Many companies still make the mistake of acquiring assets by using their line of credit. This can cause financial problems because the line of credit is calculated according to the short-term needs of the company and not the long-term needs.
When it comes to financing, the principle is fairly straightforward: matching, as much as possible, the amortization period of the financing to the lifespan of the asset being financed. So when companies acquire assets using their line of credit, they could impact your financial structure. This is due to the fact that the line of credit is calculated based on the company’s short-term needs and not the long-term needs.
Understanding the line of credit
The line of credit is essentially a loan repayable on demand. It initially consists of a single authorized amount and the disbursements processed by the financial institution are made, in most cases, according to the company’s needs, in predetermined fixed instalments. The line of credit, also known as operating line of credit, is used to finance current activities, i.e., daily operating expenses. In addition, it is used to provide the required funds to maintain inventories and accounts receivable as well as to finance working capital changes that occur during the year.
Each bank sets up financial standards to calculate the maximum amount of an operating line of credit to be approved for a company. These standards vary across industries, pledged assets and policies in place. In general, banks allow a maximum line of credit representing at least one time the shareholders’ equity.
Once the line of credit is set, the bank usually provides a margin formula that limits the amount of funds made available to the company. This formula takes into account the value of collateral transferred, which is a percentage of inventories (between 0% and 50%) and accounts receivable of less than 90 days (between 60% and 75%). Percentages will vary depending on the nature and the ease of resale of products in stock and the solvency of the customers.
3 alternatives to finance your new assets
There are 3 alternatives that companies can consider to finance new assets without using the line of credit:
- Money from shareholders or other investors, in the form of a new injection of funds into the company
- A term loan that will be repaid over a period of time depending on the asset’s lifespan
- Financing one portion of the coveted asset by term debt and the other portion by an injection of funds
The third alternative offers more flexibility and creates a financial leverage that can be converted to cash from financial institutions. These institutions can usually lend at least $2 for every dollar invested. Furthermore, some companies may already have an unused leverage in their balance sheet, which is often the case for companies with high profitability.
Some financial instruments available on the market
Once the leverage is created or discovered, it is now time to consider the financial instruments available on the market. Options for this type of transaction include:
Term loan guaranteed by financed assets
This loan consists of a pre-fixed amount, which will bear interest at a fixed or variable rate, with repayments over the duration of the loan. It can be used to finance various types of tangible and intangible assets. The guarantees will generally consist of chattel mortgages on assets acquired with the loan. For intangible assets, the financial institution will also take first-rank guarantees on available tangible assets and, if this proves to be insufficient, a second-rank chattel mortgage on other assets. It is common for the financial institution to require a personal guarantee from shareholders as well.
Term loan guaranteed by the Federal and Provincial Governments
To limit the guarantees required by financial institutions, the transaction can be financed by a term loan that will be guaranteed by a government agency. Some government programs provide loan guarantees to financial institutions if the borrower defaults. That is the case for “Canada Small Business Financing Program”, better known as “CSBFP”. However, additional management fees are payable when the company relies on these programs.
Financing provided by suppliers of the acquired asset
Unlike term loans offered by financial institutions, where only a portion of the asset’s cost is financed, many suppliers offer leases that often finance the full cost of the asset. The main guarantee lies, of course, in the leased asset. Sometimes, a personal guarantee from the company’s directors may be required.
Interest-free loans and non-refundable contributions from the Federal and Provincial Governments
Governments are an important source of assistance for entrepreneurs. Although, finding the right financial aid program can be difficult. While governments are increasingly making efforts to reduce the number of programs and optimize the processing of files, searching for the appropriate program(s), building the case and having the project approved can be time consuming. It is recommended to seek the help of a professional financing specialist and/or build strong relationships with government employees.
Bear in mind that conditions and eligibility requirements apply in all the abovementioned cases. Good preparation and solid documentation are essential elements to obtain the required financing.
Try to avoid impulse buying and take the time to consider the impact of acquiring new assets on your financial structure and profitability before making your decision. Besides, meeting your banker to explain liquidity problems caused by the misuse of your line of credit is far from being a joyful experience.
Patrick Whalen, MBA, Vice President – Financial Advisory Services