How to capitalize on the recovering economy by tapping a short-term line of credit Featured

11:45am EDT October 1, 2012
How to capitalize on the recovering economy by tapping a short-term line of credit

The recent uptick in sales is like a breath of fresh air for beleaguered business owners — unless they don’t have enough cash to meet rising expenses while they wait out a typical invoicing cycle.

A conventional line of credit may seem like the prefect solution, but since an owner’s personal and business finances are intertwined, those who fell behind on mortgage payments or bills during the recession may not qualify.

“Owners need short-term funding to carry receivables and hire staff now that the economy is improving,” says Paul Herman, small business lending manager at California Bank & Trust. “Their best bet is a short-term line of credit (SLC) since bankers primarily focus on a company’s cash flow cycle during the underwriting process.”

Smart Business spoke with Herman about the opportunities to grow your business by tapping a short-term line of credit.

What is an SLC and when are they advantageous?

Essentially, an SLC is bridge financing. Savvy executives tap the line to pay expenses between the time revenue is generated and receivables are collected. For example, they may need cash to purchase supplies or inventory to handle seasonal spikes or new contracts before the goods are finished, delivered and paid for. Contractors frequently use an SLC to pay bonding and insurance premiums so they can bid on new projects, and veteran attorneys and doctors often use the funds for operating expenses when they launch a new practice.

You can draw on the line as needed and repay the funds at will as long as you meet the terms of your agreement and attend periodic reviews with your bank.

How does an SLC differ from other loans?

It’s assumed that owners will pay down a short-term line as cash is received, so bankers are primarily concerned with how quickly a company converts receivables into cash when they consider an SLC request.

Long-term debt is typically used to purchase equipment, buildings or other fixed assets, so bankers must consider depreciation as well as a company’s profitability to assess its ability to service the loan. In fact, stable but slow growth is often a key indicator of a company’s ability to service debt over the long term, while an SLC is the perfect solution for cash flow shortages resulting from a growth spurt.

Are there risks associated with an SLC?

No loan is risk free. However, prudent owners can avoid default or cash shortfalls by following these best practices:

  • Accurate forecasting — Some owners are so afraid of taking on debt that they run out of cash because they don’t ask for a large enough line. This won’t happen if you accurately forecast your company’s growth and cash conversion cycle. In fact, it’s better to ask for the maximum limit since you have the option of drawing the funds as needed.

  • Be disciplined — Only use the funds to close short-term cash flow gaps. Otherwise, you may run out of money and have to liquidate assets to pay bills or meet payroll.

  • Be responsible — Bad debt, delinquent customers or risky business practices can leave well-intentioned owners holding the bag. Are you ready, willing and able to accept responsibility for managing your company’s credit, cash flow and an unmonitored credit line?

How can a business maintain the quality of its assets and increase borrowing capacity?

Owners often emphasize sales, but what good is top-line growth if the margins are bad or you can’t collect your hard-earned money? Even tenured customers may encounter a cash crunch as the economy rebounds, especially if they wait too long to secure short-term financing. Be disciplined about verifying a customer’s credit worthiness, keep an eye on receivables and don’t forget to make timely collections calls.

Finally, don’t ignore your balance sheet because a business can’t survive with high debt and little equity. Grow assets as well as revenue, and make sure your balance sheet reflects the norms for your industry.

What do bankers consider when evaluating a request for an SLC?

In addition to reviewing traditional underwriting criteria like business and personal credit scores, bankers want to know whether you have the means and ability to manage and repay a line of credit.

They’ll look at your industry experience, the viability and diversification of your customer base, along with the ebb and flow of your company’s cash flow during previous cycles. Will your customers pay on time? Can your business survive if one customer defaults? Do you have enough personal assets or sources of secondary support to pay your bills while you wait for an invoicing cycle to conclude?

Bankers may be able to use government guarantees to overcome minor risks, and you could qualify for a conventional line of credit down the road if you use an SLC as a stepping stone to build your credit score and your company.

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Paul Herman is the small business lending manager at  California Bank & Trust. Reach him at Paul.Herman@calbt.com.

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