A Resource For Managers, Business Owners, & Entrepreneurs
Understanding Business Operating Credit
on April 15, 2010
This post about overdrafts & operating lines is part of our banking series.
A standard operating account has no overdraft protection; meaning that if you write a cheque for more than your available account balance (total balance minus funds held) it will be bounced due to non-sufficient funds (NSF). Some institutions give their Commercial Account Managers small amounts of discretion to allow these cheques to go through but financial institutions have been reducing this discretionary authority over the years. Unless you have a borrowing relationship with your financial institution, it is unlikely that you have been assigned to a Commercial Account Manager.
Itâ€™s always a bad idea to put your account in an NSF situation. Your cheque will likely bounce but even if a Commercial Account Manager decides to pay your cheque youâ€™ve likely just weakened your relationship with the bank. Bank employees put their career at risk when they decide to pay these cheques and they grow frustrated with people who cannot balance their cheque book. Even if your NSF cheque is covered by the bank, youâ€™ll being paying 21% interest on the amount your account is overdrawn.
Overdraft protection products come in two flavours at most banks.
The process of applying for an overdraft is pretty straight-forward. The form will be simple and they wonâ€™t require detailed information but itâ€™s best to take along your financial statement and a personal financial statement so you have the information at hand. The decision will be based largely on your personal credit score. This means that if your business is incorporated youâ€™ll be providing a personal guarantee. They will also take a general security agreement (GSA) over the assets of your business. The interest rate on this will be high and there may or may not be a monthly administration fee or application fee. Most banks limit this product at about $10,000.
An operating line application is a more complex process. Youâ€™ll want to take in your last three years of financial statements, a personal financial statement and your last three personal tax returns. The personal documents are required for each shareholder.
Most banks have have a two tiered application process. For amounts under $250,000 or so, the application process will be a small set of forms and will likely be decided upon by a computer algorithm that takes into account a number of financial criteria and your personal credit score. Sounds simple right? Not so fast. If your business doesnâ€™t fit neatly into one of the boxes, youâ€™ll be declined. If this happens, I recommend applying at a credit union because they may take the time to evaluate your situation and make a personal decision.
Security will be the same as an overdraft but pricing might be lower due to the larger amount borrowed. If you offer up cash or real estate as security, your rate will be substantially reduced. There will likely be a monthly fee and an application fee.
For amounts in excess of $250,000 a more detailed process is used. Youâ€™ll have to provide aged lists of accounts receivable and payable in addition to the documents needed for lower amounts. A commercial account manager will take the time to get to know your business because it is likely that the decision process will be made by the commercial account manager and the bankâ€™s risk management department. This decision process will take longer but the good news is that you stand a better chance of being approved if your business is a bit unusual.
Security will be the same as a smaller operating line but the bank may take your accounts receivable and inventory as security. Banks generally use 50% of inventory and 75% of account receivable in its calculation of lending value. Inventory that is perceived as unsalable and accounts that have receivables that are more than 90 days old will be removed from the lending value calculation. The lending value must be greater than or equal to the operating loan limit or the limit will be reduced to match the lending value. The limit will be tested monthly for most businesses but those with a longer operating cycle may be tested quarterly or annually.
To perform this lending value calculation, the financial institution will ask for a monthly listing of inventory and an aged list of accounts receivable and payable. It is important to provide this information on time as your account will be considered out of order and the operating line could potentially be frozen until the information is received. The bank will charge a fee for this monthly calculation (called margining) ranging from $25 to hundreds of dollars, depending on the size of the operating loan limit. There will also be an application fee in the range of 0.25% of the limit applied for.
An operating line is a solution for many businesses who have insufficient working capital to handle a long cash conversion cycle. Itâ€™s important to remember that operating accounts are not band-aids. Too often business owners apply for operating lines when the issue is really someplace else. Make sure an operating line is really what you need.
If you have any questions about this topic, please comment below or use the questions box.
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