The private sector provides capital to businesses through traditional commercial banks as well as finance companies, which are geared toward growth-oriented financing. Leasing companies provide an alternate to purchases through contracted use of assets and property.
Commercial banks have traditionally been the largest source of secured short-term financing. As a result, most loans made by commercial banks are short-term demand notes, lines of credit, and term loans.
Although banks are sometimes hesitant to participate in higher-risk development finance projects, several Oklahoma lending institutions are determining the level of risk they may assume on a specific project and financing a portion of the deal.
Short-Term Demand Note
A short-term demand note, the most common type of loan made by a commercial bank, extends a sum of money to the borrower who signs a document, or note, promising to repay the loan. The funds are extended for a single purpose with clearly defined repayment sources.
Line of Credit
A line is an extension of credit with the flexibility to allow the borrower to draw it up, pay it down, and then draw it back up again. It is usually written for one year with the bank given the option to renew the line at the end of the year. The decision to renew differs with each bank, but usually relates to how well the borrower handles the line and meets repayment obligations.
Some banks may require the line to show a zero balance for a specific number of days. This generally occurs when the line is used to finance accounts receivable and inventory.
A term loan is a contractual agreement between the bank and the borrower for an advance over a period of time. The entire amount of the loan can be advanced on the front end or according to an agreed schedule.
Principal payments on a term loan are repaid according to an amortized schedule. Sometimes the agreement calls for moderate payments during the life of the loan and a balloon payment at the end.
To Finance Working Capital
Financing working capital is the primary area of lending for commercial banks. This type of loan finances current assets such as accounts receivable and inventory and generally falls into two loan categories: the short-term demand note and the line of credit.
A demand note finances temporary working capital needs caused by fluctuations in accounts receivable and inventory.
A line of credit is extended for a period of one year and can be of a revolving nature to fund company growth by financing increased levels of inventory and allowing the borrower to carry higher levels of receivables. The line is secured and based on a percentage of accounts receivable and inventory. Sometimes real estate is used as additional collateral.
A line of credit is also used to finance seasonal working capital needs. This type of loan is self-liquidating through the sale of inventory and collection of receivables. It fills the gap between the time suppliers are paid and receivables are collected.
To Finance Machinery and Equipment
Term loans are often made for the purchase of fixed assets. In this case, all funds may be advanced to the borrower at once or according to an agreed schedule for the purchase of capital assets. Usually the asset purchased is pledged as collateral for the loan along with any other collateral that may be required. The loan is to be repaid from the stream of earnings generated by the asset being financed.
To Finance Real Estate
Loans made by banks to finance real estate are either interim construction loans or mortgages.
Interim construction loans are extended to builders and developers to finance the construction of real estate projects. The loan is normally made on a short-term secured basis using a demand note.
A commercial mortgage is granted for the purchase of land and buildings and is usually a term loan secured by the real estate being financed.
When a commercial loan application is reviewed by a commercial bank, many factors are considered in the credit decision. Of primary concern is the protection of the depositor’s funds in the institution. For that reason, the banks ultimate credit decision depends upon the degree of risk involved with making the loan. Anything the borrower can offer in the form of collateral or guarantees to reduce this risk improves the possibility of a favorable loan decision. Some of the factors considered are:
Banks take collateral to reduce lending risks. However, they do not make loans that can only be repaid from the liquidation of the collateral. Any collateral offered should be readily marketable, assignable and provide a sufficient margin. The margin is known as the excess of the collateral’s appraised value over the loan amount.
The two most fundamental financial considerations made by banks when they review loan applications are cash flow and financial leverage, or total debt in relation to total equity.
Banks view cash flow as the primary source for repayment of loans. Businesses should demonstrate adequate cash generation ability from normal operations to service their total debt payments. Banks prefer that companies not be highly leveraged because there is a greater portion of business risk taken by creditors in relation to ownership interests.
Commercial finance companies offer a variety of financial services for progressive growth-oriented companies that have outstripped their working capital and no longer meet traditional bank credit criteria or that have experienced a downturn and are moving into recovery.
Since existing accounts receivable, inventory, and equipment are primarily used as collateral for commercial finance companies, the use of these lenders best applies to companies with several years of operating experience. They are typically not a valid source of financing for initial capital formation.
However, they are an excellent vehicle for meeting the cash needs of companies with rapid growth where there is little cash and a low net worth in relation to sales, accounts receivable, and inventories.
Some of the services offered by commercial finance companies include asset-based lending, factoring, and leveraged buyouts.
This type of financing creates liquidity from the current asset portion of the balance sheet by allowing the business to borrow against inventory and receivables, resulting in an immediate source of cash.
Asset-based lending provides for advances against accounts receivable and inventories which will increase and decrease in accordance with the level of activity of the business. As the activity increases, the increased level of assets will support additional loans. Thus, asset-based lending can support the funding needs of a rapidly growing firm even if its balance sheet might prevent banks from extending credit because the company is too highly leveraged.
Factoring involves the outright selling of the borrower’s accounts receivable at a discounted value in exchange for the use of the credit, accounting and collection services that the factor provides.
This form of financing can improve cash flow, reduce bookkeeping costs, and eliminate the need for a business to maintain an in-house collection staff.
Another area where asset-based lending has been exclusively used is for leveraged buyout financing. The basic concept of the leveraged acquisition is that the buyer minimizes his equity investment in making the purchase by using the value of the assets of the company being acquired as a borrowing base against which to raise most or all of the purchase price. In effect, the lender initially looks to the future cash flow and earnings of the acquired company as collateral. Thus, the seller received most or all of the purchase price in cash and the acquisition loans become direct liabilities of the new entity.
To obtain operating assets, leasing provides a financing alternative for direct purchases and conventional borrowing. However, the cost of funds may be higher.
A lease is a contract for the right to use property for a period of time at a specific rental amount. The structure of a lease determines how it will be treated for accounting and tax purposes. Lessees should consult with an accountant regarding the impact of a lease on financial statements and taxes prior to making a decision to lease. Because the tax treatment under the various types of leases differs, the structure of the lease plays an important role in the effective cost to the lessee.
Under the Capital Lease Method the lessee records a capital asset and a capital lease liability equal to the present value of the minimum lease payments. Each payment is prorated between interest expense and the capital lease liability. The asset is depreciated by the lessee and may become the property of the lessee at the end of the lease term.
Under the Operating Lease Method the lessee records no asset or liability. Rental expense is recorded during the term of the lease as rentals become payable. At the end of the lease term, the asset reverts to the lessor for disposition and is not owned by the lessee.
Sources available to small businesses for obtaining leases include commercial leasing companies, commercial finance companies, equipment manufacturers, and some commercial banks. In addition, lease brokers may provide an avenue for matching the financing needs of a business to a source of capital.
Leasing may provide 100% financing for the equipment, transportation and installation expenses, as opposed to 75% or 80% in a conventional loan.
Fixed payments for the term of the lease may be provided, as opposed to variable loan payments that may fluctuate with interest rates.
Working capital is not tied up in long-term depreciating assets.
A lease agreement may require less cash outflows for the lessee in the early years of the lease than would be required through the conventional financing of a purchase.
The expense of total lease payments may provide a faster tax write-off than depreciation.
Because the lessor retains legal ownership in the leased asset, thee lessor may be less concerned with credit quality than conventional lenders. Therefore, leasing may be the only financing alternative for thinly capitalized companies or companies with weak credit ratings.
Balance sheet ratios may be improved by providing “off balance sheet” financing of fixed assets.
Through a sale-leaseback of presently owned fixed assets, an infusion of liquidity may be provided.