Challenges with Seasonal Lines of Credit

Many businesses have seasonal variations in sales.  The firm may be characterized by building up a lot of inventory during the non-peak season, followed by high cash flow when this inventory sells.  One example of this is a retailer who builds up inventory to sell during the Christmas season.  This is why “Black Friday” is so termed because some retailers continued in a negative profit state the entire year only to turn profitable during Christmas sales, or moving into the “black”.

One example in the area we currently live is during the summer tourism season.  We have some businesses that are closed during the winter as tourism drops off substantially in the Black Hills as there are less winter activities to draw folks here.  We have some businesses which make all their revenue in a three-week period surrounding the Sturgis Motorcycle Rally!  Farmers and ranchers may also fall into this seasonal situation. 

Whatever the case that causes drags on the cash conversion cycle—from raw material to inventory to A/R to collections of accounts, or in service related firms where work is completed, operating expenses paid, and then receivables collected—a seasonal business may be best analyzed by focusing on the peaks and troughs of current assets and liabilities.  The cash conversion cycle does not matter as much for seasonal loans and the business may not even need to be profitable to repay a properly structured seasonal credit. 

Analysis of the seasonal credit requires a historical view of monthly cash flow, in addition to the standard annual financial statements.  A monthly budget is also required to determine appropriate line size and repayment time.  Therefore, we ask agricultural producers to provide us with monthly cash budgets.  Watch the levels of accounts receivable and inventory, key clients, marketing plans, and accounts payable levels and terms. 

In some cases, the appropriate structure may be to adjust the term credit to take advantage of high revenue seasons and have lower payments, or even no payment at all, during times when revenues are low or the business is closed.  This adjustment itself, may eliminate the need for a seasonal line.  If this will not meet the business needs, a non-revolving line of credit would be a good structure.  The maximum amount is determined by the peak borrowing need, plus a cushion for some unexpected operational expenses.  Maturity is tied to the point when the borrowing need is the lowest.  A retailer may have peak revenues during the Christmas season.  A farmer would have his peak cash revenue when he delivers his grain to the market.  By setting up the line maturity to match this event instead of just making it for a 12-month cycle, allows for the line maturity instead of the lender notes on his calendar to make sure the line is paid down.

If the borrower has other financing needs, such as equipment purchases or capital improvements, it makes sense to finance these outside the line or term out the purchases with a typical amortizing note.  Line advances may be based upon submission of invoices if you want to make sure the line funds are used for the proper purposes. 

The collateral should include all accounts receivable and inventory with further support from equity in fixed assets.  Monitoring inventory, work-in-process, and accounts receivable during the tenure of the line is good, but tying this to a borrowing base may be problematic.  In a typical seasonal line there are times stages when the amounts of inventory and receivables will not support the amount that is outstanding, even when the credit may be otherwise solid. 

The biggest problem occurs if the borrower is unable to fully repay the loan at maturity. This will require the lender to re-risk the credit as the assumptions used in underwriting the deal did not materialize.  It is important to not allow the borrower to remain in control at this point.  An example would be a farmer who refuses to sell his grain in hopes of getting a better price in the future.  Another is a retailer who uses funds that should have gone to the line, to open a new location that was not specified in the original plan. 

After the rating downgrade, options should be explored on how to handle the carryover portion.  This may include some or all the following: (1) liquidate the collateral, (2) sell other assets to retire the remaining debt, (3) convert the remaining portion to a term note, consummate with the collateral support, (4) move the debt from your institution, typically one that may be more asset-based, (5) infusion of additional cash into the business, and (6) guarantor support. 

It is important to look at other factors that may have caused or have a lasting influence on the business from the carry-over.  Were trade creditors paid timely?  If not, there may be a need for a larger seasonal line in the upcoming year if trade credit is curtailed.  When was the product liquidated?  Sales that occur during the end of a season may be discounted.  If the borrower cannot sell the product, how much better will the lender be at this?  Were there issues like machinery breakdowns, labor issues, or raw material costs hikes that prevented the repayment?  Were receivables collected from purchasers and do they remain collectable?  Was the loan used for non-seasonal operating expenses like asset purchases, repayment of other debt, or distributions to owners? 

The close examination of the reasons behind the failure to repay the seasonal line will assist the lender in a path to correct the situation. This must be fixed as the borrower may need another seasonal line to operate in the upcoming year.