How Big Should a Line of Credit Be?

How big should a line of credit be?  This is a question I’ve toiled with a lot in underwriting, and to be honest, there really isn’t a hard and fast rule which governs this idea. I would love to tell you it is a tightly managed equation that depends on the cash conversion cycle, but the truth is, that all gets thrown out the window once we start evaluating the underlying financial strength of a business.

When I look at a line of credit, I care most about being repaid. For me, the appropriate size for a line of credit is one which can assuredly be repaid. To determine the true capacity for repayment, it helps to look at multiple repayment sources. Oddly enough, I think it helps to start by looking at traditional real estate finance to wrap our minds around this.

How big should a real estate loan be? Well, that’s simple.  There is an acceptable loan-to-value ratio, which restricts how large your real estate loan should be.  Generally speaking, 70-75% of the value of your real estate is the size of loan you would expect to see. But wait one second, there is another important concept we first must consider. Is the sale of the real estate going to repay this loan? No, but it could as a means of last resort. The rent collected from that real estate will be the primary source of repayment.

For a real estate loan to be of appropriate size, it must actually meet two criteria: 1) It must have an adequate loan-to-value, and 2) it must generate adequate rent to regularly pay the loan. This actually places two constraints on the size of the loan, and really assures we have, at a minimum, two sources of repayment.

Now, let’s attempt to apply these constraints to a line of credit. When we have a line of credit secured by an account receivable, we will probably also take some collateral margin near 75%. Is the collection of that receivable going to repay the line of credit? Yes, and this is a major departure in most peoples’ understanding of its role as collateral. Remember, we generally don’t sell real estate to repay our loan. That is our collateral; our back-up plan. An account receivable should not be forced into this dual role of both being our primary source of repayment and our secondary source of repayment, i.e. collateral.

What I am suggesting is an account receivable should probably be viewed as our primary source of repayment, and we should look for an independent, secondary source of repayment. Perhaps that is additional cash reserves, or real estate, or a guarantor’s personal resources.  In this respect, now the proper size for a line of credit will begin to emerge. The line should generally be no more than 75% of your expected A/R and limited to the availability of your secondary source of repayment. In this way, your line of credit will have A/R as the primary source of repayment, and there will be secondary source to fall back on which could also extinguish the debt. Feel free to add a covenant or put a lien on your secondary source of repayment as well to protect your position. After all, you file a mortgage on real estate, don’t you?

So, if a borrower wants an exceptionally large line of credit, having sufficient A/R is really only proving the primary source of repayment exists. The size of the line should equally be tailored to the secondary source of repayment as well, just as we may do in a real estate loan.-