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Last Edited
April 14, 2003

 

 

ONLINE SMALL BUSINESS WORKSHOP
> Short Term Debt Financing

Short Term Debt Explained
Operating Term Loans
Revolving Lines of Credit
More Short Term Instruments
Approaching Short Term Debt Lenders

Short Term Debt Explained
Short term refers to the time for which a loan is required and the period over which its repayment is expected to take place. Short Term Loans usually take the form of operating term loans (less than one year) and revolving lines of credit. These finance the day-to-day operations of the business, including wages of employees and purchases of inventory and supplies. Supplies are used up quickly and inventory is sold resulting in stock-turns . Also bridge financing (interim loans with a short, fixed term) can be used to finance accounts receivable contracts, which are relatively risk-free, but delayed for one to three months.

Short term operations money may be secured against first, any unencumbered physical assets of the business; second, additional funds from shareholders or personal guarantees from principals. On occasion, inventories can be used as temporary security for operations loans. Bridge financing is normally secured by assignment of all the receivables and personal guarantees. On the balance sheet the accounts receivable, inventory and supplies stocks show up in the current assets section, while the counterpart loan information is displayed in the current liabilities section.

Lenders normally charge a higher base rate of interest for operating loans reflecting this relatively weaker security position. The amount of the operating line of credit, will be determined from the projected cash flow information in the business plan. Lenders favour businesses that exhibit strong management, steady growth potential and reliable projected cash flow (demonstrating the business' ability to pay the monthly interest payments on this line of credit from its projected revenues in a written business plan).

Operating Term Loans
Operating Term Loans for working capital are used to enable a retail, service or manufacturing business to purchase raw materials, retail or parts inventories, process or promote these and pay monthly expenses including principal and interest on outstanding term loans, wages and salaries, rentals, leases, utilities, etc.

If a business was able to sell all its inventory (stock) at full margin and collect the cash for it immediately, realizing its profit before it had to pay suppliers for that stock and before it had to pay its monthly expenses, that business might require no particular working capital loans. However, most are not cash businesses and don't enjoy that luxury. They face build-ups of day-to-day and monthly expenses such as stock parables, wages, rentals, leases, etc., often in advance of collecting the cash sales revenues to pay the trade suppliers, the labour commitments and the regular overhead expenses. Operating Term Loans (Working Capital) are commonly offered by credit unions and non-commercial lenders who are unwilling or unable to offer operating (revolving) lines of credit to their customers. This term loan is made like any other term loan, and is fully secured against unencumbered assets, personal guarantees and co-signers.

Revolving Lines of Credit
A line of credit is a long term commitment by a commercial lender to honour the day to day cheques of a business up to a maximum figure agreed to in consultation with the business. The lender retains a number of signed drafts (notes held for discount) from the business on hand to use as required to place funds as needed into the account. The business was made responsible for depositing all sales revenues on a regular basis into the account to "buy down" the outstanding loan balance whenever there were the funds available to do so.

This up and down, fluctuating nature of the loan amount (account balance) is why it has come to be called a "revolving line of credit." There is no scheduled repayment of principal because there is no set principal amount of the loan. The interest rate normally floats at 2%-3% above the prime rate and is applied to the largest amount of loan outstanding in that account during the course of any month. There are no other account service fees.

Traditionally, revolving lines of credit are the preferred borrowing formats of most commercial businesses and manufacturers. The normal sources of these loans are commercial lenders, the chartered banks, and more recently, some credit unions. Most commercial businesses require differing amounts of cash each month to meet their actual operating commitments for that month; they want to pay only interest justified by the actual usage of borrowed cash (without penalties); and pay nothing at all when revenues are entirely sufficient to pay the month's expenses. This requires a special kind of loan that can provide long-range flexibility (allowing the principal of the loan to vary from month to month); that can temporarily cancel the loan without penalty in a month where borrowing is not required; and that can provide an almost automatic approval from the lender for each new loan amount (to a maximum overdraft). While some of this might be achieved by a Bank Overdraft Scheme, the more commonly accepted way is to use a revolving line of credit.

More Short Term Instruments

Modern Overdraft Scenario
More recently the banks have fine-tuned this program to what could be called a planned overdraft scheme . The bank will approve a business for a certain overdraft amount. They no longer work with a series of pre-signed drafts. The actual interest rate has been dropped to a point to two points above the prime rate and a system of service charges for the overdrafts has been substituted to make up the difference.

Interim Loans
Interim loans are a type of bridge financing intended to "bridge the gap" between the time a specific receivable is received in cash and the time the company's parables become due. The assignment of the receivables is the primary security for the loan. This is quite common where a government agency purchase has been made. The lender knows the customer will pay, but also that the cash may take some time to collect. When a government financial assistance program makes an award, reimbursable only after the moneys have been spent or the project is in place, bridge financing is an appropriate format.

Assignment of Book Debts (Receivables)
The receivables are assigned to the lender to secure the operating line of credit. These are still collected by the business, but in the event of business default, the lender can assume collection of these directly. The assignment is supported by the monthly submission of the list of receivables.

Security under Section 88
Section 88 of the Bank Act allows a business to use goods-in-process, future crops, livestock, etc., as security. Possession and title are retained but the lender has certain rights with respect to the sale of the finished products.

Security for Working Capital Loans
The lender uses accounts receivable (the money owed by customers) and inventory as the security (collateral) for the loan. For accounts receivable lenders may lend between 50% and 75% of the total outstanding receivable, first deducting any invoices which have gone over 90 days. On inventory, lenders may lend up to 50% against cost based on supplier invoices. Any additional cash required must come from your own resources or by careful management and recirculation of the business' profits and cash.

Personal Guarantees
The principal makes an agreement that if the limited company is unable to repay the loan, he/she will do so personally. If this guarantee is on top of other security, attempt to negotiate a limited guarantee to cover only the shortfall in the security. Recover the personal guarantee as soon as the business has paid off its obligation or can carry the debt on its own security. A personal guarantee places all those things you and your family hold dear at risk.

Postponement
If there are also loans from shareholders, the lender may ask for an agreement that the company will not repay the shareholders until the secured lenders have been repaid in full.

Approaching Short Term Debt Lenders

Mortgage Lenders
The institutional providers of first level mortgage lending include the Insurance Companies, the Banks, the Trust Companies and the Pension Funds. There are also many short term loan financiers to be found in the private sector. Many of these advertise their services aggressively, especially where their offerings relate to mortgage extensions on property in stable real estate markets (such as the Lower Mainland market).

These can be easily located through licensed and bonded consultants known as mortgage brokers. These offerings normally involve terms of one year or less with liberal provisions for renewal. For these reasons these mortgages often charge only interest, but have hefty penalties for returned cheques and late payments.

A first mortgage will earn the lender approximately 12% interest, a second mortgage, 15%, and a third mortgage, 18% - 20%. Many of these will have, in turn, leveraged and sourced two thirds of their funds for this mortgage from an institutional or commercial lender, and accordingly they will have to comply with various restrictions placed on their investments by that lender.

Private mortgage financiers would normally be approached after you have exhausted the commercial channels and been rejected from dealing directly with them due to some weakness in your equity or personal guarantee abilities.

Approaching Mortgage Lenders:
There are many short term mortgage loan financiers to be found in the private sector. Many of these private mortgage financiers advertise their services aggressively, especially where those offerings relate to mortgage extensions on property in strong real estate markets (such as the Lower Mainland market).

Commercial Banks and Credit Unions:
The Commercial Banks and Credit Unions are normally prepared to offer financing based on accounts receivable bridging and/or inventory purchases. Revolving or operating lines of credit (and overdraft schemes) are offered by the major commercial banks and some credit unions.

Approaching Commercial Banks/Credit Unions:
Loan evaluation tends to be more rigorous and sophisticated than mortgage loan evaluation. In summary, this lender is evaluating the immediate abilities of the management team, the collateral available to support the loan and the short term commercial viability of the situation, as portrayed in the projected cash flow financial submissions. This cash flow projection will normally be included in a detailed business plan (in a bound presentation format) providing extensive information on the management of the company or project; a detailed history of the business, its current products, its production methods, its operations, its position in the marketplace; the purpose for which the loan is intended (in intimate detail); any security available to be pledged; and extensive financial information and projections.

Assistance to prepare this presentation can be accessed through the Management Services arm of the Business Development Bank of Canada or the Start-Up Centre of the Canada/British Columbia Business Services Society.

Trade Creditors, Factors and Commercial Finance Companies:
Trade Creditors offer terms of 30 days before payment for stock purchases is due. With newer, unproven operations, C.O.D. (Cash On Delivery) is often required. Occasionally, in a buyers' market, an important large dealer will be offered 60 day payment terms. Often a 2% discount will be offered to dealers who pay within 10 working days and a penalty (e.g. 1.5% per month interest) will be imposed on account balances unpaid after 30 days.

Factoring Companies may buy accounts receivable outright without recourse and assume all the risks of collection. These may advance funds against purchased receivables, less a percentage.

Commercial Finance Companies often advance funds upon assignment of receivables and warehouse shipping/receiving receipts. They will also consider short term equipment financing.

Approaching Trade Creditors, Factors and Commercial Finance Companies:
Sales finance companies, in cooperation with the product suppliers (vendors) commonly offer sales finance or factoring programs and lease-back options on their equipment. The onus is upon you to ask your vendor if he/she has access to any such finance programs, or if the vendor will finance the purchase directly, through a factor or floor-planner scheme. Small office equipment may often be purchased on a lease-to-buy arrangement. Generally, these will expect a less detailed business plan, but will be particularly interested in the parts that relate to sales projections, stock movement and replenishment and monthly cash flow information.

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