Credit Line as "Cash Flow Cushion"
Compass On Business Feature

No matter how solid your profit and loss, or how pristine your balance sheet, one principle applies to every business: Run out of cash and you’re out of business. But there’s a potential safety net—the credit line. Used wisely, it’s the one tool that gives you an uninterrupted flow of cash through any business cycle.

While it helps to have that buffer during the lean times, credit lines have a range of uses and applications. "Traditionally, we see credit lines used most often for seasonal working capital needs or to finance growth that outpaces internally generated funds," says Robin Wantland, executive vice president and national director of Commercial Banking at Compass Bank.

How much credit can you get?
Most credit lines are offered for renewable periods ranging from 90 days to several years and are subject to annual review by the lender. How large a credit line a business might qualify for depends on several factors, but balance sheet and adequacy of cash flow are both important.

"We size an applicant’s credit based on historical factors, its position within the industry where it competes, its future projections and other considerations," Wantland explains. "We are very interested in the company’s balance sheet and, to a lesser degree, its historical cash flow." Banks typically will grant lines sufficient to finance 80% of a company’s receivables and 50% of its inventory, Wantland says. "We want to see that the company has enough capital on hand to cover the rest of its needs. If a company’s cash flow is insufficient to term out the line (pay it off within a year), the lender generally looks to see if the business is profitable enough to pay it off over a two- or three-year period," he says.

ImageIf a company has very strong cash flow, the bank may not rely quite so much on its balance sheet in sizing the credit line. Conversely, if there is too little cash flow, then the size of the line is based on the company’s assets.

"The company’s amount of cash flow dictates how closely the bank looks at the credit application," Wantland says. "There are different levels of financing. Factoring is the most expensive and invasive. It’s used for a company that is highly leveraged, has little cash flow and/or is a new business. Asset-based lending is the next step down. It’s not as invasive or expensive, but it’s for companies that are more leveraged and less profitable than the bank would like to see."

When a credit line is being used to finance seasonal working capital, the borrower should absolutely pay it down to zero at some point during the year, Wantland advises. If the funds are being used to finance growth, there may be more leeway. "If you can’t pay it down to zero, we call that lack of cleanup. That dictates higher risk to the lender and higher costs to the borrower," he says.

Lenders typically review credit lines at least annually, and most do so more frequently. A lot of banks have "early warning systems," Wantland says. They look for triggers, such as lack of cleanup or heavier usage on an ongoing basis, which could indicate the lender is financing more of the company’s growth than expected or that the business is not meeting its profit projections.

"We provide financing based on what our risk is in terms of being repaid," Wantland says. "We look at the company’s balance sheet and cash flow, but we’re also interested in the credit-worthiness of the owner. In many cases, how the owner manages his or her personal finances is a good indicator of how the business is being managed."