What amount can I use on my operating line of credit?

The level of inventory and accounts receivable affects your borrowing capacity. “The math can be complex, and many companies make mistakes, such as calculating more capacity than they actually have,” says Amélie Jacques, Director, Business Restructuring, BDC.

The banking agreement always describes exactly how to calculate your borrowing capacity, and that can vary considerably from one financial institution to the next. In addition, even if the purpose of the calculation is to determine the bank’s position in the event of realization of the assets, this same calculation is performed in the normal course of the company’s business to ensure that the bank is still covered in the event of liquidation.

Comiré and Jacques explain the main steps needed to calculate a borrowing base and the true capacity of an operating line of credit.

1. Verify the amount authorized for the line of credit

The amount authorized for the line of credit is included in the banking agreement given to the company by the financial institution when it grants the line of credit. That’s the maximum amount the company can borrow.

For this example, let’s say the authorized line of credit is $1.7 million.

2. Calculate borrowing capacity

Borrowing capacity is the calculation that determines how much you are entitled to borrow on your authorized line of credit.

The calculation is as follows:

A. Calculate eligible accounts receivable

The first step is to calculate the eligible receivables recorded in the monthly financial statements, excluding the items indicated in the banking agreement. Accounts that have been outstanding for 90 days or more are an example of receivables that are often excluded under banking agreements. “The bank excludes them because of the lower chance of collecting them,” says Jacques.

The banking agreement also generally provides for the exclusion of intercompany accounts, when different companies in the same group sell products to one another.

Normally, the accounts receivable of suppliers should also be excluded. “Because they have the right to make offsets in certain situations,” says Jacques. It is important to note that other types of accounts receivable may be included in the calculation; refer to your banking agreement for details.

The bank also gives itself leeway on accounts receivable. For this example, let’s say it takes 75% of the accounts receivable, so the amount eligible for the borrowing capacity calculation is $648,750.

B. Calculate eligible inventory

Caution should be exercised when calculating eligible inventory since, for example, it may not all count for the same percentage in the borrowing capacity calculation. For instance, the calculation may include raw materials at 40% and finished products at 60%. Some types of inventory even have to be completely excluded. Like accounts receivable, the bank retains flexibility in the calculation.

“For example, the bank may consider that completing work in progress is to expensive and could be exclude them from their borrowing base calculation,” Jacques says. We also exclude obsolescent items and samples because they are almost worthless.”

So, for example, out of a total inventory of $1,470,000, the borrowing capacity is $827,000.

C. Calculate senior debt

“Senior debt is all debts for which the law provides for priority payment to other creditors, such as sales taxes and source deductions,” explains Jacques. They must therefore be excluded from the borrowing capacity calculation.

D. Calculate your borrowing capacity

Lastly, input right numbers into the formula presented at the start of this point to determine your true borrowing capacity.

As you can see in this example, we are far this month from the authorized line of credit of $1.7 million.

3. Calculate your cash position

Once these calculations are completed, you can easily calculate your cash position by subtracting the use of the line of credit (in the example: $1,600,000) from the borrowing capacity for the month.

So even with an authorized line of credit of $1,700,000, the company can only use $1,298,750. If it uses $1,600,000 of its line of credit, it will have a security shortfall of $301,250. Solutions must be found quickly to reduce the security shortfall and remain within the borrowing capacity.

“This calculation allows us to see whether the company still has funds in its line of credit, or whether it has a security shortfall,” says Jacques. “The result should not be a surprise. You have to anticipate what your borrowing capacity is going to be on a monthly basis, and you have to plan your cash flow to meet your needs.”

4. Plan your cashflow needs

Knowing your cash position on a monthly basis helps you better plan your cash flow needs. “This is important because a company in a period of very rapid growth often faces cash flow challenges,” says Comiré. “If this growth is uncontrolled, it is a sign of financial difficulties for the company.”

Knowing whether your line of credit will be sufficient to meet your company’s needs when you win new contracts or make acquisitions is therefore critical to your success.

“Faced with a need for cash, you have to present your new contracts to your banker and increase your line of credit,” says Comiré. “The goal is to never end up with a security shortfall.”

For further explanations, you may wish to consult your external accountant and your banker.