| As businesses grow and have more of a need | | | | A similar calculation is done for inventory. |
| for working capital a valuable financing tool is the | | | | The inventory calculation is a little trickier. Why? |
| 'operating line of credit '. This facility is also | | | | That is because the bank understands receivables |
| commonly called a 'revolver' by finance | | | | and could step in to collect them if they had to - |
| professionals. | | | | however, they don't understand inventory, and |
| What is the revolver? It is a financing facility, | | | | their customers have all types of inventory! Our |
| most commonly done with a bank that provides | | | | experience is that as a rule the banks will pick an |
| credit against the customer's receivables and | | | | amount close to 40% for the inventory portion |
| inventory. | | | | of the credit line. So if a customer has a month |
| How does the facility work? After the facility is | | | | end balance of 200,000.00 in inventory the bank |
| approved and negotiated with the bank the | | | | will arbitrarily allow them to write cheques of |
| customer submits, usually monthly, a detailed list | | | | 80,000.00 against the inventory. |
| the firms account receivables and inventory. The | | | | The bank has now calculated the facility based on |
| bank calculates what is known as a 'margin limit | | | | our above A/R and inventory figures. |
| 'and advises the customer that the business can | | | | It is very important to know that the whole |
| write cheques against that overdraft, or line of | | | | exercise with the bank is subject to a number of |
| credit up to the maximum of that margin limit. | | | | other factors, such as the profitability of the |
| That new limit is of course approved until the | | | | business, the risks associated with the customers |
| next month's receivables and inventory are | | | | industry, and any personal guarantees that also |
| reported on by the customer. We would say that | | | | support the facility. |
| in 99% of industries the reporting by the | | | | In summary, operating lines of credit are |
| customer is done once a month, but on occasion | | | | important, dare we say critical, to a customer |
| it can be more regular with some customers, and | | | | that is growing and needs working capital. More |
| on rarer occasions it can be less often. | | | | cash is available, per our formulas, as the business |
| How does the bank or financial institution calculate | | | | grows. Problems can arise when a business is no |
| the approved amount? Typically the bank looks at | | | | longer growing though - the bank restricts the |
| the accounts receivable and calculates how much | | | | borrowings, less cash is available, and supplier |
| of the receivables less than 90 are days old. | | | | payables place pressure on the company's |
| Banks assume there is a high level of | | | | working capital. It is also important to note that if |
| uncollectibility on receivables older than 90 days. | | | | the operating lines of credit are significant the |
| This may or may not be the case according to | | | | customer may lose focus on profits and |
| the customer - but the bank makes the | | | | operations, thinking he or she has all the cash |
| assumption on the conservative side. (What a | | | | they need. That's not good. Business owners are |
| surprise!) Given that the bank now has an amount | | | | cautioned to used operating lines properly, and |
| of A/R less than 90 days they take 75% of that | | | | also focus on their profits and operating |
| amount, typically, and use that as the credit limit. | | | | capabilities. |