Short-term lines of credit (SLCs) are different animals from the usual real
estate or other loans that a business might obtain from a bank. Using short-term
money for the wrong purposes can land a
business in hot water.
Smart Business spoke to Chris Ramos,
commercial banker with Fifth Third Bank in
Cincinnati, who works with SLCs on a daily
basis, for some tips on how businesses can
use SLCs to their best advantage.
How does a banker evaluate requests for an
SLC?
Perhaps the most critical element of any
loan is the confidence the lender has in the
shareholders and managers of the borrowing company. These individuals and the
decisions they make are the key to the financial viability of the business and the repayment of the loan.
Nearly every commercial bank loan
involves a company with a historical track
record of positive cash flow and a balance
sheet that allows the company to continue
meeting its financial obligations. Ideally,
lenders also prefer that the borrower would
pledge collateral assets to support the loan
further. Banks accept a relatively small
return on their loans (typically 2 to 4 percent). This model works when the bank
keeps losses well below 1 percent of total
loans. The need for collateral arises from
the desire to assure that — even if a business fails — the loan will be repaid.
Describe a typical SLC arrangement.
Typically, a bank provides a line of credit
with a maximum borrowing amount.
During the term of the loan, the borrower
may borrow up to the maximum line
amount or pay down the facility (any or all
of the facility) at any time. In some cases,
the borrowing and pay down can be automated using a loan sweep product. The loan
sweep allows for funds to be automatically
advanced from the loan to maintain the
company’s cash position.
If a company is growing rapidly, an asset-based revolving line of credit can be the best
way to leverage short-term assets. This specialized SLC allows a company to maximize its borrowing capacity on its most liquid
assets — accounts receivable and inventory.
The asset-based line of credit relies heavily on the liquidation value of the company’s
accounts receivable and inventory. These
lines of credit usually limit the amount borrowed to a specified percentage of accounts
receivable and inventory. These percentages allow the lender to take comfort in its
ability to be repaid by the liquidation value
of the company’s short-term assets. As a
company’s borrowings increase, the lender
often will monitor these short-term assets
more carefully to assure that liquidation
value remains sufficient to retire the loan.
What are some of the common uses for
SLCs?
SLCs finance the growth of short-term
assets like accounts receivable and inventory. As sales grow, the need to support higher
inventory and receivable balances also
grows.
An SLC might also be used to take advantage of discounts offered by a company’s vendor. For example, if a vendor offered a 2 percent discount to pay in 10 days versus a typical 30-day term, a company would be well-served to borrow on its line of credit.
How available are SLCs for businesses now?
Financial markets have tightened in the
last 12 to 18 months. Capital is less plentiful.
For high-quality companies, SLC remains
readily available. SLCs are the type of
financing most banks are the most comfortable with because the short-term assets
securing the loan can usually be liquidated
more quickly than long-term assets.
As a company’s balance sheet becomes
more leveraged, an asset-based loan
becomes an appropriate alternative. These
loans continue to be available to businesses that have high-quality inventory and
receivables.
How can a business maintain the quality of
its short-term assets to increase borrowing
capacity?
Accounts receivable and inventory growth
typically drive the need for SLC, but also provide the asset base to appropriately support
the loan. Maintain the quality of receivables
by keeping customers within stated payment terms. Lenders shy away from receivables that are more than 90 days past due.
Diversifying your customer base so that you
don’t appear overexposed to any particular
customer can help improve your chances of
borrowing against your receivables.
SLCs are typically renewed annually.
Many lenders, including banks, have additional capital costs when they provide SLCs
for longer than one year. If a borrower is
credit worthy for a line longer than one year,
the line can be provided. In this situation,
however, lenders will often charge additional commitment fees to help defray the capital costs for the longer-term line.
An SLC should ordinarily be used to
finance short-term assets. Long-term assets
should be supported with long-term financing. This protects the lender and the company. For a lender, perhaps the most inappropriate use of a short-term line would be
financing a company’s operating losses.
CHRISTOPHER RAMOS is vice president, middle-market commercial banking, with Fifth Third Bank in Cincinnati. Reach him at
(513) 534-3667 or [email protected].
