How do lenders structure a line of credit for a manufacturer or machine shop?

Where a manufacturer's money sits

A manufacturer's working capital moves through stages: material bought on supplier terms, labor and machine time added on the floor, finished parts waiting for a ship date, an invoice on shipment, and a customer who pays on its own terms, which for large manufacturers and prime contractors can be long. Each stage is a different kind of asset, and a lender values each one by the same question: what could we get for it if we had to sell it without you?

The rest of this page follows from that table. The more of your working capital sits in receivables and marketable stock, the more a line will carry. The more sits in work in process and custom parts, the more of it you fund yourself. The general inventory rules are in how lenders advance against inventory.

Why a job shop's line is smaller than its balance sheet

Two manufacturers can carry the same working capital and get very different lines. Compare a job shop that machines parts to customer prints with a producer of standard components sold from a catalog, each with 7,000 of receivables and inventory.

The job shop has the same assets and borrows less, because more of its money is on the floor. That gap grows with the business: a new program with long cycle times puts more into work in process before a single part ships. Job shops handle it in three ways. They bill sooner, by negotiating deposits or progress payments on long or large orders. They fund the permanent part of their working capital with term debt or equity rather than the line. And they lean on the machines, which are often their most valuable collateral.

Machinery: the collateral a machine shop does have

A shop with a floor of well-maintained machining centers, lathes, presses or grinders has collateral an appraiser can value. Asset-based lenders often add a machinery and equipment term loan alongside the revolver, sized against the appraised orderly liquidation value and repaid over a few years. That piece funds what a revolver should not: the long-lived assets. See machinery and equipment in an ABL and, for the appraisal terms, orderly liquidation value vs fair market value.

Three things complicate it. Newer machines are often already financed by equipment lenders with a purchase-money lien on each one, so only the owned machines are available. A shop in a leased building needs a landlord waiver so the lender can reach the machines if it has to. And when the line lender and an equipment or term lender share the company, their claims are split by agreement; see how an ABL and a term loan share collateral and equipment loans alongside senior debt.

Buy machines with term money, not the revolver. A line that paid for a machining center is permanently drawn, and a permanently drawn line has nothing left for a slow-paying customer.

Customers: slow payers and big ones

Manufacturers selling to large industrial companies, prime defense contractors or automotive suppliers run into receivable problems that lenders price in.

• Concentration. A shop with one or two anchor customers will hit the single-customer cap, commonly 20% to 25% of eligible receivables. The excess drops out of the base. Some lenders allow a higher cap for a customer with strong credit; it is worth asking before signing. See customer concentration and debt.
• Long terms and supplier-finance programs. Large customers often stretch payment terms and offer early payment through a supply-chain finance program. Invoices sold into such a program no longer belong to the shop and leave the borrowing base; the discount taken is a cost the lender sees. Tell the lender before you enroll.
• Rejects and chargebacks. Parts rejected for quality and debited against payment are dilution. A high rate lowers the advance.
• Foreign customers. Export receivables usually count only when backed by credit insurance or a letter of credit; see foreign receivables in a borrowing base.
• Government work. Receivables from public customers need extra steps to be pledged; see lines of credit for government contractors.

The inventory reporting a lender will ask for

Manufacturers are asked for more inventory detail than any other borrower, because inventory is where both the value and the uncertainty sit. Expect a lender to want:

• Inventory by category and location, split into raw material, work in process and finished goods, each month.
• A perpetual inventory system or regular cycle counts. A shop that only counts at year-end gives the lender eleven months of estimates. Lenders will still lend, but with larger reserves or lower inventory advances.
• Slow-moving and obsolete reports, because stock with no recent usage is usually excluded.
• Inventory held elsewhere: at outside processors for plating or heat treating, at a customer on consignment, at a third-party warehouse. Each location needs a letter from whoever holds the goods, or the goods are ineligible.
• An inventory appraisal before closing and periodically after, which sets the liquidation value the advance is based on, and a field exam that tests your costing and counts.

Costing matters more than owners expect. If labor and overhead are rolled into inventory generously, the books show more inventory than an appraiser will value, and the gap shows up as lower availability than the balance sheet implies.

Covenants and structure

Most manufacturer lines carry a fixed charge coverage covenant, which measures cash flow after capital spending that was not financed. Machine-intensive businesses spend steadily on equipment, and a big purchase paid in cash can trip the test in the quarter it is made. Many agreements also cap annual capital spending, restrict new equipment debt and limit distributions. On non-bank lines the coverage test often applies only when excess availability falls below a set level.

A consistently profitable manufacturer with modest inventory can also get a bank line sized on earnings instead of collateral, often with lighter reporting and a debt service coverage test; conventional bank lenders commonly look for at least 1.25x. The trade-off is that an earnings-based line does not grow with receivables and inventory. See asset-based vs cash-flow lines. A manufacturer coming off losses can still borrow against assets; see asset-based lending for unprofitable companies.

What trips manufacturers up

• A new program. Tooling, first articles and a build of work in process all happen before any invoice. Negotiate tooling payments and deposits, and model the program's cash before accepting the purchase order. See purchase order financing for one way to fund it.
• Material price spikes. When steel, aluminum or resin costs jump, the same volume ties up more cash, and a line sized last year runs short.
• Machines bought from the line, as above.
• Consigned and off-site stock without bailee letters, which a field exam will exclude.
• Merchant cash advances taken to cover a slow quarter, which lien the same receivables; see refinancing cash advances for manufacturers.
• Year-end-only counts and generous costing, which make inventory look larger on the books than it is to a lender.

Preparing the file

Transparent's line of credit checklist: an AR aging by customer with days outstanding; an AP aging; the balance sheet and P&L; a year-to-date P&L through last month-end; a debt schedule showing existing liens; an inventory report, since inventory will be part of the borrowing base; and, if available, bank statements and two to three years of business tax returns. For a manufacturer, add a machinery list with makes, models, years and any lienholder, and a list of the top customers with their terms.

From those documents Transparent builds the full lender package in a day and takes it to the 235 lenders in its book that write asset-based loans and lines, and the 244 that write equipment, where a machinery piece is part of the answer. Nothing is charged before a loan closes. Buyers of a shop should read financing a machine shop acquisition.