Business loans can be separated into two categories: unsecured loans and secured loans. Almost without exception, finance companies do not offer unsecured loans, simply because a borrower who serves unsecured credit can borrow at a lower cost from a commercial bank. Consequently in this article our discussion of unsecured loans will involve only commercial banks.
Short term, unsecured bank loans are typically regarded as â€œself liquidatingâ€? in that the assets purchased with the proceeds generate sufficient cash flows to pay off the loan. At one time, banks confined their lending almost exclusively to this type of loan, but they now provide a wide variety of business loans tailored to the specific needs of the borrower. Still, the short term, self liquidating loan is a popular source of business financing, particularly in financing seasonal buildups in accounts receivables and inventories. Unsecured short term loans may be extended under a line of credit, under a revolving credit agreement or on a transaction basis. The debt itself is formally evidenced by a promissory note signed by the borrower, stating the interest to be paid along with how and when the loan will be repaid.
Line of Credit
A line of credit is an informal arrangement between a bank and its customer specifying the maximum amount of unsecured credit the bank will permit the firm to owe at any one time. Usually, credit lines are established for a one year period and are set for renewal after the bank receives the latest annual report and has had a chance to review the progress of the borrower. If the borrowerâ€™s year end statement date is December 31, a bank may set its line to expire sometime in March. At that time, the bank and the company would meet to discuss the credit needs of the firm for the coming year in light of its past yearâ€™s performance. The amount of the line is based on the bankâ€™s assessment of the creditworthiness and the credit needs of the borrower. Depending on changes in these conditions, a line of credit may be adjusted at the renewal date or before, if conditions necessitate a change.
The cash budget often gives the best insight into the borrowerâ€™s short term credit needs. If maximum or peak borrowing needs over the forthcoming year are estimated at $800,000 a company might seek a line of credit of $1 million to give it a margin of safety. Whether the bank will go along with the request will depend, of course, on its evaluation of the creditworthiness of the fi0rm. If the bank agrees, the firm then may borrow on a short term basis — usually through a series of specific promissory notes whose average maturity is around 90 days — up to the full $1 million line. Because certain banks regard borrowing under lines of credit as seasonal or temporary financing, they may impose a â€œcleanupâ€? provision. Under a cleanup provision,, the borrower would be required to clean up bank debt that is, to owe the bank nothing for a period of time during the year. The cleanup period is usually one to two months. The cleanup itself is evidence to the bank that the loan is truly seasonal in nature and not part of the permanent financing of the firm. (Otherwise, the bank might end up providing, in essence, long term financing at short term rates) If the interval during which a profitable firm were out of bank debt decreased from four months two years ago, to two months last year, and to no clean up this year, the trend would suggest the use of bank credit to finance permanent funds requirements.
Despite its many advantages to the borrower, it is important to note that a line of credit does not constitute a legal commitment on the part of the bank to extend credit. The borrower is usually informed of the line by means of a letter indicating that the bank is willing to extend credit up to a certain amount. This letter is not legal obligation of a bank to extend credit. If the creditworthiness of the borrower should deteriorate over the year, the bank might not want to extend credit and would not be required to do so. Under most circumstances, however, a bank feels bound to honor a line of credit.