Businesses with a December 31 year end are about to begin the annual ritual renewal of their bank lines of credit. Most lines of credit must be renewed annually at an expiration date that coincides with the completion of year-end financial reports, audits, and tax returns. While the process may seem relatively routine, it is important that the process be understood and taken seriously by small business borrowers.
- The bank needs accurate financial information to approve your line of credit. Depending on the size of your business, and amount of debt, the bank may require an Audit, Review, or Compilation of your financial statements. Regardless of these requirements, it is important that the bank trust the accuracy of the financials. The financials are the primary basis for the approval of your loans.
- You need to determine your borrowing needs for the coming year. Your annual sales forecast, budget, cash flow and balance sheet projections should demonstrate that your line of credit is adequate to meet your needs for the coming year. If not, these projections can be used to justify an increase. If you need to increase your line of credit (and even if you don’t) you should schedule a meeting with your banker. In that meeting, you present your financials and budget for the new year. Be prepared to explain what happened during the year to revenues and expenses. Also, explain your budget and sales forecast, and opportunities for the coming year. Sales growth can be used to explain the need for additional borrowing. Anticipated borrowing needs for equipment and other long term needs should also be presented to the bank.
- Your line of credit should zero out or “rest’ at some point during the year. The line of credit is meant to be used for short term, or seasonal fluctuations in cash flow. It should not be used for long term needs, such as, capital equipment or real estate acquisitions. If a line of credit remains outstanding for a year or more it is considered “evergreen”, and a sign that your business is not properly financed, or capitalized. The bank may suggest that you need additional equity, or might want to convert a portion of the line to a longer-term amortizing loan.
- It is important to remember that a line of credit is a short term, or temporary loan. At maturity, the bank can choose to renew, reduce, or even not renew your line of credit. If it chooses not to renew the line they can demand repayment at maturity. After years of routine renewals, borrowers may come to expect their line to be automatically rolled over at maturity. A drop in sales, or just a bad year financially, can quickly change a banks willingness to renew. Even a change at the bank itself, such as a sale to another bank, or a change in management, can trigger a change in underwriting standards.
- Be sure to understand your bank loan covenants. Most banks have loan covenants as part of the borrowing agreement with your business. Covenants generally impose limits on your leverage and minimums on cash flow. Covenants are calculated monthly, quarterly or annually. If you exceed the leverage limit, or do not meet the cash flow requirement, you trip the covenant, and are in default on your loans. The bank could call your loans and demand repayment. While this is a serious matter, often the bank will meet with you, and discuss your unique circumstances. The bankers may be convinced that the business is not in a permanent state of decline, and the collateral is sufficient to protect the bank. If so, they may waive the covenant violation, and may even change the requirements of the covenant.
B2B CFO consultants are experts at assisting businesses work with their banks and optimizing the renewal process.
George A Bares, CPA MBA
Partner, B2B CFO