By Aneel Eijaz, Senior Credit Risk Specialist
Working Capital Lines of Credit (“LOC”) are one of many forms of Commercial and Industrial (“C&I”) lending. These LOCs are common in commercial banking and are relatively riskier when compared to Commercial Real Estate and/or Residential loans. They are generally secured by an UCC-1 lien on business assets or are unsecured and solely rely on the borrower’s strong cash flow. Due to the elevated risk, banks should monitor these loans closely and have proper processes and procedures in place. Based on our loan review experience, many banks’ loan policies do not contain specific guidance for such loans, and if they do, then the periodic monitoring is not done. In order to understand the reason for enhanced monitoring of these types of loans, it is important to understand the purpose and use of such.
Working Capital LOCs are typically given to businesses for short-term financing to bridge the gap between when a product is sold and payments are received. They typically have a one- year term with annual renewals based on a review of the financial statements. Depending on the type of business and its cycle, the “gap” may be in a different place. For a typical retail business, inventory is purchased then sold, which may result in a delay before the receipt of payment. In a manufacturing business, the raw materials are purchased, manufactured and sold to retailers/wholesalers based on a payment schedule (receivable). In both cases, the lines of credit are used to finance continued purchase of inventory or raw material, as in the second example. This credit facility may also be used to support seasonal businesses. The amount of lines of credit necessary for a business depends on the working capital ratio or current ratio. Some additional ratios for a bank to monitor are inventory turnover, receivables turnover, current debt to net worth and working capital turnover ratio.
Lending institutions are required by regulatory agencies to monitor cash flows of businesses as part of Credit Risk Management to forecast potential issues. As shown above, Working Capital LOCs require frequent monitoring due to the nature of the credit facility, which is based on the day-to-day operation of the businesses. It is often recommended that a bank follow sound due diligence practices by requesting/analyzing financial statements. Additional monitoring may also include the loan officer visiting the place of business periodically to observe the business activity and perform a periodic inventory of the collateral. Banks should require businesses to submit monthly/quarterly financial statements, including A/R and/or A/P Aging reports. As part of the annual analysis, the use of the line of credit is also taken into consideration, as the facility is supposed to show adequate use.
Working Capital advances are sometimes inappropriately used by businesses to fund long-term capital needs. A line of credit that is not paid down from business profits may indicate a potential cash flow issue that needs to be addressed by the borrower and the bank. Additional due diligence on these loans can stop misuse of funds, reduce the overall risk that is inherent in these credits and minimize loss.
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