By Eugene E. Valdez AKA the Loan Doctor™
One of the key tenets of my consulting business model is “one loan type does not fit all”. That is to say that you can’t use the same type of loan for all business purposes as each business is unique in terms of their profit margins, how fast they turn their inventory and ARs and how quickly they must pay their vendors or AP. Add to that sales growth and balance sheet leverage and you get what I call a company’s “Cash Needs Profile.” Every company’s cash needs profile is different and thus it is incumbent that CEOs, CFOs and their bankers seek a loan type that matches up with their company’s unique profile.
One of the most flexible loan types is an asset based AR line of credit or “formula Line,” which based on my daily work as a banking consultant, is not used nearly as much as it should be. The reason for this is that this type of loan product is more costly to administer than a conventional line and requires more expertise as there is more risk. In the banking & finance community of today, lenders tend to shy away from more risk and greater set up and administrative loan costs.
Asset based AR financing is ideal for companies that are growing, (or have aspirations to grow) have low profit margins, are thinly capitalized, have good customers that pay slow and have vendors that expect to get paid with their terms (usually 30 days). The variables I just described apply to about 70% of all the clients and or prospects that I have worked with over the last ten years and most of them did not have formula LOCs in place.
When I take on a new client their current financing usually consists of an ill-suited SBA loan, an expensive factoring arrangement, a very small conventional bank line of credit that is not doing the job or worse of all a loan extended by an online lender, (interest rates 30%- 70% in my experience).
Pure Asset based AR lines are extended by a few banks and commercial financing companies. Borrowings under the line are based on monthly gross ARs less ineligible ARs, times an advance rate of 75% to 80%. Ineligible ARs are usually those 90 days plus from date of invoice, government & foreign ARs and other exclusions. The beauty of this type of financing is that as your sales & AR grow you automatically increase your borrowing capacity. You never have to pass on an incremental sales opportunity because you are fearful you don’t have enough working capital.
Most companies endeavor to pay all of their monthly operating expenses and AP in 30 day cycles. If your AR collections are averaging 45 days then your company has a 15 day financing gap. The ABL AR Line of credit is the mechanism to finance that 15 day gap. ABL AR Lines can be used to carry high ARs, buy inventory, take trade discounts, keep AP current, pay past due taxes and pay all operating expenses in a timely fashion.
ABL AR Lines can be used to finance both short and long term working capital needs and unlike conventional bank lines of credit there is no stupid 30 day out of debt requirement, i.e. “cleanup.” You only pay interest on what you borrow. Normally principal payments are at your discretion as long as your loan balance is “within formula” i.e., no greater than 80% of the most recent eligible AR figure. If you are out of formula you will have to pay enough principal to bring you in formula immediately.
Loan pricing can range from 7.00% to 18.00% which is better than SBA loan of 8.00%, factors of 24%- 30% and online lenders of 40% to 70%.
Conventional Bank Lines of credit typically require that your balance sheet reflect a maximum debt to equity ratio of 3.00 to 1. An ABL LOC can be as high as 6.00 to 1 depending on the bank. For a commercial finance company it is largely irrelevant as long as you have good clients who pay, you have good AR bookkeeping processes and that your customers have no rights for set off.
In summary, if your sales are growing, your profit margins are small, you have high balance sheet leverage and you’re not in an Asset Based AR line of credit structure, your current financing structure is flawed and is not allowing your company to meet its full potential. What CEOs want that?
See you next week.
Eugene E. Valdez is President and CEO of The Loan Doctor and Associates, Inc., a full service banking and finance consulting company located in Upland, CA. He can be reached at 909-230-0024. Like and follow him on social media Facebook, LinkedIn.