Cash is the lifeblood of any business, and most business owners experience the need for an occasional short-term infusion of capital to bridge cash flow gaps, finance bulk inventory purchases or to meet other working capital needs. But after the long recession and credit crisis, many owners are reluctant to take on debt that could prevent them from capitalizing on the rebounding economy.
The solution is a short-term line of credit, or STLOC, which is typically secured by business assets and provides owners a less expensive way to access capital versus other forms of capital such as additional equity injection from the owner or another investor.
“Although business owners should avoid excessive debt, an appropriate amount of short-term debt can help a company grow and allow the owners to maximize return on assets and equity,” says David Song, senior vice president and head of the Corporate Banking Group at Wilshire State Bank. “Despite lingering uncertainty in the overall economy, banks are willing to make short-term loans to well-run businesses.”
Smart Business spoke with Song about maximizing growth opportunities through a STLOC.
When should business owners consider a STLOC?
STLOCs are typically used to finance operating expenses until receivables are converted to cash or to finance inventory purchases until they’re sold and converted to cash. For example, as demand for goods and services rises during a recovery, manufacturers and wholesalers need cash to produce/purchase inventory and finance accounts receivable, while importers need lines to open letters of credit and purchase products from overseas suppliers. Retailers can use STLOC to make volume purchases ahead of a peak selling season, while professional service firms can use the funds to expand by hiring additional employees.
How does a STLOC differ from a long-term line of credit?
A STLOC is a revolving line that is typically used to finance short-term business assets for less than one year, whereas a long-term loan is used to finance long-term assets such as equipment, leasehold improvements and real estate. With STLOC, a borrower can draw on a line as needed within the allowed parameters of the borrowing arrangements and then pay down the debt as cash flow allows. Banks offer various types of STLOCs depending on the business needs, borrowers’ qualifications and industry characteristics.
- Nonformula line of credit. This line is similar to a credit card, because it can be advanced or paid down at the borrower’s discretion as long as the borrower is in compliance with loan terms and conditions.
- Trade cycle financing. This type of line is often reserved for importers that use the line to purchase goods from overseas suppliers. Under this arrangement, trade advances are used to finance individual import purchases, which must then be paid back within the pre-determined terms that are based on the operating cycle of the business.
- Asset-based line of credit (ABL). If a company is highly leveraged and/or growing quickly, bankers often suggest an asset-based line, which allows the business to borrow against a specified percentage of accounts receivable and inventory up to a predetermined amount. The amount available to borrow under this arrangement is referred to as a borrowing base.
Are there risks associated with a STLOC?
While a STLOC can provide access to needed capital, a business owner must be aware that there usually is a set of loan terms and conditions with which the business needs to comply. These terms and conditions require the business to submit certain financial information to a bank within a specified timeframe and maintain financial performance at a level that is acceptable to the bank. Obviously, required payments need to be made on time and it is also important to note that loan outstanding does not exceed the borrowing base in an ABL arrangement. If you stay on top of cash flow, and diligently manage accounts receivable and inventory turnover, you’ll maintain the integrity of your assets and boost your ability to borrow. Noncompliance with loan terms and conditions may adversely impact the business’s ability to borrow.
How can a business maintain the quality of its assets and increase borrowing capacity?
Typically, banks will not lend against receivables older than 90 days or stale inventory that hasn’t turned over within a year. Owners should have adequate staff to monitor collections and avoid excessive inventory build-up. Banks will also look at your customer base to see if sales are dispersed among a large base of customers or concentrated in a few accounts, which increases risk. They’ll also examine the credit worthiness of your accounts and they’ll be concerned if you’re shipping products to delinquent customers.
What do bankers consider when evaluating a request for a STLOC?
A business must demonstrate stable or growing trends, an acceptable track record of profitability, solid credit history and adequate cash flow to service the debt. Bankers will also look for a balance sheet that shows positive working capital and adequate equity levels without excessive leverage. A business will also be asked to provide accrual-based financial statements. Bankers will evaluate the requested STLOC amount and the company’s borrowing needs based upon the business’s operating cycle together with all other business and personal information provided to the bank. As a banker will rely on the accuracy of financial information provided by the business to make lending decisions, the quality of information provided to the bank is vital.
David Song is a senior vice president and head of the Corporate Banking Group at Wilshire State Bank. Reach him at (213) 365-3302 or [email protected].
