A Line of Credit (LOC) is debt. Whenever it is accessed, it represents future cash outflows to the business.
Experience difficulty in paying down the LOC is a sign of cash management issues. Allow the LOC to get suspended, and you will have serious cash flow problems due to losing your cash buffer against tight cash inflows.
Overview
In general, loans are better for significant, one-time investments or purchases. In contrast, Lines of Credit (LOC) are better for ongoing, small, unanticipated expenses or to even out cash flow. It is a revolving loan that allows access to a fixed amount of capital (cash) to use when needed to meet short-term business needs.
Unlike business loans, a LOC is not designated for a specific purpose or purchase. Funds are typically drawn from the Line of Credit in increments, repaid, and borrowed again to a preset borrowing limit as long as the line remains open. They are a valuable financing option for businesses that need nonoperating cash inflows to help them manage day-to-day cash requirements by accessing funds for such things as:
- Bridging a seasonal cash flow gap
- Purchasing materials
- Repairing business-critical equipment
- Financing a marketing campaign
You should not use an LOC to cover operating losses. The LOC is for positioning the business when cash is tight to make more money in the future. Drawdown from the line to make more money, everyone wins. Failure to make more money than the LOC costs will only delay the inevitable business failure on the horizon. Disciplined cash management is the best way to protect you from wasting any draws from a business line of credit.
When the LOC is drawn against, interest begins accruing immediately and is only charged on the outstanding balance until the full line is paid back. Unlike most credit cards, there is no grace period before interest begins to accumulate on funds drawn. The benefits of a LOC include:
- Borrow only the money you need
- Interest incurred only on funds borrowed
- Flexible repayment options
- Constant access to funds
- Lower average APR than credit cards
- Few restrictions on use
A business Line of Credit is a valuable financing tool to fuel growth and fund other profit-generating initiatives. They offer the financial flexibility to cover gaps in your business cash flow cycle that allow you to capitalize on opportunities at the best time, not only when you have the available operating cash. Use it to build value that amplifies your profits, and you won’t have difficulty staying eligible for this financing tool.
The best way to maintain a LOC is to periodically pay down your balance and avoid keeping your average running balance near your credit limit. To reduce risk, it’s not uncommon for the lender to require the business to pay down their outstanding LOC balance to $0 at some point during the year, often for at least 30 days. This assures the lender that the borrower generates sufficient cash flow to operate independently of the LOC. Relying on the LOC as a substitute for operating cash flow or owner’s capital puts both the borrower and lender at risk.
Due to the unpredictable nature of any market, a lender might reserve the right to call a LOC, making it payable in full immediately by the borrow. If this happens, the full balance outstanding would have to be repaid, to reduce the LOC to zero without warning. If your business depends on the line of credit, you need to be prepared to either replace the LOC or scale back to weather the loss of credit.
Another fundamental difference between a business term loan and a business line of credit is seen from the lender’s perspective. When a lender evaluates your creditworthiness for a term loan, they look at a business’ credit profile to decide on a loan today. For a line of credit, they are looking at a business’ credit performance today, to make decisions about the creditworthiness of the business in the future. To a lender, these are two very different situations that make qualifications for a line of credit more difficult.
Think strategically about the best time to apply for a LOC. Lenders are more inclined to grant a credit line when the business cash flow is strong. Like a term loan, lenders will want to see financial records and documents that demonstrate creditworthiness, such as:
- Business License
- Three years of tax returns
- Three months of business bank statements
- Three years of your P&L Statement and Balance Sheet
- Your current A/R and A/P aging report
Your documentation will be used to determine if your business is profitable and successful in generating revenue. Management understands the financial aspects of running a business and that the business will have the ability to repay the LOC.
There are two types of business LOCs:
- Secured Business Line of Credit requires the business to pledge specific assets as collateral to secure the line. Since this financing represents a short-term liability, lenders will secure short-term assets, such as accounts receivable and inventory. If the borrower cannot repay the line, the lender will assume the ownership of any collateral and liquidate it to pay off the secured credit line.
- Unsecured Business Line of Credit do not require specified assets as collateral yet will generally require a personal guarantee. Because no specified collateral is associated with this type of credit line, the business will likely need a stronger credit profile and a positive business track record to qualify. Interest rates will be slightly higher, and the unsecured credit line amount will be smaller.
When you open a business line of credit, the business receives access to a stated amount of funds to use as needed. A monthly statement reflecting the amount of credit used will also include any interest charges for the funds in use. In addition to the interest charges, an annual fee for a LOC is not uncommon. If your business frequently accesses the LOC, transaction fees may also apply.
Most lenders prefer to offer a LOC to more established businesses with a track record and revenues to support the more flexible financing a line of credit provides. A new business without an established business credit profile or a business owner with a low personal credit score will have difficulty qualifying for an LOC. Lenders will rarely offer a LOC to:
- Business startups
- Cover losses on past operations
- Meet immediate expenses that won’t necessarily lead to profits
Remember, as with all debt, it is never a good option to incur new debt to clean up past mistakes because you don’t earn any money paying down old debt, making repayment against the new debt more difficult.