Tips for Understanding your Customer's Bank Credit Line
By Cindy Moorhead
Moorhead Management Services

A bank credit line (also called a revolving credit facility) is a working capital loan. Your customer may have, for example, a $10 million line of credit with their bank. This means they have the ability to borrow up to $10 million and, up to that amount, may increase or decrease their borrowing on a daily basis. The amount borrowed under the bank credit line is included when calculating most leverage ratios.

When analyzing your customer's financial statement, it is important to understand how close the company is to reaching their maximum borrowing under the bank credit line. Also, looking at trends will help understand if, over a period of time, they are increasing or decreasing the overall borrowing.

Seasonal fluctuations go hand in hand with credit lines. It is typical to see the highest credit lines just before and during the busy season when a company builds inventory but has not yet collected the sales from the busy season.

However, if it is not the busy time of year and you see the customer being close to the total available on the line of credit, a red flag should go up. The balance sheet will show the amount borrowed. The total amount they can borrow under the bank credit line (called the availability) will probably be noted in the footnotes or management discussion. If your customer has borrowed their maximum in the nonbusy season and will not have additional availability on the credit line when they need it, be aware they may stretch their payments to you to fulfill their working capital needs.

Even though a company may always have a certain level borrowed, in theory, a credit line is borrowed and repaid each day. Therefore, a credit line is usually shown in the current liability section of the balance sheet.

From time to time you may receive a financial statement that has the credit line in the long-term section of the balance sheet. They justify the long-term classification as always having a certain amount borrowed that would not be paid down in the next twelve months. If I find the bank credit line in the long-term liability portion of the balance sheet, I move it into current liabilities for analysis purposes (particularly when calculating the current and quick ratios). The reason for this is that industry standards for these ratios generally have statements with the bank line of credit in the current liability section.

If you do not move it from non-current liabilities into current liabilities for analysis purposes, the company's liquidity will look better than other companies in a similar situation. In fact, sometimes it will look real good when there may be liquidity problems that will be hidden because the bank line of credit is shown as a non-current liability. Classifying a credit line as a long-term liability is one way a company may try to make their statements look better.

Another thing to look at with the bank line of credit (and other borrowings as well) is the interest rate on the debt. If the borrowing rate is close to the prime rate, I assume this working capital loan is a standard risk for the bank. A red flag goes up if the rate is well above prime. Borrowing at a high interest rate means the company is considered a risky loan to their bank.

Many times you will receive financial statements without footnotes or management discussions. In these cases, the bank credit line is an excellent discussion point to use when you call your customer to discuss their financials. Asking questions about their banking situation can help open up communication on finding out what is really going on in their company. Discussing your customer's financials also lets them know you are analyzing the statements!

Cindy Moorhead is a CPA and founder of Moorhead Management services. She speciaizes in financial statement analysis for credit professionals. Her e-mail is cindy@moorheadmgmt.com

Reprinted by permission from Trade Vendor Quarterly
Blakeley & Blakeley LLP Spring 01