Do you really know how Lines of Credit work?

ToddLay

December 14, 2020

One of our clients has a large trucking business out of the Los Angeles area. We’re getting them ready for next year as we are seeing growth in the double digits for their business. We want to make sure that we place a good line of credit for him. 

But for everyone else, do you know how line of credit works? Our involvement in that area is important. I just want to make sure that people and business owners know how vital it is for a business. 

As the state-wide mandated lockdown has started here in California, I wanted to make sure for my client that his line of credit is good and up-to-date. I wanted to be pro-active even though the second round of PPP money is coming. 

What is a Line of Credit?

A line of credit is basically like a credit card for a business. You’ve got maybe a hundred thousand dollars, $300,000, whatever it might be. And the payments that you make on this are interest only payments.

For example, if it is a hundred thousand dollars and you end up using $10,000 of it, you’re only going to pay the required monthly payment on that $10,000 that you’ve used. It is going to be the interest and that’s actually accrued on it. 

And the beautiful thing about a line of credit is that once you use it, you pay it down or you pay it off. It will be refreshed again. You’ve got access to a hundred thousand dollars in capital at that moment. 

As a result, if there’s an opportunity you want to be able to get access to immediately at that moment, you don’t have to go through the traditional manner of going through a full documented loan, waiting for it, to go through underwriting and then having it under a term where it’s maybe financed over 60 months, 72 months, that revolving line of credit.

Approval Process of Line of Credit

Usually, what happens is, once they get approved, you will not have to wait for the process. You can pull the trigger and know you’ve got a hundred grand or $300,000 instantly at that moment available to you to be able to do this. 

Moreover, it’s not subject to things like the PPP loan. It is not limited to only use for rent, for labor or you can only use it for this, the line of credit. You can use it for anything. 

For instance, if the amount is over $75,000 there, the banks are typically going to ask for projections and you might say, well, what are projections?

Well, you’ve got your profit and loss, the income and expenses. That’s going to be on the income statement. You’ve got your balance sheet, it shows all your debts and liabilities, your assets, accounts receivable, cash in the bank, and so forth. 

That’s all obviously on your balance sheet, but the projection itself is they’re going to want to see a play out over the next 12 months of the various types of income that you’ve got coming in. 

The bank would want to see not only one type of money or one type of revenue that’s going to be coming in. They’re going to want to see if you have multiple sources of revenue coming in. And they want to see it happen over the next 12 months.  They want to know if there’s a cost of materials that is related to your business.

Like if you’re in construction for that matter, there’s the work can’t be done unless you are buying lumber and supplies and the direct labor that’s associated with it. So they want to see all that kind of stuff, your overall overhead operating expenses. They’re going to want to see projected out over the next 12 months. 

And I think for a lot of business owners, it is tough enough just being able to have regular financials to say the least. Being able to not just look at Wells Fargo and actually know whether you’re profitable or not. But to be able to have your financials on a regular basis. 

It probably difficult for a lot of folks to be able to see those monthly and doing it on their own, or just trying to get them from their existing bookkeeper or accountant, but to be able to have projections put out, that’s a whole another layer.

And that’s one of the things that we’ve actually been doing for several of our clients, assisting with projections. And in the instance I was talking about here is just for 12 months. They’re looking for at least a $75,000 line of credit.

If you’re going to go up to say, for instance, $250,000 or $500,000 line of credit, they’re going to be looking for at least, 24 months of what projections are going to be playing out for your business.

It is fairly time consuming to be able to get some of these things put in order. And I think just a lot of business owners, they really just don’t have the time. Or their accountant for that matter really has the time to be able to sit down and to crunch and get all this stuff put together for them.

Another thing is that lines of credit are typically index against 15% of your gross sales. So, if you’re looking for $150,000, you better be doing at least a million dollars in gross sales. It is what that should be looking like. For that $2 million or $300,000 line of credit, you should be looking at the other thing that they’re actually going to do to prevent business owners from getting multiple lines of credit.

They’re going to do, what’s called a UCC filing and think of it as kind of like putting a lien on your business. So when they go ahead and look at issuing that $150,000 line of credit they’ll place, this UCC filing at that basically says, look, the bank or the SBA has issued alone of a line of credit to this entity corporation, or what have you have $150,000.

And so if the business owner was attempting to look at getting a secondary line of credit from somewhere else to try to game the system, they too would file a UCC filing and see that. They will prevent you from getting a second line of credit because of the first existing one. 

Lastly, let’s say you don’t have trucks, equipment, and things like that. Well, many banks safe credit union is another example. They will be able to issue you a line of credit unsecured up to a hundred grand. It is pretty good. 

So a lot of that is just against your good credit, or your business credit for that matter. So that would be something to look at. They would be looking at the balance sheet that you would be getting from us.

And they’re going to be looking at the accounts payable, accounts receivable. They will also check your debt to income ratio and how those types of things actually look like at that point.

And a lot of times you’ll find too, is that the debt to income ratio that they’re looking at is roughly about 45% across the board. Now that might subject to change depending on the industry that you’re in. 

Whether if you’re in professional services or if you’re a dentist or maybe a veterinarian, it might be subject to change. They’ll give a little bit more leniency maybe on that. But across the board, what I’m finding is about 45%.

Interest Rates in Line of Credit

Let’s talk about interest rates. If this is your second line of credit and you’ve already been through this process a few years ago. 

Let’s say it was three years ago, and you’ve been able to enjoy the full experience of having this line of credit in place after it. Usually, about three years, the loan itself, if it’s not paid off in full, will actually convert to a term loan.

You could pay it off. If you had a hundred thousand dollar line of credit and at the end of the three years you can’t draw it down anymore, again, and maybe you’ve got $10,000 on it. We’ll at that point, it converts to a traditional loan. Then, you would just make payments on it for the next 24 months or whatever the case is. And then it actually goes down to zero and the loan goes away. 

Well, if it’s maybe your second one or your third one, a third experience of going through this process, you can see an interest rate. They’re pretty good, just 5.7, 5%, or up to 6.7, 5%. 

If it’s your first go, sometimes I’m seeing them as high as 10%. For that 10%, interest only loans, revolving lines of credit with that. 

Interim Financials 

The other part I could share with you is interim financials. We had a fencing company in Sacramento over off 12th Avenue and one of the bankers contacted us and said, “Todd, we’re going to have a little bit of an issue here on interim financials from this company.” They’ve been around like 50 years.

They reached out to us and asked if we could you provide a profit loss and a balance sheet that has every six months record just to go ahead and show that the business is financially solvent. They want to make sure that the million dollars that they loan to them for their building and some operating capital will be paid. 

Those are a few things that we usually do to help our clients. It is either providing the interim financials or helping them get approved for these loans. Or like other instances is providing the projections on a regular basis to help get the loan into underwriting. 

I say, right now, we’ve only got a couple of weeks left this year. If you’ve had a strong year, this is your time right now to go ahead and make sure you get your financials together, be proactive and make sure that you bulk up and have some ready ONTAP resources available that comes into this next year before you need it. 

So, if you want to find out a little bit more about what we’re doing, send me a direct message. You may also email at support@simplebackoffice.com

TODD LAY
Chief Experience Officer
SimpleBackOffice

“Know Your Numbers, Know Your Business”
916-520-8560