Lines of Credit - What is the Right Amount?
First things first, a quick definition: 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. Got it? Ok, good...now, on to the fun stuff!
When discussing lines of credit with business owners, one of the questions we hear all the time is, "How much should I be asking for when I go into the bank?" While no two operations are alike, the size of a line of credit can be estimated through a fairly simple formula.
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.
A quick example;
Annual Sales $14,600,000/365 = $40,000 (daily cash need)
Accounts Receivable days on hand 52 days (usage of cash)
Add Inventory days on hand + 69 days (usage of cash)
121 days (usage)
Less Accounts Payable days on hand – 46 days (source of cash)
75 days
Multiply by usage x $40,000 (daily cash need)
$3,000,000 (estimated need)
Your company estimated line of credit need is now known ($3,000,000 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. 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?
Liquidity, cash flow, and leverage are all key performance metrics of a company that the bank measures when determining the size of the credit line. While there are some generally accepted benchmarks that prospective borrowers should aim to hit, each bank will have slightly different underwriting requirements that they adhere to.
Having a partner like Clover Capital to help guide you through this process can not only ensure that you get the appropriate line of credit in place for your business, but they can also make sure that the cost of the credit facility is at (or below) market. This can be the difference in putting hard-earned profits into the pockets of of owners or paying additional interest to the bank.
If you still have questions, don't hesitate to learn more at www.clovercapital.org.
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