Credit on call - small business credit

Nation's Business, Sept, 1995 by J. Tol Broome, Jr.

Todd Heim knows the value of a bank line of credit. He launched his business six years ago without one. He has used it occasionally since then. And now he plans to use it again, this time to help finance a move to larger quarters.

"I think every company should have a credit line at a bank," says Heim, owner of Future Cure Inc., a Westlake, Ohio, company that manufactures paint-spray booths for automotive body shops. "There's a big neon sign in every small-business owner's office that says 'Game Over' when the checking account gets to zero. You need a line of credit for those cash-flow shortfalls."

Heim used his line of credit in the beginning to purchase equipment. Since then he has used it to finance inventory and accounts receivable and to cover payroll and other expenses.

Future Cure hasn't used its credit line recently, but Heim says he plans to draw on it later this year when he moves the company. "The moving expenses alone will run about $30,000. And we also plan to use the line for part of the down payment on the purchase of the building."

If Heim sounds like an advertisement for the benefits of a line of credit, it's for good reason: He says his growing company couldn't have made it to this point without its line. Yet his experience isn't unusual. A line of credit is the most common type of "loan" that small businesses negotiate with their banks. Following are major aspects of this financing tool.

Defining The Term

A line of credit, simply put, is a type of loan--with a preset ceiling--that a small business may draw upon as needed to fund various needs. It differs from a regular loan in both duration and repayment structure. A typical line of credit is for one year, meaning the amount borrowed must be repaid within that time. In contrast, a standard bank loan to finance fixed-asset purchases has a repayment schedule of 10 to 15 years for real estate and five to 10 years for equipment. Repayment of a standard loan also requires a fixed monthly amount.

There are a number of different types of lines of credit: short-term lines, import lines, contractor lines, revolving lines, asset-based lines, and factoring lines. But they all fall into two basic categories--lines to finance seasonal needs and lines to fund long-term growth.

Seasonal Lines

Line-of-credit financing is most commonly used to fund seasonal purchases. For instance, most retailers use a line to finance the temporary but sizable buildup of inventory that takes place each year before the Christmas season. And most businesses that manufacture goods tied to the holiday season must do the same.

"We could not operate our business without an operating line," says Robert Worth, vice president of finance with Shamrock Corp., a Greensboro, N.C., firm that makes gift wrap, gift bags, and other Christmas accessories.

Worth says Shamrock begins using its line in mid-July to purchase raw materials and meet payroll. The line balance increases steadily for the next several months, reaching a peak in early November. Then, as Christmas-related revenues start flowing in, the line is rapidly reduced and is paid off by mid-December.

Most banks allow the use of a seasonal line of credit at the borrower's discretion; a standard requirement, however, is that the balance be paid to zero for at least 30 days during the year. Even though the business owner may use the line for discretionary needs, the uses should be seasonal or the company may have difficulty complying with the 30-day clean-up covenant.

If there is a balance outstanding at the time of the required 30-day cleanup period, then the line has probably been misused to fund large, fixed-asset purchases or even to fund losses. This could cause problems with the bank when it comes time to renew the line of credit.

Long-Term Growth

Small businesses also frequently use lines of credit to fund sustained sales growth, says Mark Edwards, a commercial-loan officer with BB&T bank in Columbia, S.C. "Small businesses usually find themselves in need of cash when they are going through a period of rapid growth," he explains. "A line of credit often is the most effective way to finance a boom period."

A line to finance company growth, known as a long-term cyclical line, is set up a bit differently from a seasonal line. Although a line that helps with long-term cyclical expansion may come up for renewal each year, no 30-day cleanup period is required. A company experiencing rapid revenue growth would be unable to meet a zero-balance requirement.

The bank's control mechanism with a long-term cyclical line is the loan base report. It is completed by the small business to reflect current levels of the assets being financed--usually inventory, accounts receivable, or both. The report allows the bank to monitor whether the line balance is below the contracted coverage margins of 40 to 70 percent of the value of inventory and 50 to 80 percent of the value of accounts receivable.

"We require a line to be tied to the level of assets being financed," says Edwards. "If the line increases, we check the balance against the asset margins. Likewise, we must ensure that line-of-credit reductions are commensurate to corresponding asset-reduction levels."