Operating Lines of Credit and Letters of Credit
We highly recommend that, if you have not already
done so, you read the first article in this series, Banking
Business Loan Application, at :
Everything explained in this article on inventory collateral
financing will then fall into place naturally.
As in the other articles in this series on fundamental principles
of business banking, we wish to clarify the following facts:
This is not intended to be a detailed accounting or banking
course. I have put together the essential information you need
in order to give yourself the best chance of succeeding in your
business. I shall tell you what your bank manager would like
to hear from you at your meetings. I shall tell you the early
warning signs that your business needs positive action.
These comments are not for retail business finance, or personal
loans; they apply to wholesalers, importers and manufacturers.
To cover the vast amount of banking information, even in thumbnail
format, I shall break it down into various segments. Some will
apply to your business, others may not. I am intentionally phrasing
the segments in very simple laymans terms. I would advise you
to discuss my advice with your accountant, or even your banker,
before you decide to act on it.
Let us assume that you make an application to a bank, or other
financial institution, for an operating line of credit for your
As explained elsewhere in this series on business bank loans,
the potential lender will examine various important aspects
of the business in order to assess, among other things, the
The viability of the business
The profitability of the business
The track record of the business
The credit history of the business
The credit history of the owners
The quality of the collateral
The adequacy of the collateral
The collateral to cover the operating line of credit usually
comprises the following:
Personal guarantees of the owners
A floating charge covering any other unencumbered assets
This segment will explain the essentials of how a bank evaluates
inventory that is offered as collateral for a business loan
or an operating
line of credit. As explained in the segment on equity, this
is not supposed
to be a text book course, but explains briefly what you will
the real world of business finance.
The amount of money the financial institution will be prepared
to lend you against inventory, will depend a great deal on the
ease of realization of the inventory collateral you can offer
to cover the loan, in case there is a default in repayment.
It is not just the dollar book value of the collateral,
but the quality of the collateral, and whether it would realize
enough to repay the loan if there was a liquidation of the business.
A typical example might be that your main collateral for a $1
million loan application is your inventory of widgets. The widgets
will cost you $1,250,000 and you expect to sell them for a total
of $2,000,000 which would gain you a $750,000 profit. You would
think your bank would be pleased to approve the loan.
These are some evaluation techniques related to the inventory
that the bank will utilize before the credit approval decision
can be made:
Quality of the widgets:
~ What percentage, if any, are damaged and non-saleable?
~ Are they a seasonal item and, if so, are they carried over
from the last
season, or are they current?
~ Are they a basic necessity or a gimmick that may not last?
~ Are they easily saleable?
What is the history of returned merchandise? For what reasons?
What would be a reasonable liquidation value of the inventory,
after auction and liquidation expenses?
~ Is there a ready market for them?
~ Will one have to store them at an expense, and attempt to
sell them in the next season?
~ Would the liquidation value cover the loan?
~ Would the bank have to incur any expenses to render the inventory
~ Will customs duty have to be paid before the inventory is
released from bond, in the case of importers?
What percentage of your existing inventory, if any, is covered
by customer orders?
~ Has the stock been purchased against orders?
~ Or is it purchased on speculation, in expectation of orders
to come in?
When was the last physical count done of the inventory?
~ Was the count supervised by the auditors?
~ Is the dollar value based on GAAP ? (generally accepted accounting
Depending on the nature of the widgets, how often does the
inventory turn over each year.
~ Is it comparable to the industry average?
It is unusual for a bank to finance more than fifty percent
of the cost value of inventory, because of the perceived risks
involved. However, if you are an importer, and you require the
bank to open letters of credit for your suppliers, the bank
may provide higher financing temporarily if you can show that
a substantial portion of the inventory being bought is against
customers purchase orders. Once the inventory arrives and is
shipped within a short time to customers, the loan is then covered
by the new accounts receivable generated, and the risk factor,
as far as the bank is concerned, is reduced.
Your borrowings, as shown in your cashflow projections, should
also be within the line of credit approved for your business.
If the loan is going to temporarily peak beyond the line of
credit approved, be sure to explain that to the bank. Point
out the reason why, and how it will be adequately covered by
collateral. Banks hate surprises, unless they are of a positive
nature. The last thing you want is for the bank to refuse to
cover cheques you have issued for business expenses.
So, give them all the information they need upfront to make
a credit decision. If there is any negative aspect, bring it
up and explain how you plan to deal with it.
Additional segments in this series deal with collateral other
than inventory, as well as other aspects of commercial finance
that you will find useful to know.