By Teresa Courrier, Plumas Bank
Well-managed companies who are growing and reaching for that next level often find themselves stretched thin financially as they wait for customers to pay them, and they turn to their banker for a line of credit.
Often, a line of credit is precisely the right tool to help managers keep a business running smoothly even when payments are bumpy. But not always. Used incorrectly, a business line of credit can result in sleepless nights for a business owner.
When a line of credit is used correctly, it provides short-term financing to companies that have a long operating cycle — the cycle between the time that the company begins paying the costs involved with a job and the time that the customer pays.
A manufacturer, for instance, buys raw material upfront then pays workers to make a product. But even after the finished product is delivered to the customer, another 30 or 60 days may elapse before the manufacturer gets paid. During that gap, the company is likely to be pinched for working capital. It may not, for instance, have enough cash to buy raw materials to begin the next job on its books.
Simply put, a bank line of credit provides funds to smooth that gap. If the credit line is well-managed, the amounts that are borrowed will go up as jobs are under way, drop down when payments are received, then go back up as new projects begin.
But a line of credit isn’t for all businesses. Restaurants, for instance, don’t have a long operating cycle. Their customers are paying cash at the time that they purchase a meal and restaurants typically don’t have any significant accounts receivable.
Retailers sometimes use a line of credit to finance their inventory. The line of credit allows them to cover the gap between the time they purchase inventory and the time that a customer buys it off the shelf. Because the value of inventory can be volatile — What if that bright fuchsia dress doesn’t sell at full price? — bankers tend to be more conservative with the size of credit lines they make available to store owners.
Just as a line of credit isn’t for all businesses, it’s not for all business purposes, either.
It’s not all that unusual, for instance, to find that a business owner plans to use a line of credit to purchase a new vehicle for her company — or even to pay for improvements to a building.
The problem? Lines of credit are short-term loans, designed to be repaid quickly. Vehicles and buildings are long-term assets that typically are financed with long-term loans. There’s no promise that short-term financing will be available throughout the time that a long-term asset is financed. And when short-term financing dries up or the size of a credit line is reduced, business owners who financed long-term assets with short-term loans may find themselves scrambling to find financing.
One of the most useful rules of business is this: Always match liabilities and assets. Use long-term money for long-term purchases and short-term financing for short-term needs.
Business owners and managers who work closely with their community banker to establish an appropriate business line of credit usually will find that the size of the available credit line is something less than the accounts receivable that the company carries on its books. If the company typically carries about $1 million in receivables, borrowings under the credit line might be limited to $750,000. (Again, the limit is often lower for retailers or other companies that are financing inventories.)
Generally, a business that establishes a line of credit can expect to pay a loan-origination fee equal to 1 percent of the maximum borrowing — $7,500 on a $750,000 credit line — along with a loan-document fee which runs about $250 to $500. Interest, which is paid only during the time that money is actually borrowed, usually is tied to the prime rate.
Although business credit lines generally are automatically renewed, borrowers can expect to provide the bank with updated financial information either quarterly or annually.
About 75 percent credit lines are secured. The company puts up its inventory and accounts receivable as collateral, providing some measure of risk-reduction for the bank that’s making the loan.
When is a credit line the right tool for a business? A community banker, one who knows a business and its owners well, can provide important counsel about whether appropriate use of a line of credit can help deliver continued solid growth.
Teresa Courrier is Senior Vice President and Commercial Loan Officer, Plumas Bank (serving Reno and Northern Nevada)