Working Capital Financing 101!

Working capital is what funds business operations. It is used to pay salaries, taxes, vendors, inventory purchases and many other operating expenses! The typical working capital credit facilities that business bankers offer their business clients are commercial credit cards, business lines of credit, asset-based lines of credit, and SBA Express lines of credit. Businesses repay working capital facilities through the turn of trade assets (by selling inventory or services and collecting accounts receivable). Working capital facilities are meant to be repaid in less than a year. We’ll just call working capital facilities “LOC” for the remainder of the article!

 The way your credit team approves a LOC largely depends on the credit limit. A LOC with a credit limit less than $500K is typically approved using a scorecard and a one-page business line of credit application. Credit limits greater than $500K typically require a complete business loan application package, and your credit team analyzes the business’ financials to determine if there is collateral support, debt service coverage support and balance sheet support for the LOC.

Business Line of Credit < $500K:

For this type of LOC, a bank typically requires only a one-page application form asking for basic information about the business. The bank uses the stated information on the application and a scorecard to determine if it will approve the application. A scorecard is a statistical model used to determine the probability that a business will repay the LOC. The probability is determined by the business’ stated information such as revenue & profitability, industry, years in business, third-party credit scores and others. LOC less than $500K requires the least amount of work!

 Business Line of Credit > $500K:

You will have to do more work for a LOC greater than $500K. Your bank will likely require a complete business loan application package which will include personal returns, business returns and an accounts receivable aging & inventory report. Your credit team will use this information to determine if there is debt service coverage support, balance sheet support (aka leverage) and collateral support (aka trade asset support) for the LOC. Determining if there is debt service coverage support is beyond the scope of this article. If you want to become a Business Banking Superstar, learn how to quickly calculate debt service coverage, leverage and borrowing base support (aka trade asset support).

 Determining balance sheet support is easy! You basically look at the business’ balance sheet and find the total liabilities and total equity. You might need to make some adjustments to liabilities and equity. If there is a due-to-shareholder loan, you want to subtract it from total liabilities and add it to total equity. You also want to add the new line of credit to total liabilities and remove any existing line of credit balance. If you divide the adjusted total liabilities by adjusted total equity, you get leverage. If the resulting number is 4 or less, you’ve got balance sheet support.

 Estimating trade asset support is also quick! There are two ways of estimating trade asset support. The first method (the quick method) is using 80% of total accounts receivable and 50% of total inventory and adding the two amounts. If the resulting sum is similar (could be a bit less or a bit more) to the amount of business line of credit being requested, then you likely have trade asset support. The second method is to perform an AR & Inventory analysis which will give you a more accurate estimate of the borrowing base (aka trade asset support). You make adjustments for ineligible AR & inventory. Ineligible AR are concentrations, delinquents accounts, foreign receivables, etc. Ineligible inventory can be raw materials or work in progress. If you want to become a Business Banking Superstar, you will need to learn how to perform an AR & Inventory Analysis…especially for business line of credit requests north of $1 million.

 Quickly Vet Your Client or Prospect:

You will save yourself a lot of time and headaches by asking your business client or prospect three very quick questions when they request a business line of credit! What is your annual revenue? Is the business showing a profit? What is your total accounts receivable and total inventory? These are prequalifying questions that you want to ask right out of the gate! Let’s say your client or prospect is requesting a $1 million business line of credit. If you ask about the business’ annual revenue and the answer is $2 million, it is unlikely that $2 million of revenue will support a $1 million LOC. You then ask if the business is showing a profit. If the answer is no, should ask why the business is not profitable. If there are recurring losses, the deal is not likely to get approved. If it is a one-time loss, there might still be a chance! Finally, you ask for total AR & inventory. If the numbers are $500K in AR and $500K in inventory, you do the quick trade asset estimate (80% of AR + 50% of inventory which equals $650K). This means that you don’t have trade asset support, and your prospect or client will have to scale back the amount being requested.

 Bizpetrol has information, insight and tools that will help you become a Business Banking Superstar!  You can start elevating your business credit skills using the free Commercial Lending Toolkit at www.bizpetrol.com. You can see all the Business Banking articles (like this one) at www.bizpetrol.com/blog. You can access a series of how-to business banker guides at https://www.bizpetrol.com/Downloads-Free.

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