As businesses grow and have more of a need for working capital a valuable financing tool is the 'operating line of credit '. This facility is also commonly called a 'revolver' by finance professionals.
What is the revolver? It is a financing facility, most commonly done with a bank that provides credit against the customer's receivables and inventory.
How does the facility work? After the facility is approved and negotiated with the bank the customer submits, usually monthly, a detailed list the firms account receivables and inventory. The bank calculates what is known as a 'margin limit 'and advises the customer that the business can write cheques against that overdraft, or line of credit up to the maximum of that margin limit.
That new limit is of course approved until the next month's receivables and inventory are reported on by the customer. We would say that in 99% of industries the reporting by the customer is done once a month, but on occasion it can be more regular with some customers, and on rarer occasions it can be less often.
How does the bank or financial institution calculate the approved amount? Typically the bank looks at the accounts receivable and calculates how much of the receivables less than 90 are days old. Banks assume there is a high level of uncollectibility on receivables older than 90 days. This may or may not be the case according to the customer - but the bank makes the assumption on the conservative side. (What a surprise!) Given that the bank now has an amount of A/R less than 90 days they take 75% of that amount, typically, and use that as the credit limit. A similar calculation is done for inventory.
The inventory calculation is a little trickier. Why? That is because the bank understands receivables and could step in to collect them if they had to - however, they don't understand inventory, and their customers have all types of inventory! Our experience is that as a rule the banks will pick an amount close to 40% for the inventory portion of the credit line. So if a customer has a month end balance of 200,000.00 in inventory the bank will arbitrarily allow them to write cheques of 80,000.00 against the inventory.
The bank has now calculated the facility based on our above A/R and inventory figures.
It is very important to know that the whole exercise with the bank is subject to a number of other factors, such as the profitability of the business, the risks associated with the customers industry, and any personal guarantees that also support the facility.
In summary, operating lines of credit are important, dare we say critical, to a customer that is growing and needs working capital. More cash is available, per our formulas, as the business grows. Problems can arise when a business is no longer growing though - the bank restricts the borrowings, less cash is available, and supplier payables place pressure on the company's working capital. It is also important to note that if the operating lines of credit are significant the customer may lose focus on profits and operations, thinking he or she has all the cash they need. That's not good. Business owners are cautioned to used operating lines properly, and also focus on their profits and operating capabilities.
What is the revolver? It is a financing facility, most commonly done with a bank that provides credit against the customer's receivables and inventory.
How does the facility work? After the facility is approved and negotiated with the bank the customer submits, usually monthly, a detailed list the firms account receivables and inventory. The bank calculates what is known as a 'margin limit 'and advises the customer that the business can write cheques against that overdraft, or line of credit up to the maximum of that margin limit.
That new limit is of course approved until the next month's receivables and inventory are reported on by the customer. We would say that in 99% of industries the reporting by the customer is done once a month, but on occasion it can be more regular with some customers, and on rarer occasions it can be less often.
How does the bank or financial institution calculate the approved amount? Typically the bank looks at the accounts receivable and calculates how much of the receivables less than 90 are days old. Banks assume there is a high level of uncollectibility on receivables older than 90 days. This may or may not be the case according to the customer - but the bank makes the assumption on the conservative side. (What a surprise!) Given that the bank now has an amount of A/R less than 90 days they take 75% of that amount, typically, and use that as the credit limit. A similar calculation is done for inventory.
The inventory calculation is a little trickier. Why? That is because the bank understands receivables and could step in to collect them if they had to - however, they don't understand inventory, and their customers have all types of inventory! Our experience is that as a rule the banks will pick an amount close to 40% for the inventory portion of the credit line. So if a customer has a month end balance of 200,000.00 in inventory the bank will arbitrarily allow them to write cheques of 80,000.00 against the inventory.
The bank has now calculated the facility based on our above A/R and inventory figures.
It is very important to know that the whole exercise with the bank is subject to a number of other factors, such as the profitability of the business, the risks associated with the customers industry, and any personal guarantees that also support the facility.
In summary, operating lines of credit are important, dare we say critical, to a customer that is growing and needs working capital. More cash is available, per our formulas, as the business grows. Problems can arise when a business is no longer growing though - the bank restricts the borrowings, less cash is available, and supplier payables place pressure on the company's working capital. It is also important to note that if the operating lines of credit are significant the customer may lose focus on profits and operations, thinking he or she has all the cash they need. That's not good. Business owners are cautioned to used operating lines properly, and also focus on their profits and operating capabilities.
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