Annual Clean-Up
Remember how every once in a while, your mom would suddenly declare some Saturday that you absolutely would NOT be leaving the house until your room was completely cleaned. The annual clean-up is the financial equivalent of that, only in this case a bank is your mom and a business with a line of credit is you as a kid.
In order to make sure that a business has viable prospects on its own, some lines of credit require an annual clean up. This means that at least once a year, the business with the credit line has to pay it back completely.
Businesses use lines of credit to smooth over slow parts of the year. So if you own an ice cream stand, you might use a line of credit in the winter to pay your employees when demand for cold treats is low. Then, in the summer, when lines are around the block, you can use the extra profits to pay back the credit line and get it back to even.
Banks want to make sure that a business can survive on its own and isn't just keeping itself open with the line of credit. They don't want the business to draw the credit down to nothing and then just declare bankruptcy. The annual clean up guards against this kind of eventuality, because it forces the business to prove it has the money at least sometimes in order to get even.
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Finance: What is a Line of Credit?133 Views
finance a la shmoop what is a line of credit? oh I'll definitely pay it back. [ man talks to camera]
yeah, that's a line of credit, but it's just a line like can I buy you a drink
or do you come here often or I bet my mother would love you, in financial real
life a line of credit or LOC if you just like using acronyms to make yourself
seem are keenly smart, is deb,t or rather an LOC is an option to take on debt. why [man in front of power point]
would somebody want an option to take on debt? well here's why.
yep companies can't ordain their futures. they don't know what's coming .but paying
a few bucks today for financial life insurance tomorrow is usually a really
good idea because the skies are not always sunny all day. so a company that [robot assembly line]
makes shoelace tying robots might be doing great today but there's a big fat
product release coming and they have no idea if it'll do well right away or take
three years to catch on. or you know rip people's feet off well who knows, maybe
people will actually be able to tie their own shoelaces by then. what do you
think America? how are we doing but yeah it's unpredictable this sort of thing [man sits on a couch]
happens to tech companies all the time. so while the company doesn't need cash
today they may need it in the future .so they pay a bank or lender a small token
amount in return for that lender guaranteeing that the money will be
there at a set price in rent and set terms at some point in a defined future.
ie the next three years or something like that. that is, you know prevailing
rates or five percent they might pay half a percent to guarantee they can
borrow it 10 million dollars at 5% but, we'll get into. that all right if a [smiling man on the phone]
company does in fact decide to exercise its option to draw down cash from its
line of credit or rather to get the bank to wire the cash they have reserved into
the company's own bank account then usually it just starts paying interest
or rent on the money the day it's borrowed, just like it would have if it
borrowed money at the outset. well why wouldn't a company just borrow money
today and have it stuffed under its mattresses? [woman holds a stash of cash]
well because almost always the option to draw down money costs a fraction of the
interest it would cost to actually borrow the money itself. so we have a
company who wants the right to borrow ten million bucks and
they're willing to pay half a percent per year for a guarantee to be able to
borrow that money I'd say five percent per year when or if they borrow it. if
they never borrow it that half a percentage is wasted. [definitions on the screen]
well the half a percent line of credit option fee is 50 grand a year and let's
say two years go by in the company doesn't need the money.
they've just wasted that fifty grand a year each year. but then they borrow all
of it in year three and guess what in those three years interest rates went up
two percent 3 percent four percent something like. that yeah it could happen.
so the company paid 100 grand for the option to borrow the money at five [equations ]
percent interest, and yes that hundred grand is a lot of dough ,but compare it
with the cost of borrowing had the company borrowed all ten million right
away. well had they done that they would have paid five percent per year in
interest on that ten million bucks or five hundred grand a year and that's
times two years .so it would have cost them a million dollars in interest had
they borrowed all the money right away. instead miserly wiserly, they only [man scribbles with a pen]
paid a hundred grand for the option for two years because they didn't need the
money right away and that line of credit structure saved them nine hundred
thousand dollars in borrowing costs. a nice job mr. CFO. so why isn't it free to [thumbs up]
just reserve a line of credit with a bank? like why do they charge anything
when they're not actually loaning out money today? well the bank has to
allocate gets finite resources to accommodate that line of credit drawdown.
sure enough Murphy's Law happens at work and the company will want to exercise
the LOC and draw down the money from the bank at just the worst time in history [woman frowns in front of a bank vault]
like say in the middle of 2008 or 9, when nobody had anything right. okay.
well banks have tightly regulated laws or covenants around which they can
borrow money from the Fed or the government at say 2%, then mark it up to
4% and lend it out. and they make money on that spread right? so if the bank had
tons of LOCs out there it could be bad news if they weren't charging a little [hands reach for cash]
something for them. and no a credit card essentially is a line of credit you fill
out a bunch of forms swear and then pinkie swear to pay back the money .if a
month goes by and you don't pay back the money you owe well then you
get charged enormous rates for borrowing. it but if you do pay it back, the rates
are really low maybe you have a small annual fee although most credit cards,
they don't even have those anymore. but more directly, the fee is paid by the merchant
ie the earring store that sold you the seven belly button rings for forty bucks. [ pierced and tattooed woman holds document]
each in the form of a transaction fee that is, the $280 you would have spent on
a constellation for your stomach, the merchant paid the credit card company
about 1% or 280 for managing the bank in that transaction. what about as much as
you're gonna be spending on cotton swabs and antibacterial soa.p I hope you
weren't planning on wearing a tube top anytime soon. anyway that's a line of
credit .use it wisely. it can bite you [woman with red stomach grimaces]
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