– 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:
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!