Lines of Credit

By Todd Nelson
Senior Vice President, Business Banking

Many businesses use a line of credit to finance their working capital needs. While it’s a popular option for many companies, not everyone knows exactly what it is and how it can be used.

What is a Line of Credit?

A line of credit is a type of commercial loan which finances a business’s working capital. Unlike a term loan, a line has no set regular amortization of its principal. Rather, it is highly flexible—changing at the borrower’s direction as often as daily to match the business’s working capital financing needs (subject to sufficient collateral while loan proceeds are outstanding under line). All it takes to alter the line’s outstanding loan amount is a simple call or email to the bank.

A line typically has a one-year term, is guaranteed by the business’s owner(s), and is secured by the business’s accounts receivable and inventory. To ensure sufficient collateral, the line is subject to a monthly collateral borrowing base provided to the bank. Typically, a bank will lend up to 70-80% of current accounts receivable (with lesser percentages advanced against receivables of up to 60 and 90 days old) and up to 50% of finished goods (typically subject to a cap). Accompanying the borrowing base report will be monthly accounts receivable aging and inventory reports. For undercapitalized/highly leveraged borrowers, specialty lenders (bank and non-bank) require these reports as often as daily and expect a much higher interest rate and level of monitoring to compensate for the increased risk.

A line will also often have one or more financial covenants as to the business’s debt service coverage, financial leverage, and consecutive days the line of credit is unused (30 days being common) over its one-year term—the latter ensuring that this source of financing current assets is not financing long-term assets (which should be financed with an amortizing term loan). Finally, for a large, new relationship, sometimes a bank will require an upfront, on-site collateral exam in which an independent professional reviews a borrower’s accounts receivable and inventory to corroborate the borrower’s valuations.

How Businesses Use Lines of Credit

While there are some restrictions, how you use your line of credit is based on the needs of your business. A few of my customers use their lines to purchase inventory, which they later pays down upon the collection of their accounts receivable. It has been a valuable tool for many of them financing their growth.

Next Steps

A first step in applying for a line of credit is to contact a business banker, who will seek to review both a borrower’s tax returns and financial statements and its guarantor(s)’ tax returns and signed current personal financial statement(s)

If you are seeking more information about a line of credit--or any other type of loan—for your business, please contact me at tnelson@nabankco.com or 612.455.1112.