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Line of Credit Loans

A line of credit is a formal or informal agreement between a bank and a borrower concerning the maximum loan a bank will allow the borrower for a one-year period. Often the bank will charge a fee (usually a percentage of the line of credit) for a definite commitment to make the loan when requested. Line of credit funds are used for such seasonal financings as inventory buildup and receivable financing. These two items are often the largest and most financeable items on a venture's balance sheet. It is general practice to repay these loans from the sales and reduction of short-term assets that they financed. Lines of credit could be unsecured, or the bank may require a pledge of inventory, receivables, equipment, or other acceptable assets. Unsecured lines of credit have no lien on any asset of the borrower and no priority over any trade creditor, but the banks may require that all debt to the principals and stockholders of the company be subordinated to the line of credit debt. The line of credit is executed through a series of renewable ninety-day notes. The renewable ninety-day note is the more common practice, and the bank will expect the borrower to pay off his or her open loan within a year and to hold a zero loan balance for one to two months. This is known as "resting the line" or "cleaning up." Commercial banks may also generally require that a borrower maintain a checking account at the bank with a minimum ("compensating") balance of 5-10 percent of the outstanding loan.

For a large, financially sound company, the interest rates for a "prime risk" line of credit will be quoted at the prime rate or at a premium over LIBOR (London Interbank Offered Rate). Eurodollars (American dollars held outside of the United States) are most actively traded here, and banks use Eurodollars as the "last" dollars to balance the funding of its loan portfolio. Thus, LIBOR represents the marginal cost of funds for a bank. A small firm may be required to pay a higher rate. It should be noted that the true interest calculations need to take into consideration the multiple fees that may be added to the loan. Any compensating-balance or resting-the-line requirements or other fees will also increase effective interest rates.

Time-Sales Finance

Many dealers or manufacturers who offer installment payment terms to purchasers of their equipment cannot themselves finance installment or conditional sales contracts. In such situations, they sell and assign the installment contract to a bank or sales finance company. (Some very large manufacturers do their own financing through captive finance companies. Most very small retailers merely refer their customer installment contracts to sales finance companies, which provide much of this financing, and on more flexible terms.)

From the manufacturer's or dealer's point of view, time-sales finance is, in effect, a way of obtaining short-term financing from long-term installment accounts receivable. From the purchaser's point of view, it is a way of financing the purchase of new equipment.

Under time-sales financing, the bank purchases installment contracts at a discount from their full value and takes as security an assignment of the manufacturer/dealer's interest in the conditional sales contract. In addition, the bank's financing of installment note receivables includes recourse to the seller in the event of loan default by the purchaser. Thus, the bank has the payment obligation of the equipment purchaser, the manufacturer/dealer's security interest in the equipment purchased, and recourse to the manufacturer/dealer in the event of default. The bank also withholds a portion of the payment (5 percent or more) as a dealer reserve until the note is paid. Since the reserve becomes an increasing percentage of the note as the contract is paid off, an arrangement is often made when multiple contracts are financed to ensure that the reserve against all contracts will not exceed 20 percent or so.

The purchase price of equipment under a sales financing arrangement includes a "time-sales price differential" (e.g., an increase to cover the discount, typically 6-10 percent) taken by the bank that does the financing. Collection of the installments may be made directly by the bank or indirectly through the manufacturer/dealer.

Term Loans

Bank term loans are generally made for periods of one to five years, and may be unsecured or secured. Most of the basic features of bank term loans are the same for secured and unsecured loans.

Term loans provide needed growth capital to companies. They are also a substitute for a series of short-term loans made with the hope of renewal by both the borrower and bank. Banks make these generally on the basis of predictability of positive cash flow.

Term loans have three distinguishing features: (1) banks make them for periods of up to five years (and occasionally more); (2) periodic repayment is required; and (3) term loan agreements are designed to fit the special needs and requirements of the borrower (e.g., payments can be smaller at the beginning of a loan term and larger at the end).

Because term loans do not mature for a number of years, during which time there could be a significant change in the situation and fortunes of the borrower, the bank must carefully evaluate the prospects and management of the borrowing company. Even the protection afforded by initially strong assets can be wiped out by several years of heavy losses. Term lenders place particular stress on the entrepreneurial and managerial abilities of the borrowing company. The bank will also carefully consider such things as the long-range prospects of the company and its industry, its present and projected profitability, and its ability to generate the cash required to meet the loan payments, as shown by past performance. Pricing for a term loan may be higher, reflecting a perceived higher risk from the longer term.

To lessen the risks involved in term loans, a bank will require some restrictive covenants in the loan agreement. These covenants might prohibit additional borrowing, merger of the company, payment of dividends, sales of assets, increased salaries to the owners, and the like. Also, the bank will probably require financial covenants to provide early warning of deterioration of the business, like debt to equity and cash flow to interest coverage.

Chattel Mortgages and Equipment Loans

Assigning an appropriate possession (chattel) as security is a common way of making secured term loans. The chattel is any machinery, equipment, or business property that is made the collateral of a loan in the same way as a mortgage on real estate. The chattel remains with the borrower unless there is default, in which case the chattel goes to the bank. Generally, credit against machinery and equipment is restricted primarily to new or highly serviceable and resalable used items.

It should be noted that in many states, loans that used to be chattel mortgages are now executed through the security agreement forms of the Uniform Commercial Code (UCC). However, chattel mortgages are still used in many places (for, example, moving vehicles like tractors or cranes), and, from custom, many lenders continue to use that term even though the loans are executed through the UCC's security agreements. The term of a chattel mortgage is typically from one to five years; some have longer terms.

Conditional Sales Contracts

Conditional sales contracts are used to finance a substantial portion of the new equipment purchased by businesses. Under a sales contract, the buyer agrees to purchase a piece of equipment, makes a nominal down payment, and pays the balance in installments over a period of from one to five years. Until the payment is complete, the seller holds title to the equipment. Hence, the sale is conditional upon the buyer's completing the payments.

A sales contract is financed by a bank that has recourse to the seller should the purchaser default on the loan. This makes it more difficult to finance a purchase of a good piece of used equipment at an auction. No recourse to the seller is available if the equipment is purchased at an auction; the bank would have to sell the equipment if the loan goes bad. Occasionally, a firm seeking financing on existing and new equipment will sell some of its equipment to a dealer and repurchase it, together with new equipment, in order to get a conditional sales contract financed by a bank.

The effective rate of interest on a conditional sales contract is high, as much as 15-18 percent if the effect of installment features is considered. The purchaser/borrower should thus make sure that the interest payment is covered by increased productivity and profitability resulting from the new equipment.

Plant Improvement Loans

Loans made to finance improvements to business properties and plants are called plant improvement loans. These intermediate- and long-term loans are generally secured by a mortgage (or a second mortgage) on that part of the property or plant that is being improved.

Commercial Finance Companies

The commercial bank is generally the lender of choice for a business. From whom does a business seek loans when the bank says no? Commercial finance companies, which aggressively seek borrowers, are a good option. They frequently loan money to companies that do not have positive cash flow, although they will not make loans to companies unless they consider them viable risks. In tighter credit economies, finance companies are generally more accepting of risk than banks.

The primary factors in a bank's loan decision are the continuing successful operation of a business and its generation of more than enough cash to repay a loan. By contrast, commercial finance companies lend against the liquidation value of assets (receivables, inventory, equipment) that it understands, knows how and where to sell, and whose liquidation value is sufficient to repay the loan. It should be noted that banks today own many of the leading finance companies. The good news here is that, as a borrower gains financial strength and a track record, transfer to more attractive bank financing can be easier. For the small business owner, this transition can be initiated by a growth plan that engages the lending capabilities of these institutions. You would be wise to study the lending habits of your current relationships to assess their appetite.

In the case of inventories or equipment, liquidation value is the amount that could be realized from an auction or quick sale. Finance companies will generally not lend against receivables more than 90 days old, federal or state government agency receivables (against which it is very difficult to perfect a lien - and they are slow payers), or any receivables whose collection is contingent on the performance of a delivered product. Because of the liquidation criteria, finance companies prefer readily resalable inventory items such as electronic components, or metal in such commodity forms as billets or standard shapes. Generally, a finance company will not accept inventory as collateral unless it also has receivables. As for equipment loans, these are made only by certain finance companies and against such standard equipment as lathes, milling machines, and the like. Finance companies, like people, have items in which they are more comfortable and therefore would extend more credit against certain kinds of collateral. How much of the value of collateral will a finance company lend? Generally, 70-90 percent of acceptable receivables under 90 days old, 20-65 percent or even 70 percent of the liquidation value of raw materials and/or finished goods inventory that are not obsolete or damaged, and 60-80 percent of the liquidation value of equipment, as determined by an appraiser. Receivables and inventory loans are for one year, while equipment loans are for three to seven years.

All of these loans have tough prepayment penalties: finance companies do not want to be immediately replaced by banks when a borrower has improved its credit image. Generally, finance companies require a three-year commitment to do business with them, with prepayment fees if this provision is not complied with.

The data required for a loan from a finance company includes all that would be provided to a bank, plus additional details for the assets being used as collateral. For receivables financing, this includes detailed aging of receivables (and payables) and historical data on sales, returns, or deductions (all known as dilution), and collections.

For inventory financing, it includes details on the items in inventory, how long they have been there, and their rate of turnover. Requests for equipment loans should be accompanied by details on the date of purchase, cost of each equipment item, and appraisals, which are generally always required. These appraisals must be made by acceptable (to the lender) outside appraisers.

The advantage of dealing with a commercial finance company is that it will make loans that banks will not, and it can be flexible in lending arrangements. The price a finance company exacts for this is an interest rate anywhere from 0 to 6 percent over that charged by a bank, prepayment penalties, and, in the case of receivables loans, recourse to the borrower for unpaid collateralized receivables. Because of their greater risk taking and asset-based lending, finance companies usually place a larger reporting and monitoring burden on the borrowing firm in order to stay on top of the receivables and inventory serving as loan collateral. Personal guarantees will generally be required from the principals of the business (sometimes defined as more than 5 percent ownership, but this is negotiable). A finance company or bank will generally reserve the right to reduce the percentage of the value lent against receivables or inventory if it gets nervous about the borrower's survivability.

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