Business loans typically fall into one of two categories, demand loans, and term loans. In this article, we will focus purely on demand loans, also known as working capital loans, or simply operating lines. The lingo used speaks to the underlying purpose of the loans, to fund working capital and operations.
What is a Demand Loan?
A demand loan is just that. It is a loan provided by a lender, the repayment of which can be demanded at any time. In reality, it is not quite as harsh or uncertain as it sounds. Banks are in the business of lending and want to have their money out there earning interest for them. At the onset of a demand loan, all parties are made aware of at least the following:
- The debt is quantified and acknowledged by the parties
- There is clarity around the interest rate and terms of repayment
- All parties are aware that the amount is due at any time and that the lender is within its rights to demand full repayment at any time
A demand loan agreement may or may not require some form of collateral or security to be provided by the borrower. Security provides the lender with additional comfort that they will recover their outstanding debt. Common forms of security taken by a lender can include the following:
Personal guarantees:
Where certain individuals (most often directly related to the borrower) make themselves (personally) jointly and severally liable for the company debt
Cross collateral guarantees:
These are typically in the form of related companies making themselves (corporately) jointly and severally liable for the company debt
Registration of a General Security Agreement (“GSA”):
This gives the lender first charge security over all of the borrower’s present and after-acquired property.
While this may seem extensive and even onerous upon a borrower, it is generally a requirement for the approval of the loan. Sometimes providing additional security to a lender may lead to an increased authorized loan amount or a lower interest rate as the lender’s risk is reduced.
How Does a Demand Loan Work?
Most often with business demand loans, the full amount approved versus available is subject to margining based upon the underlying assets of the company, the most common being accounts receivable and inventory. How the bank determines the actual amount available for use by the business will be detailed in the originating loan facility agreement.
For example, if a business is approved for a $1,000,000 working capital loan, they may only be able to access the full extent of the facility if their balance sheet supports it. A common measure used by a lender to determine the actual amount to be made available for this would be 75% of “good” (less than 90 days old) accounts receivable plus 50% of inventory. So a company with $600,000 of good AR and $1,500,000 of inventory technically could qualify for $1,200,000 of working capital, but they are capped at the $1,000,000 facility. Conversely, if that company only had $300,000 in accounts receivable and $1,000,000 in inventory, they could only access $725,000 of their $1,000,000 approved facility. Generally, lenders will cap the amount of exposure against inventory depending on the strength of the borrower or the quality and saleability of the inventory being financed.
What Can a Demand Loan be Used Towards?
Each facility agreement is unique, and as such, there may or may not be restrictions on the use of funds. Most often, there are not defined restrictions, though there are best practices and implied expectations. The most common use of a demand loan is to be used as working capital to support day-to-day operations. Prior to funding a demand loan, a lender will usually ask for a summary of the anticipated use of funds. This may include small asset purchases, partnership or investment loans, inventory purchases, day-to-day operations, as well as repayment of bridge financing. Bridge financing is a type of debt intended to be short-term while a company sources longer-term, lower-interest debt.
While not prohibited, a working capital loan is not intended to make large asset or equipment purchases. Doing so will almost certainly put a company in a tight cash flow position as well as risk putting the company in a negative borrowing base position. The borrowing base is the calculation noted earlier, which is determined using the underlying assets. In our example, we used the accounts receivable and inventory as the underlying assets. If the amounts outstanding to the lender are greater than the calculated amount available to the company, they will have maxed out their facility meaning the lender will make no further advances.
Some advanced demand loans will include direction on the use of funds, for example, paying out an existing creditor with the first advancement of funds. The lender is looking to better leverage its security and ensure that a company is not overextended on its liabilities.
What are the Reporting Requirements to the Lender in relation to a Demand Loan?
Depending on the type of industry the borrower is in, the bank may require the company to report its financial position on a monthly basis to confirm the amounts available for use. Some borrowers that are in cyclical businesses may only have to report annually, such as agricultural companies.
The lender will compare the amount of debt outstanding as compared to the current balance sheet of the company to ensure that there is adequate debt coverage on their loan. Debt coverage is the ability of the company's assets to pay off the company's liabilities. Most often, short-term assets versus short-term debt are often considered as short-term assets in theory and can be easily liquidated or monetized. How the lender determines the availability of cash advances to the company will have been contemplated and documented in the initial loan facility agreement.
Is a Demand Loan the Right Choice for You?
Demand loans are very common and effective tools used by both lenders and borrowers. Borrowers can have flexibility and insight as to how much cash they have access to utilize, and lenders take comfort in the ability to demand at any time. Borrowers also benefit from a working capital loan in that they only have to pay interest to the extent of actual funds outstanding. The borrower does need to remain mindful that while there are generally no covenant requirements attached specifically to a demand loan, there are usually margin and reporting requirements, and the loan can be called at any time to be repaid within a reasonable period of time.
What Happens if a Demand Loan is Called?
We’ll discuss this scenario next week. Stay tuned!
