Obtaining a Higher Credit Limit and Paying Less Interests on Commercial Loans by Lending Guarantees
Guarantees open more possibilities for companies looking for commercial financing. Businesses possess a great variety of them and a secure credit helps get a bigger loan at a lower interest rate. Commercial financing can also find guarantees from the shareholders' assets. Securities are an exchange value that businesses should know about, and that will help reach growth objectives, improve cash flow process and lower costs of financing.
Hypothecs and Security Agreement
Account receivables are money related to the exchange of goods and services, but that hasn't been paid yet by the buyers. Most companies have to deal with a certain delay before receiving their payments since they don't cash it automatically after the exchange. The money from the transaction can be received 30 days, 60 days, 90 days and sometimes 120 days after the exchange of goods and services has been done, depending on the relation the client has with his supplier. However, all the account receivables have good value to the eyes of financial institutions and they can be given away as guarantees in exchange for a line of credit. The money related to the transactions can then be used right away, before receiving the actual payments. A business can normally seek for 75% of their receivables less than 90 days late as a credit limit. Not a lot of banks would finance the receivables that are more then 90 days late since they are more likely not to be recuperated.
For companies operating in the industry of goods, the inventory represents a big portion of their assets, and it is possible to give it as guaranty in exchange for a line of credit. Banks could provide a credit limit equivalent to a portion of the inventory. They wouldn't attribute a credit limit of 100% of the inventory, because there is a risk of devaluation of goods and a decrease of the inventory level. When banks have to take action on a client, there is a delay between taking the decision of seizing the inventory and doing it. During that time, the business can sell a good amount of the stocks and lower the level of inventory considerably. Also, after banks seize the inventory, if the demand is low, the goods could be resold at a much lower price and not to their usual gross margin. For these reasons, banks attribute a credit limit at approximately 50% of the level of inventory.
The account receivables and the inventory are considered short term assets, because the inventory material comes and goes regularly and the level of receivables changes every day. When banks and other financial institutions search for guarantees on both the receivables and the inventory, they are looking for a contract called the security agreement. The amount of a line of credit secured on both the receivables and the inventory combine to approximately 75% of the receivables under 90 days late and 50% of the inventory. With a higher credit limit obtained at a lower interest rate, the business has more room to manage their cash flow.
For loans related to real estate, banks and financial institutions search to protect themselves by taking the property as a guaranty. It is a high limit loan and aim for long term financing. It functions the same way as a consumer mortgage; the bank owns the property until the balance reaches zero. Businesses are able to get from 80% to 95% of the property value in financing. Since real estate appreciates with time and the amount is high, it is the lowest interest rate you can find when borrowing.
Security agreement and mortgages include securities that have high value for banks and it is the first thing businesses should give to obtain low cost financing.
Motor vehicles, equipments and letter of credit
Motor vehicles and equipments are collaterals also used as guarantees when financed. It is frequent that these engines are financed in a rent-acquisition contract. The financial institution that provides the financing secures itself by registering as the owner of the motor vehicle or equipment until the balance reaches zero. In a context where the businesses would stop their payments, the lender would repossess the good and resale it on the market to cover the unpaid balance.
The company financing the product can require cash down or a security deposit on the product in order to acquire equity on the vehicle. An equity position for the lender is obtained by having a balance on the loan lower then the market value of the motor vehicle or the equipment, so in the eventuality that the financial institution would repossess the engine, the value of the vehicle could cover the balance left to pay. Since in the first three years the motor vehicle or the equipment devaluate faster then the balance is decreasing, the possible amount obtainable for financing is maintained at around 90% of its value, depending on the commercial credit of the borrower.
Many financial institutions offer financial services on vehicles and equipments. Companies that originally make the vehicles and offer the financial services give lower interest rate, because they know how the vehicle or equipment will devaluate and they structure the loan consequently. Toyota, Ford and GM are good examples; for a long time they offered low monthly payments and competitive interest rate knowing how much the vehicle will be worth at the end of the term. It is then beneficial to search for financing with the company that originally made the product.
In addition to equipment, other types of guarantees exist that are just as effective for banks. The letter of credit represents a way to get financing when a business has some cash surplus. This type of guaranty requires the business to fill out a letter in favour of the lender institution, which will freeze a specific amount in the bank account that the business won't be able to withdraw. In the event of default by the business, the lender would apply the letter of credit by cashing the amount written on the letter. A security deposit is similar; the business can't use the specific amount during its activities, and it will lose it if it stops making payments.
Priority order on the securities
A business can diversify its financing resources and it is possible to have different financial institutions sharing guarantees on the inventory, receivables, real estates, motor vehicles and equipments. Certain companies have enough assets to get four different financial institutions (or more) on the same asset. Indeed, if, for example, a business has a line of credit of 100,000 secured on its inventory, and during the whole year the inventory level is maintained at around 400,000, it is possible to obtain other source of financing that will secure itself on the rest of the 300,000. In the context where many financial institutions share the same asset as a security, there are some priorities; certain creditors will be paid first in case of bankruptcy. These priorities are normally established under the principle of the first arrival, but there is always a way to modify the order by signing specific contracts.
Some businesses have debt from related companies, shareholder or other individuals that lend money to the company under official terms. It is then possible for banks and financial institutions to reduce their risk by looking for loan subordination on other lenders. With this contract, the bank takes officially priority on other creditors that signed the loan subordination. In the event that a company would sell all its assets, the financial institution will pass in front of the one who signed the loan subordination to be paid. This technique decreases significantly the credit risk for banks. It is rarer however, that banks sign loan subordination between each other, because none of them would give up their priority position to another. It is a procedure banks use mainly on other familiar creditor to the company, in order to shift the risk on them instead of external creditors.
Another very effective security is the personal guarantee from the administrators. It is primarily an incentive security to motivate the company to make their payments on time. Financial institutions measure the value of a personal guarantee by calculating the net value of the endorser. The net value is calculated by taking all the assets of the endorser, i.e. real estate, investment and bonds, and by subtracting all personal debt from it. Normally, banks will not take into consideration assets that devaluates such as cars, trucks and other vehicles. Personal values are collaterals that take longer to seize in the event of default by the business, so they are not considered as guarantees easy to recuperate like inventory or receivables. It is primarily an incentive guarantee.
A financial institution can find all the guarantees enumerated in a universal security, which regroups all the business' and endorsers' assets. One thing is for sure, when there is a guarantee on commercial materials, the lending institution will ask for a proof of insurance, in order to avoid ending up with an important balance to be paid, or goods destroyed by fire.
Security agreement, mortgage, vehicle, equipment, letter of credit, personal guarantees and loan subordination are securities that a business can lend in order to get a higher credit limit at a lower interest rate. If no guarantees are given to banks, the business will have to work with a smaller amount or a credit card with an interest rate close to 20%. It is very hard to manage a business with a small credit limit and expensive to use a credit card as a financing tool. Lending some guarantees doesn't put a business in jeopardy if the administrators have the intention of making their payments on time, and it increases importantly the chances of success.