As we credit professionals hurry to gather all of the substantiating documentation to evaluate a customer’s creditworthiness, which may include the customer’s financial statements and trade and bank references, not much thought may be given to the timing and amount of the customer’s bank credit line.
A bank credit line (which can also be referred to as a revolving credit facility) is essentially a working capital loan. These are funds that a bank provides to its commercial customers to facilitate their operation, in which accounts receivables, inventory, equipment and other liquid or movable assets are often pledged as collateral. Your customer may have, for example, a $25 million line of credit with their bank, which means they have the ability to borrow up to approximately $25 million at any given time. The amount borrowed and outstanding under a bank credit line is the amount that will be included as a current liability in the financial statements, and used when calculating most leverage and liquidity ratios.
When analyzing your customer’s financial statements, it’s important to understand how close the customer is to reaching their maximum borrowing limit under their bank credit line. For example, as seasonal fluctuations go hand in hand with credit line limits, it’s typical to see the highest amounts borrowed just before and during the busy season, when a company builds inventory but has not yet collected on their accounts receivables.
However, if it’s not the busy time of the year and you see the customer already being close to their total available line of credit, a warning bell should go off. If your customer has borrowed up to their maximum limit during the off season and will not have additional availability on their credit line when they need it, they may be stretched for cash and this could translate into not being able to pay you timely.
From time to time you may receive a financial statement that has the loan amount against a credit line classified within the long-term liability section of the balance sheet. This long-term liability classification is sometimes justified by the idea that the loan will not be paid down within the next twelve months. However, the problem is that from a cash flow and current asset ratio perspective, it’s best to include this loan within current liabilities. In addition, although classifying working capital loans as a long term liability may make the financial statements look better (indicating better liquidity), accounting standards will generally dictate that outstanding loan balances against working capital loans be classified as current liabilities.
A few other points of concern to the bank credit line have to do with the interest rate, what parts of the A/R portfolio and inventory are being collateralized, and the respective footnotes or management discussions.
If the borrowing rate is close to the prime rate, we can assume the working capital loan is a standard risk for the bank. Conversely, as the interest rate becomes significantly higher than the prime rate, the risk to the bank or other financial lender will also be perceived to be greater.
We also should confirm what part of the accounts receivable portfolio and/or inventory are being collateralized for the loan. If for example the entire A/R portfolio is being used, does that included overseas receivables as well and receivables up to ninety days past due? Or, is only the portion of the A/R portfolio covered under commercial credit insurance being used as collateral? The same idea applies to inventory. Is only the inventory that is turning over within sixty days being collateralized for the loan or is slow moving inventory also included? These are very important ideas to confirm.
Finally, footnotes or management discussions regarding the bank credit line can often be an important point to bring up with your customer as they will also yield insights that can’t always be determined from the figures alone.
Again, although the amount of the bank credit line may be a figure we credit professionals tend to look past, taking the time to carefully evaluate its significance may help us to anticipate the possibility of a payment problem down the road.
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This article was edited by Steven Gan.
