Ravi Chandran
There are many reasons why credit lines get in trouble. The following listing can be used as a diagnostic tool to identify the cause of a credit line problem.
By: Phoenix Lee/
Solutions can be developed once problems have been identified. The listing can also be used as a prevention tool to identify potential weaknesses before they become a problem.
Failure to supervise the loan
Failure to supervise the loan by either the lender or the borrower is a common cause of credit problems. The loan should be monitored on a regular basis to insure that it will be properly repaid. Loan supervision is not the responsibility of just the lender but is also in the best interest of the borrower.
Lack of communication
Successful loan repayment is often based on open discussion between lender and borrower. Lack of communication and trust by either party often results in a breakdown of the business relationship.
A major reason why credit lines get in trouble.
Table of Contents
Inefficient business
To generate sufficient income for debt repayment, the business must be well managed and achieve production efficiencies. To avoid repayment problems, the lender may want to monitor business and production efficiency.
Business too small
Credit lines get in trouble because the business may be too small to generate sufficient income for family living needs. The shortfall is often covered by short-term borrowing. However, the accrued debt makes the income deficiency even greater.
Failure to analyse the business
Debt repayment capacity is based on the ability of the business to generate income and cash flow. Failure to accurately analyze the income, expenses, and cash flow of the business may lead to errors in projecting debt repayment capacity.
Unrealistic prices and production levels
Unrealistic assumptions may lead to errors in analysing the repayment capacity of a loan. Typical errors pertain to estimates of selling prices and production or sales levels. However, poor assumptions about efficiency factors are also common.
Credit lines get in trouble because the borrower may intentionally use unrealistic assumptions in order to obtain or keep a line of credit. However, the use of unrealistic assumptions can also be unintentional. The borrower may not have sufficient business records or outlook information to realistically describe the business.
Lack of partial budgeting
Partial budgeting involves projecting the added costs and added returns from a capital investment. Unless partial budgeting or a similar procedure is used to estimate the additional income generated from the loan funds, the repayment capacity may fall short, and credit lines get in trouble. Just because a business decision involves new technology or is common among other farmers does not mean that it is profitable or financially feasible.
Uncontrolled living expenditures
Many small business owners are negligent about monitoring and controlling family living expenditures. Monitoring expenditures involves keeping records of the money spent for family living. Keeping the business and family financial transactions in separate checking accounts will often be helpful. Successful control of family living expenditures often involves developing and monitoring budgets of expected family living needs.
Lack of business direction
The planning horizon for many small business owners is often one production period. So, the business lacks any long-term goals or direction. This lack of long-range business planning is often accompanied by a lack of progress on long-term debt repayment.
Failure to structure repayment
If possible, the repayment terms of the loan should be tied directly to the additional income generated from the loan. Unless the loan repayment is structured and the additional income designated for loan repayment, the income will be spent elsewhere and the debt carried over from year to year.
Repaying debt too rapidly
Reducing debt as quickly as possible is often a good objective. However, trying to repay debt too rapidly may unnecessarily cause a shortage of cash for operations and credit lines get in trouble. The length of debt repayment should be tied to a conservative estimate of the life of the assets the borrowed funds were used to purchase.
Purchasing capital assets with cash
Using cash reserves to purchase capital assets may result in cash shortages in the future. Sufficient cash should be maintained to cover intermediate and long-term debt payments, income taxes, family living expenditures, and other items.
Buying non-productive assets
Using borrowed funds to purchase non-productive assets requires the repayment to come from other sources. The alternative repayment sources should be carefully identified in advance.
Carryover debt
Short-term loans that cannot be repaid are often carried over from one production period to the next. Unless properly monitored, carryover debt may grow until it jeopardizes the health of the business. Carryover debt is often too large to be repaid during one production period. It may need to be paid over a period of years. Progress should be made each year in retiring carryover debt.
Poor risk management
A cash buffer should exist between the projected repayment ability of the business and the business debt repayment schedule. For example, if the debt repayment schedule is based on the repayment ability in an average year, a shortfall will occur in low income years. This shortfall is often covered by borrowing additional money. Due to this additional debt, the total debt load cannot now be serviced in average years, and credit lines get in trouble.
Poor use of profit windfalls
An abnormally profitable year often provides additional income. However, the additional money is often consumed or used to purchase non-productive assets rather than repaying debts. As a result, when below average years occur in the future, there is no reserve for debt payments.
Using multiple credit sources
Small business owners often obtain credit from a variety of sources. Usually the larger the number of credit sources the more difficult it becomes to monitor overall debt repayment. Consolidating credit and reducing the number of sources may improve the ability to successfully project and monitor debt repayment.
Ignoring tax consequences
Although interest payments are tax deductible, principal payments are not. Debts must be repaid with after-tax income. This calculation needs to be included in the debt repayment analysis.
Selling assets to repay debt may also have significant tax consequences. The sale of low basis property may trigger a large tax liability and reduce the amount of funds available for debt repayment.
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