Understanding Your Line of Credit

‘Twas the week after Halloween and all through thru the town, everyone was thinking about turkey – except for Chuck “Charlie” Brown. Chuck runs a local farmers market called It’s The Great Pumpkin, LLC and he just had the most amazing Halloween season in his history, but he was stressed. Chuck came into my office and began to unload on how he was not sure if he was going to make it another year. Sure, this year was great, but he had to re-invest all the profits he made into pumpkin harvesting machines after his manager (a fellow that looked like a beagle) unionized his workers and demanded better harvesting equipment (and for some reason dog treats). With all his money tied up in equipment, Chuck didn’t have enough cash to pay for his next shipment of seeds.

Wanting to help Chuck out, I suggested a working capital line of credit and explained the two critical points of a line of credit.

1. A line of credit has to revolve.
2. The characteristics of the collateral securing the line of credit.

The most important thing that Chuck had to learn about lines of credit is that they need to revolve. This means that the outstanding balance of the line has temporary highs followed by temporary lows (or paid off completely). Typically, this follows the working capital cycle of the business. The cash borrowed from the line of credit purchases inventory, which is made into finished goods, which is sold to a customer and cash is collected, which pays back the line of credit.

In a perfect world, Chuck would borrow on the line of credit to fill a short-term gap in his working capital cycle (i.e., purchase seeds and fertilizer, pay his employees, and provide the dog treats), then, after his crop had grown and he collected the cash, he would pay the outstanding balance on the line off. This is what us bank nerds like to see – a revolving line that goes up and comes back down. If a line of credit does not revolve, then it is considered permanent working capital (sorry, first of many bank nerd terms) and most likely the bank will require it be paid back a little each month.

The second thing to remember about lines of credit is how a bank will secure (or collateralize) it.

Depending upon the amount of the line of credit, some banks provide what is commonly called an unmonitored line. This means that the entrepreneur can draw the entire line amount at all times. They just need to pick up the phone, text, or email their banker and have the money deposited into their account.

An alternative to the unmonitored line is the (you guessed it) monitored line. A monitored line requires periodic reports of the components of your line of credit collateral. Most often this is an accounts receivable aging and inventory report. (nerd alert) This is often referred to as a borrowing base.) The frequency can be quarterly, monthly, weekly or any other period required by the bank. (I have even seen daily loan base reports.) After receiving and validating the report, the bank will adjust the amount of the line that is available for you to access.

Imagine this month you had $1,000,000 in current accounts receivable, and the bank allowed you to access 85% of this amount (or $850,000). During the month, you collect $750,000, so now you have $750,000 of cash in your bank. You are only left with $250,000 in accounts receivable, so you only have access to $212,250 ($250,000 x 85%) on your line of credit.    

Depending upon your bank, you may have to have independent audits of your inventory and accounts receivable (nerd alert: also known as a field exam).

Normally, the bank does not lend 100% on the value of the AR and inventory. The percentage that the bank allows to be financed is also known as (double nerd alert) advanced rate. The advance rate may be different for accounts receivable than inventory. If you would like a higher advance rate (giving you access to more of your line of credit), talk with your banker about what it would take to achieve this. In other words, what can you do that would make it less risky for the bank.

In addition to understanding the advance rate, there are some types of accounts receivable and inventory that are taken out of the equation. Accounts receivable that is over 90 days old is often disqualified. This is because in most instances, the likelihood of collecting receivables that are over 90 days old are slim. Receivables from a related party (i.e., a sister company that has similar ownership) is also disqualified. After all, this is basically a loan to yourself that you could forgive at any time. The most common type of inventory that is disqualified is work in progress (or WIP). Imagine Chuck’s cousin, Chris St. Nick, who owns a doll factory. The raw goods have value, and the completed product has value, but a half-made doll has no value (and is just creepy).

Finally, if you have a lot of receivables (25% or more) from one customer, then the amount of receivables over the limit is removed from the report. (Final nerd alert) this is called The concentration limit. As with everything else, this limit can be negotiated, but there are exceptions. My favorite exception is that some banks have no concentration limit on receivables from the United States Government. Of course they are going to pay- they literally have a machine that makes money.

After discussing these finer points with Chuck, he said that he could to use the line of credit as agreed and we helped old Chuck out. Now, I sure hope he doesn’t default, because I like pumpkins as much as the next guy; but if I have to collect his inventory, I am going to be eating pie until Woodstock comes home.

Being an entrepreneur is one of the most difficult and demanding things you can do. The good news is that entrepreneurship today is a team sport. Let’s connect on LinkedIn and together we will start taking control of your business finances which will lead to peace, fulfillment and achievement of your strategic goals. When we connect, tell me about the craziest excuse you had for why a receivable was late.

Greg Martin is an entrepreneur’s insider to the banking industry and passionately believes that every person was uniquely designed for a higher purpose and calling. Greg guides entrepreneurs in defining and achieving their purpose and calling. His deepest passion is living life with his wife of 17 years and their wonderful son.