, you should first meet with your financial adviser or CPA before arranging a meeting with your banker. Preparing beforehand and gathering your information will allow the banker to better understand your business and determine your capital needs. If those needs are short term, a line of credit may be the appropriate solution, as a line of credit should not be any more than an amount that can be repaid through revenue production within 30 to 90 days.
However, if those needs are longer term, another type of loan may provide a better solution. Term loans are used primarily for long-term capital expenditures such as purchasing equipment, buildings, building improvements, etc., and are made for periods of three to 10 years.
How do banks determine what credit line they’re willing to extend?
With a line of credit, the way funds are used is left to the discretion of the borrower, so the bank carries more risk. As a result, a company must have a good business credit rating and a solid company financial history; it is unlikely a lender will approve lines of credit for start-ups or businesses without a track record of financial success.
Lenders generally also require collateral to secure a line of credit, which is nearly always asset-based, with equipment and facilities backing the line. However, credit lines can also be secured by receivables, inventory and by the owner’s personal assets, and it is not unusual for the bank to require a business owner to personally guarantee repayment of the line of credit.
When entering credit discussions with your bank, be as open as possible about the financial picture of your company. Be prepared to provide financial documentation including profit and loss statements, balance sheets and company tax returns.
Having an inside look at the business not only provides your banker with the confidence to recommend the loan package, but he or she is more likely to lobby on your behalf when the line comes up for approval.
How can a business identify a suitable bank to partner with?
Ultimately, you want to be able to lean on your banking relationship to help your business in good times and in bad, so begin by examining your existing relationship. Has your bank been responsive to your needs, acting not just as a lender but as a partner? If not, it may be time to find another bank.
Look for a banking partner that is the right size and complexity for your needs. For example, a national bank may use an automated scoring system to determine credit. Regional banks are often compartmentalized by market share and industry, and when a business changes or evolves, a different banker is assigned.
Community banks, on the other hand, usually have one person, a commercial relationship manager, who coordinates products and services. That person will understand the needs of your business and create a package of products and services that meets those needs.
Select a banker who understands your industry, as well as your marketplace. You will not only benefit from a line of credit but from your banker’s experience, industry insight and solutions to your company’s financing needs.
Alfred DeFlaviis is chief lending officer and senior vice president of First State Bank. Reach him at (586) 445-6615 or firstname.lastname@example.org.
Insights Banking & Finance is brought to you by First State Bank
Determining how much credit your business can obtain or should have can seem like a complicated endeavor for businesses. However, your banker can simplify the process and help you determine that figure, says Stephen Klumb, senior vice president and chief lending officer, National Bank & Trust.
“A line of credit is a commitment by a bank to a borrower to advance short-term money, working capital or receivables financing over a specified period of time for short-term working needs,” says Klumb. “And that line of credit can be estimated through a fairly simple formula.”
Smart Business spoke with Klumb about how to work with your banker to determine your line of credit and how to identify the right banker to help you through the process.
How can a business determine what its line of credit should be?
Take your total estimated annual gross revenue (sales) and divide by 365. That gives you your daily cash need. Next, determine your total number of accounts receivable, plus inventory days on hand (Use of Funds) and subtract your accounts payable days on hand (Source of Funds), and this is your usage. Multiply your daily cash need times the usage (accounts receivable days less accounts payable days) and you will get the estimated line of credit needed for your business.
Sales ............... $9,125,000/365 = $25,000 (daily cash need)
Accounts Receivable days on hand ............. 68 days (usage of cash)
Add Inventory days on hand .................... + 30 days (usage of cash)
........................................................................98 days (usage)
Less Accounts Payable days on hand ........ - 52 days (source of cash)
Multiply by usage ................................ x $25,000 (daily cash need)
..........................................................$1,150,000 (estimated need)
Your company estimated line of credit need is now known ($1,150,000 in the example) and that number sets the tone for discussion in terms of the amount of money you need in working capital to operate your business.
Is this number a moving target?
Generally, it’s a one-year commitment. Most customers do an annual projection, but if, for example, the business picked up a new contract or lost an existing contract, then it would become a point of discussion. A new contract could require an adjustment to the working capital needs. However, the number is not always a moving target. You might instead do a guidance line, which is a little extra during a period of time that eventually comes back to the normal operating line.
Is there such a thing as too much credit?
Absolutely. Too much credit, when not monitored, could become a problem if you’re allowing your receivables to go out too far. Talk to your bank about what your peer group average receivable days are and to get perspective on where you fall within that group. If your receivables are coming in later than those of your peer group, a good bank would recommend that you address your internal collection process to get your receivables in more quickly; otherwise, you’re borrowing money and the additional credit is taking up profits.
How do banks determine what credit line they’re willing to extend?
Because they’re giving you a line of credit to operate, they need to know your liquidity, so they’re going to use a current ratio. Current ratio is determined by taking current assets minus current liabilities, or a quick ratio, those assets that can be easily turned within a short period of time to produce cash.
Sometimes a line of credit will be established, but if it never goes to zero during a 12-month cycle ,you might lower your line and make a portion of it term debt to get back in balance between term debt and line of credit debt.
What can a company do to set itself up for a line of credit?
The best way to do it is to be on top of your accounts receivable aging report. Monitoring your accounts receivable for payment and having those reports available lets the banker know you are aware of where your receivables are. Having receivables crawl into 90 days could affect your operating line and won’t be counted as collateral.
What are some common mistakes businesses make when applying for a line of credit?
Not having their controller or accountant in meetings with their bankers. When you’re talking to a banker and he’s asking specifics, having the people there who know the answers makes the banker feel more comfortable. Meetings should include the owner, accountant and CFO for lines of credit or term debt. And be honest with your bankers. If you’re having a problem, the bank’s going to know, and it gives you the opportunity to explain why it happened.
How can your choice of bank affect how creditworthiness is determined?
A very large bank may use systems to determine credit. In short, the commercial lender feeds information into an often-automated system, and it comes back with an answer.
At community banks, generally speaking, there is individual involvement. They don’t use those types of systems and instead give more attention to the numbers and to understanding the individual business’ situation.
Regional banks are compartmentalized by market size and often have multiple officers handling each market. Once a business jumps into another category, it has to get a new loan officer. Today’s market is not just about being a lender, it’s value added. If your banker can’t bring value to the table, the bank is just a commodity, and the lowest price wins. Community banks provide a higher value because they are selling the value that can be brought to the relationship going forward.
Stephen Klumb is senior vice president and chief lending officer with National Bank & Trust. Reach him at 1-800-837-3011.
Insights Banking & Finance is brought to you by National Bank and Trust