by Nick Reynolds, VP/Credit Services Manager
The risks associated with business lending differ significantly from those associated with traditional consumer lending. While consumer information is still an important part of knowing your member, the types of risks associated with MBLs tend to be more varied and wider in scope. The credit union industry is expanding further into relationship lending with business members. The next logical step is to gain capabilities in lines of credit, as these are often the lifeblood of a business’ cash flow. This article is one in a series to help credit unions more clearly understand some of the unique risks.
Lines of credit are an important product to offer your business members. However, they tend to be complex, and if they are not managed properly, your member can get into hot water.
One of the biggest questions surrounding business lines of credit is in determining how large of a line of credit should be offered to the member. The correct answer to that question is dependent on the member’s unique circumstances in regard to their sales and credit practices.
Consider a business that offers 30 day net terms to its customers, and sells 100% on account. In this scenario, monthly sales will equal the amount of accounts created each month. If the business’ customers pay an average of 30 days from invoice, accounts receivable will remain consistently at a 30 days of sales level. For example, if the business has sales of $1.2 million each year, and it collects all accounts at an average of 30 days, then accounts receivables will remain at an average of $100,000. But the average collection time for most businesses is about 45 days, and as the lender you should not advance much more than 70% against receivables. So in a typical business that sells all on account, a line of no more than 10% of gross sales is recommended (Ex. 1).
Ex. 1: 100% of Sales Account
- $1,200,000 sales * (45 days/360 days) * 70% advance ratio = $105,000 line of credit
Now consider a retail business, in which half of sales are paid for in cash or credit card payments, and half is paid on account. How large of a line would this business need? The short answer is: half as much. They are now selling $50,000 per month on account, and receivables are running at an average of $75,000. At an advance rate of 70%, an appropriate line would be no more than 10% of annual receivables, or a maximum of $60,000 (Ex. 2).
Ex. 2: 50% on account/50% cash:
- $1,200,000 sales * 50% on account * (45 days/360 days) * 70% advance ratio = $52,500 line of credit
Seasonality is another key decision factor. I once had a client in Alaska that worked only during the summer months, just three months out of the year. In his case, the normal receivables level was one third of his sales! Businesses with significant seasonal fluctuations in sales have a much greater need for a line of credit than those with little or no seasonality. The advantage to you as the lender in this scenario is that at the end of the season, sales go to zero, expenses go to zero, all accounts are collected, and the line is paid off in full.
Now, consider a business with no seasonality at all. How would your member pay off the line of credit? The aggregate level of receivables never goes down (a source of cash) nor does it ever increase (a use of cash). In a non-seasonal business, the only way to experience large swings in line of credit usage is with big swings in sales! So, while it is useful to have a cleanup or resting requirement in your loan covenants, you can create automatic covenant violations if the business does not experience large seasonal variations. A better course is to establish a line to fund only the seasonal variation in the accounts. The permanent, fixed portion of those accounts should be funded with capital, i.e. a working capital loan or equity in the business.
Lines of credit are complex products that require extensive due diligence up front, and regular monitoring going forward. Don’t make the mistake of providing your member with the wrong product for their needs, or “setting and forgetting” the line of credit after closing. This is a disservice to your member, and one that may result in many headaches down the road.
About CU Business Group
Established in 2002, CU Business Group, LLC, provides a wide array of business lending, deposit, and consulting services to credit unions nationwide. Based in Portland, Oregon, with offices in the West, Southwest and Eastern U.S., CU Business Group has a staff of 40 professionals and serves more than 500 credit unions in 46 states.
