A line of credit (a.k.a. a revolving line of credit, or a revolver) can be a very useful form of financing for many businesses. Think of it as a credit card, but one that is more nuanced that has some pluses and minuses that need to be taken into account. If you are wondering if your business would benefit, here are some things to consider.
A bank (or other lender) will typically issue a line of credit to a business that has some track record of success (generally at least two years). These loans can be backed by specific collateral (i.e. secured), they could be unsecured (this is rare), or they could even be backed by a personal guaranty of an owner (this will require the disclosure of personal assets and liabilities).
In some instances, a line of credit may only have a one-year commitment, while others can be for longer periods, such as five years.
In an asset-based loan (ABL), the revolver is secured by specific collateral (usually Accounts Receivable and Inventory). A bank will decide what a reasonable percentage is to advance against these assets, and the company can borrow based upon how much collateral they have. Standard advance rates can be 80% – 85% for accounts receivable and up to 50% for inventory. The reason for the discount is that a bank is looking at the worst-case scenario, which is when they have to inherit the collateral and liquidate it. The advance rates reflect the net proceeds that have been received in prior liquidations.
For larger lines of credit, the bank may charge an unused line fee, which is based on the amount available, but not borrowed. This fee is usually less than 1%, but it compensates the lender for making capital available, which is a cost.
A line of credit can be very flexible, giving the company many options. It can borrow when needed, without having to continuously apply for credit. It can help smooth out cash flows, allowing the company to more easily manage payments to employees and vendors. If the loan is paid down to $0, then the company can avoid paying interest (except for the unused line fee).
If everything above sounded too good to be true, there is something of a “catch”. The items below list out some of the negatives.
Other Costs – Since there are other costs involved, some lines of credit will not make economic sense for smaller businesses.
- Employee Time – If you operate under an asset-based lending arrangement, there are additional costs involved. The company has to report available collateral to the bank, this can vary from monthly to daily. This requires having reliable systems and personnel in place, it also consumes your employees’ time (which impacts the bottom line).
- Field exams – The bank may periodically send out a representative to audit the books and the company’s processes. Most institutions outsource this, but the customer is billed.
- Appraisal Fees – In certain instances, the bank may want to lend against the liquidation value of the inventory instead of an arbitrary advance rate. The fee for the appraisal is also paid by the company.
- Additional Fees – Having poor controls in place can lead to phantom collateral. Once this is caught (and it almost always is), it can generally be an unpleasant experience. There are many forms of resolution, including the owner investing additional capital, incurring default interest, and a forbearance waiver (this generally requires legal counsel for both sides, the bank and the company, all of which is paid for by the company).
It is best to keep in mind that penalties for non-compliance are steep, therefore it is imperative that the company has reliable controls and personnel.
Covenants – When you bring in another partner, they are going to want to install some safeguards, especially a partner that is more risk-averse (since debt typically has very limited upside, they need to limit downside). One example is a limitation on ownership compensation or distributions. Essentially, the business gives up some control.
Other Restrictions – The following features are also important to keep in mind, but they may not always apply.
- Accounts Receivable – A lender will only be interested in the current receivables, not those that are well beyond the due date. A standard cut off can be 90 days beyond the due date. Therefore, if an economic downturn causes slow payment, this can compound an already bad situation.
- Accounts Payable – While the bank would get paid first before vendors in any sort of liquidation, it could put restrictions on how far past due payments can be to vendors, for instance, not allowing them to be owed more than 30 or 60 days past their due date.
- Carveouts – A bank will sometimes maintain the right to add other reserves as it deems necessary. This can be carte blanche to do almost anything they want. If this clause appears in the fine print, it is best to trust the institution and person you are working with.
Downsides in real life:
Imagine a company that is very heavy on inventory and is financing it via a line of credit, where the advance rate is based on an appraisal. This means that the collateral value could swing every time a new appraisal is done (either up or down). If the company is already close to using up all the room on the line, and the appraisal comes in lower, it could easily find itself without the ability to borrow, or worse, be in the red and be “underwater” with the bank. Think about if your home was re-appraised and if the value fell (yes, sometimes real estate values do decline), what if you had to immediately make up the difference to the bank?
One client had over $20 million of inventory and was already past due with its vendors. The advance rate on inventory (determined by appraisal) kept steadily declining, and dropped by over 10%, meaning a loss in liquidity in excess of $2 million.
The best way to get ahead is to liquidate any excess inventory above the advance rate (assuming of course, that it can be done). If a company gets a 50% advance, and can sell inventory for 85% of cost, then for every $1 (at cost) the company sells (getting $0.85), it generates $0.35 of liquidity.