Demystifying Small Business Lines of Credit: When to Offer Them and How to Size Them

By Hubbs, Justin | The RMA Journal, June 2018 | Go to article overview

Demystifying Small Business Lines of Credit: When to Offer Them and How to Size Them


Hubbs, Justin, The RMA Journal


FACING COMPETITION FROM fintechs and other nontraditional lenders, many banks are finding it challenging to stay in the small business lending space. Some have moved toward scoring models or "app only" products to improve delivery, keep costs under control, and maintain profitability. Others have ceded the space altogether.

Bankers know, however, that lines of credit can be the make-or-break difference for many small businesses. They also know that a scoring model alone may not be enough to determine whether a line of credit--much less a line of credit offered at the maximum amount for which a borrower can qualify--is the best solution. So it only makes sense that bankers, as experienced and trusted advisors, should continue to offer this important product at a reasonable price and on reasonable terms.

This article highlights the important advisory role bankers play in determining whether a line of credit is appropriate and how much to offer.

A Quick Overview

Working capital lines of credit provide customers with the ability to manage their short-term cash flow needs when there are timing differences between the receipt of cash from the sale of goods and services and the payment of operating expenses or debts. This product is typically best for borrowers that are heavy in trade assets such as inventory or accounts receivable. Essentially, these customers are looking to bridge the timing between the purchase and sale of inventory, and the collection of accounts receivable.

A typical pattern of usage is as follows. A borrower uses the line of credit to purchase inventory (which effectively becomes the bank's collateral) and sells the inventory approximately 60 days later. If the sale was a cash transaction, the customer uses a portion of the collected funds to pay down the line, making it available again for the next inventory purchase and the cycle continues from there.

If the sale is purchased on credit, there will be an account receivable established whereby the borrower's customer agrees to pay the borrower within a prescribed time frame (typically 30 days). So the borrower will need to use the line of credit to cover operating expenses while waiting for the customer to pay. When the borrower's customer pays at the end of the 30 days, the borrower uses a portion of the funds to pay down the line of credit and the cycle continues.

Under both these scenarios, the borrower will be in and out of the line frequently within short periods of time (certainly less than a year). Meanwhile, collateral is created in both types of transactions: inventory and accounts receivable.

Lines of credit are typically appropriate for businesses that carry inventory and receivables, such as manufacturers, wholesalers, and retailers. Cash-heavy businesses such as restaurants and service businesses do not need to hold material levels of inventory and typically do not carry receivables; therefore, they typically don't need lines of credit because their sales are paid for in cash or with a credit card. The profits from those sales would then be used to cover the business's working capital needs.

So why would such a business request a working capital line? Good question. An acceptable answer would be for short-term needs that contribute to the expansion of sales. Some uses that typically do not fit this definition would be tax payments of any kind, purchases of any equipment or materials that last longer than a year, the desire to bridge current losses with future projected profits (which is usually what paying taxes does), and funding of an owner's personal expenses and investments unrelated to the core business. With these transactions, collateral is generally not being created as it is in the earlier example.

So why can't a business use a line of credit to purchase equipment or fix up a store? What's the big deal?

What Can Go Wrong

Let's look at a scenario that illustrates what can happen when a line of credit is a mismatch for the stated purpose. …

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