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Banking – Equity in the business
Operating Lines of Credit and Letters of Credit



 

If you have not already done so, read the introductory article at Business Loan Application . It will provide you with the necessary background that leads up to the banking articles that follow, including this one.

These articles are designed to help you speak the same “language” as your prospective, or existing, banker. They will also help you to understand how a banker “thinks”. You will, accordingly, be in a better position to present your case in a favourable light.

The articles are written to assist you in applying for an operating line of credit for your business. The line may or may not include letters of credit – that will be the subject of a separate article.

These articles do not address the retail business; they apply to wholesalers, importers and manufacturers.

This article describes your equity in your business, and how your banker may view it differently from you. Simply put, your equity is the value of the total assets of the business minus the total liabilities of the business. This should be a positive figure as it reflects the profits that have accumulated in the business plus the initial capital that you contributed. A negative equity means the business has either suffered losses or has depleted its capital in some other way.

The financial institution will consider your equity as one of the determining factors in granting a line of credit for your business. It will also play a part in establishing how much the line of credit will be. Depending on its evaluation of all the relevant criteria, the bank may offer you a line of credit equal to your equity, more than your equity, or less than your equity. If the bank deems that, after adjustments, you have no real equity in the business, it may refuse your loan application altogether.

Look at it this way - your equity is your stake in the business, and if the business fails, your stake is lost. That is the risk you take for being in business. The bank may be prepared to match your risk by approving a line of credit equal to your equity, but you must present a convincing argument to induce the bank to take a bigger risk than you! The bank is always aware of the risk to return ratio.

You may think that you have a healthy equity in your business, but be prepared for certain “adjustments” an astute banker will make to reduce its value:

  • The bank will go over your accounts receivable with a sharp- toothed comb to ensure that they are collectible in the normal course of business. Any delinquent accounts, or excessively past due accounts, will not be included with assets. Accounts receivable are usually the prime security for the operating line of credit, and banks are careful to adjust for past due accounts, usually on a monthly basis
  • Any special terms given to customers such as consignment sales (where the customer pays you only as he sells the goods) will render the receivable ineligible as collateral.
  • Obsolete inventory will be discounted, or be ineligible as collateral.

Any intangible assets on the balance sheet, such as goodwill, will be subtracted from the assets.


The above are just some examples of how your equity can be discounted when the bank is considering granting a line of credit.

But the banks are fair too, in spite of being strict. After all, they are responsible for their shareholders funds and must do “due diligence” before making loans.

They will usually agree to consider as equity, a subordinated long-term loan made by you to the business. A long-term loan is one that is not repayable for five years or more. The bank may require an undertaking from you that the loan will not be repaid without the bank’s prior permission. This makes it subordinate to the bank loan.

So, that in a nutshell, is the banker’s evaluation of your business equity. Make sure you use the above information to make your equity palatable to him. Your chances of obtaining the loan will improve greatly!

Present all the positive points to the bank. And, explain what action you have taken, or are taking, to counter any negative aspects. Stress the good value of the underlying assets that support the equity. Point out that the inventory is current, or can easily be liquidated in an emergency. Explain that your accounts receivable are up-to-date and that delinquent receivables have been provided for. If you have unencumbered fixed assets, point out that there is additional collateral for the bank in them. And offer to assign adequate personal life insurance over to the bank to protect their loan.

Equity does, indeed, take on different colors, depending on the glasses you are looking through!


Other segments on business banking cover:

Banking - application for business loans from banks
Accounts Receivable Collateral
> Equity in the business
Inventory Collateral
Letters of Credit
Cashflow projections


Cybernetic Transposition to earn money fast

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