Borrowing Working Capital for Your Small Business

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Commercial banks obviously are the largest source of such loans, which have
the following characteristics:

1) The loans are short-term but renewable

2) they may fluctuate according to seasonal needs or follow a fixed schedule of repayment (amortization)

3) they require periodic full repayment (“clean up”)

4) they are granted primarily only when the ratio of net current assets comfortably exceeds net current liabilities

5)they are sometimes unsecured but more often secured by current assets
(e.g., accounts receivable and inventory). Advances can usually be obtained
for as much as 70 to 80 percent of quality (likely to be paid) receivables
and to 40 to 50 percent of inventory. Banks grant unsecured credit only
when they feel the general liquidity and overall financial strength of a
business provide assurance for repayment of the loan.
You may be able to predict a specific interval, say three to five months,
for which you need financing.

A bank may then agree to issue credit for a
specific term. Most likely, you will need working capital to finance
outflow peaks in your business cycle. Working capital then supplements
equity. Most working capital credits are established on a one-year basis.
Although most unsecured loans fall into the one-year line of credit
category, another frequently used type, the amortizing loan, calls for a
fixed program of reduction, usually on a monthly or quarterly basis. For
such loans your bank is likely to agree to terms longer than a year, as
long as you continue to meet the principal reduction schedule.

It is important to note that while a loan from a bank for working capital
can be negotiated only for a relatively short term, satisfactory
performance can allow the arrangement to be continued indefinitely.
Most banks will expect you to pay off your loans once a year (particularly
if they are unsecured) in perhaps 30 or 60 days. This is known as “the
annual clean up,” and it should occur when the business has the greatest
liquidity. This debt reduction normally follows a seasonal sales peak when
inventories have been reduced and most receivables have been collected.
You may discover that it becomes progressively more difficult to repay debt
or “clean up” within the specified time. This difficulty usually occurs
1) Your business is growing and its current activity represents a
considerable increase over the corresponding period of the previous year;

2) you have increased your short-term capital requirement because of new
promotional programs or additional operations; or 3) you are experiencing a
temporary reduction in profitability and cash flow.

Frequently, such a condition justifies obtaining both working capital and
amortizing loans. For example, you might try to arrange a combination of a
$15,000 open line of credit to handle peak financial requirements during
the business cycle and $20,000 in amortizing loans to be repaid at, say
$4,000 per quarter. In appraising such a request, a commercial bank will
insist on justification based on past experience and future projections.
The bank will want to know: How the $15,000 line of credit will be
self-liquidating during the year (with ample room for the annual clean up);
and how your business will produce increased profits and resulting cash
flow to meet the schedule of amortization on the $20,000 portion in spite
of increasing your business’s interest expense.

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