Business line of credit explained

BUSINESS CREDIT - THE LINE OF CREDIT

A business line of credit is normally used to finance temporary working capital needs of the borrower typically accounts receivable and inventory. It is usually extended for one year. However, the structure of the line is flexible and can be accommodated to the needs of both the borrower and the lender.

A serious lending institution will focus on a company's cash flow, credit profiles and financial ratios to determine the appropriate level of leverage and debt repayment capability of the business. Generally, line of credit facilities are secured only by a lien on the assets of the company and extended to companies with a proven earnings track record, adequate financial ratios and overall moderate credit risk.

Some of the common types of structure or "terms" for lines of credit are:

Demand line of credit: A loan payable "on demand" is one in which the lender leaves the loan open until the lender calls it due. In other words, there is no set term or schedule for repayment. This is very common and is actually preferred by the lending institution as it makes it possible to "demand" payment from the borrower when deemed necessary.

Revolving line of credit: It usually involves a commitment from the lending institution for a set amount of time "anywhere from 1 year to several years". It allows the borrower to use the funds, as they need them and to repay them at will.

Asset Based line of credit: Is a revolving line of credit where the amount available for disbursement is governed by a formula, which is usually the sum of the accounts receivable outstanding plus the inventory and multiplied by a factor (usually around 80% for accounts receivable and 50% for inventory). The amount owed by the customers of the borrower (account debtors) and the inventory is monitored by the lending institution and the submission of monthly accounts receivable agings and inventory listings is a requirement.

Other controls that can be placed on the line of credit are:

Draws payable within a certain period: The line might include requirement that each disbursement is paid within a certain period usually 90 days.

Clean-up: The borrower is required to pay-off the line in its totality and keep the balance at $0 for a certain amount of time during the year usually 30 days.

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