How to determine what your business's line of credit should be

Stephen Klumb, Senior Vice President and Chief Lending Officer, National Bank & Trust

Determining how much credit your business can obtain or should have can seem like a complicated endeavor for businesses. However, your banker can simplify the process and help you determine that figure, says Stephen Klumb, senior vice president and chief lending officer, National Bank & Trust.
“A line of credit is a commitment by a bank to a borrower to advance short-term money, working capital or receivables financing over a specified period of time for short-term working needs,” says Klumb. “And that line of credit can be estimated through a fairly simple formula.”
Smart Business spoke with Klumb about how to work with your banker to determine your line of credit and how to identify the right banker to help you through the process.
How can a business determine what its line of credit should be?
Take your total estimated annual gross revenue (sales) and divide by 365. That gives you your daily cash need. Next, determine your total number of accounts receivable, plus inventory days on hand (Use of Funds) and subtract your accounts payable days on hand (Source of Funds), and this is your usage. Multiply your daily cash need times the usage (accounts receivable days less accounts payable days) and you will get the estimated line of credit needed for your business.
For example:
Sales …………… $9,125,000/365 = $25,000 (daily cash need)

Accounts Receivable days on hand …………. 68 days (usage of cash)
Add Inventory days on hand ……………….. + 30 days (usage of cash)
………………………………………………………………98 days (usage)
Less Accounts Payable days on hand …….. – 52 days (source of cash)
………………………………………………………………………..46 days
Multiply by usage ………………………….. x $25,000 (daily cash need)
………………………………………………….$1,150,000 (estimated need)
Your company estimated line of credit need is now known ($1,150,000 in the example) and that number sets the tone for discussion in terms of the amount of money you need in working capital to operate your business.
Is this number a moving target?
Generally, it’s a one-year commitment. Most customers do an annual projection, but if, for example, the business picked up a new contract or lost an existing contract, then it would become a point of discussion. A new contract could require an adjustment to the working capital needs. However, the number is not always a moving target. You might instead do a guidance line, which is a little extra during a period of time that eventually comes back to the normal operating line.
Is there such a thing as too much credit?
Absolutely. Too much credit, when not monitored, could become a problem if you’re allowing your receivables to go out too far. Talk to your bank about what your peer group average receivable days are and to get perspective on where you fall within that group. If your receivables are coming in later than those of your peer group, a good bank would recommend that you address your internal collection process to get your receivables in more quickly; otherwise, you’re borrowing money and the additional credit is taking up profits.
How do banks determine what credit line they’re willing to extend?
Because they’re giving you a line of credit to operate, they need to know your liquidity, so they’re going to use a current ratio. Current ratio is determined by taking current assets minus current liabilities, or a quick ratio, those assets that can be easily turned within a short period of time to produce cash.
Sometimes a line of credit will be established, but if it never goes to zero during a 12-month cycle ,you might lower your line and make a portion of it term debt to get back in balance between term debt and line of credit debt.
What can a company do to set itself up for a line of credit?
The best way to do it is to be on top of your accounts receivable aging report. Monitoring your accounts receivable for payment and having those reports available lets the banker know you are aware of where your receivables are. Having receivables crawl into 90 days could affect your operating line and won’t be counted as collateral.
What are some common mistakes businesses make when applying for a line of credit?
Not having their controller or accountant in meetings with their bankers. When you’re talking to a banker and he’s asking specifics, having the people there who know the answers makes the banker feel more comfortable. Meetings should include the owner, accountant and CFO for lines of credit or term debt. And be honest with your bankers. If you’re having a problem, the bank’s going to know, and it gives you the opportunity to explain why it happened.
How can your choice of bank affect how creditworthiness is determined?
A very large bank may use systems to determine credit. In short, the commercial lender feeds information into an often-automated system, and it comes back with an answer.
At community banks, generally speaking, there is individual involvement. They don’t use those types of systems and instead give more attention to the numbers and to understanding the individual business’ situation.
Regional banks are compartmentalized by market size and often have multiple officers handling each market. Once a business jumps into another category, it has to get a new loan officer. Today’s market is not just about being a lender, it’s value added. If your banker can’t bring value to the table, the bank is just a commodity, and the lowest price wins. Community banks provide a higher value because they are selling the value that can be brought to the relationship going forward.
Stephen Klumb is senior vice president and chief lending officer with National Bank & Trust. Reach him at 1-800-837-3011.
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