Line of Credit

A line of credit is an 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 1 year period and are subject to 1 year renewals. Frequently, lines of credit are set for renewal after the bank receives the audited annual report and has had a chance to review the progress of the borrower. If the borrower's year end statement date is December 3 1, a bank may set its line to expire some time in March. At that time, the bank and the company meet to discuss the credit needs of the firm for the coming year in light of its past year's performance. The amount of the line is based upon the bank's assessment of the creditworthiness and credit needs of the borrower. Depending upon 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, perhaps, gives the best insight into the borrower's shortterm 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, of course, will depend upon its evaluation of the creditworthiness of the firm. If the bank agrees, the firm then may borrow on a short term basis usually 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 require that the borrower be out of bank debt at some time during the year, Frequently, the borrower will be required to clean up (payoff) bank debt for a period of time during the year. The cleanup period required usually is 1 or 2 months. The cleanup itself is evidence to the bank that the loan is truly seasonal in nature. If the interval during which a profitable firm were out of bank debt decreased from 4 months two years ago to, 2 months last year and to no cleanup this year, the trend would suggest the use of bank credit to finance permanent funds requirements.

Despite its many advantages to the borrower, 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. An example of such a letter is shown in Fig. 16 4. This letter is not a legal obligation of the bank to extend credit. If the creditworthiness of the borrower should deteriorate over the year, the bank may not want to extend credit and would not be required to do so. Under most circumstances, however, a bank feels morally bound to honor a line of credit.