Every entrepreneur would agree that at some point of time they need access to working capital as their business starts growing. Every business being small or large, at some points experiences the need for makeshift capital when going through delayed customer payments or requiring addressing impromptu expenditures.  There may be situations for a short period of time when your business is witnessing a cash flow crunch.  In such situations, having accessibility of certain extra funds (albeit at some cost) can result into the difference between winding up your business or surviving through hard times.  So, when it comes to financing your business, entrepreneurs these days have a wide array of options.  A business line of credit is a popular choice for businesses.

Read on to understand all you need to know about a business line of credit before getting started to apply for one.

Business Line of Credit

Unlike a traditional term loan, a line of credit is something where you are assigned a “predetermined limit” of finance that you may borrow whenever your business needs it and then repay later as per your convenience.  It however comes at an interest cost which needs to be serviced or paid for monthly until the funds are borrowed or remain unpaid.  Businesses primarily use such line of credits to meet their inventory purchases, supplies or other operational expenditures.  A term loan typically mandates you to meet a fixed monthly instalment (principal + interest) and has prepayment fees should you wish to repay sooner than the allotted loan tenure.  A credit line has no prepayment fees should you repay sooner, and the interest costs too are restricted till the date of your repayment.

A vital distinction between a term loan and a line of credit is that lines of credit are revolving in nature, meaning you may use the funds up to your sanctioned limits and then repay what you have borrowed to only make them available for use again.  Alternatively, term loans are kind of lump sum loans that you borrow once and repay once along with interest.

Uses of Business Line of Credit

Businesses typically use their line of credit to facilitate their business growth or accomplish their goals faster.  Situations like delayed customer recoveries or urgent need to finance any equipment purchase to meet growing demands, may heavily impact your stability in absence of capital availability to bridge the contingencies.

For instance, a credit line can come in handy in scenarios where you need to hire new employees to meet your increasing product or service demands, equipment procurements, opening new business locations/offices, buying additional inventory to benefit with positions or simply to get ready for a busy holiday season or a pandemic!  Thus, a line of credit can facilitate your business in times of cash flow shortages or volatility that many entrepreneurs commonly face.  It relieves you of the stress since you have access to finance when you need it the most.  You use it when you need it, repay it when you don’t need it and keep it on standby for when the need arises again.

Secured Vs. Unsecured Business Lines of Credit

Lines of credit can broadly be of two types – a secured line of credit or an unsecured line of credit.  The important differences between the two are as follows:

Secured: Here the lender (being a bank or online lender) would demand pledging of your business or personal assets as a collateral against the line of credit.  Lines of credit, being short term (usually a year, subject to renewal per lender norms), the lender may accept your inventory or accounts receivable as a collateral to be taken over incidental to your failure to repay the line of credit.  They may not ask for huge assets like equipment or real-estate.

Unsecured: Businessmen prefer getting these since the lender would not require any collaterals.  However, this is a riskier deal for the lender, meaning they would traditionally set high criteria to meet before approving it.  For getting approval to such unsecured lines of credit, a business or owner needs to prove good personal and business credit overall, a proven track record to generating revenues.  These lines of credit are often given for lower limits coupled with higher than conventional interest rates.

Advantages & Disadvantages of getting a Business Line of Credit

Advantages:

Ease of access:  Once approved, a line of credit is available to be used whenever you need it, for any legitimate business requirement.  Unlike a term loan, these are revolving, so you can put them back by repaying and use when only necessary.

Interest & Costs:  Interest is payable only on the portion of credit that you have borrowed or drawn at any point.  You shall not be charged any interest on the un-utilized portion of the credit.  In case of a term loan, you are charged interest on the entire principal value of the loan outstanding (even though you may have not spent it fully after receiving it).  Lender usually charge an upfront fee while sanctioning your line of credit plus also in cases where there is any inactivity.  Again, this may vary from lender to lender, and it is not the norm.  One should however read the term sheet before signing on accepting a business line of credit to be aware of the costs associated.

Healthy relationship with lender:  A well performing business line of credit, where a business repays timely its credit borrowed and interests serviced, can put it into the lenders favourable customers bucket and increase the chances for receiving finances for any future projects.  Also, lenders usually report the borrower performances to credit bureaus, so business having good standing on servicing its line of credit can draw better credit scores, thereby helping you in future when you wish to increase your credit limits or seek any major term loans.

Disadvantages:

Application process:  This may not be always the case, but application for a business line of credit can be challenging at times.  Mainly it depends on the lender with whom you may apply.  The process may not be as easy with any large bank, as it may warrant complete set of financial statements for your business as well analytical reports on its revenue, cash flow statements, tax returns, personal credit history of business owners.  You may avoid these by opting for other lenders such as online banks etc. but they risk the requirement of heavy collaterals as well has high interest costs.

Fees for Credit Lines: A business line of credit may require hefty withdrawal and maintenance fees. You may want to try to negotiate a low rate of interest to account for such fees. You should at least be aware of them so you can avoid as many fees as possible.

Cumulated Debt:  Using debt is always a slippery slope, so at any point if you are unable to repay the credit drawn, because of poor markets, dip in sales, your line of credit too can become a burden as the interest service keeps mounting.  If you are unable to repay in full for some reason, the unpaid principal rolls over to the next repayment period but the interest also compounds on the new principal.  So, one missed payment can result into larger payments owed in future.  It is always wise to keep a track of your requirement and draw only as may be necessary assuring you are always able to repay your credit line.

Pre-requirements to apply for a Business Line of Credit

Before going ahead with your application for a line of credit, you need to be more than just ready with your basic documents.  Commonly, prerequisites to getting the credit line are as follows:

Collateral: Seeking a secured line of credit for a business is usually safeguarded by the lender through pledging of collaterals.  This may include, but not limited to, real estate, business equity, inventory, equipment, accounts receivable etc.  That way your business guarantees the loan payment, reducing the lender’s risk.  Many a times a lender might require a small business owner to pledge all its assets to secure the credit line.

Business lifeline: Most lenders would require any business it finances to be operational for a certain tenure before becoming eligible for its line of credit.  For instance, banks usually attend to application from businesses that at at least operational for a couple of years.  But if the lender feels a start-up has good collaterals and sound personal credit of its promoters/founders, it could make an exception.  The lifeline requirement of a business may differ from lender to lender.

Financial statements and Reports: Per a US Small Business Administration survey, only 20% of new start-ups survie past the first year of operation.  As a result, banks prefer comprehensive financial statements and other financial reports to evaluate the consistency of a business.  A firm like GJM & Co. can be extremely useful to prepare your up-to-date set of financial statements and reports which would be handy in submitting to your bank for the credit line.  GJM & Co. can also help you catch up with your historical business accounts if they are unprepared.  The lender would ascertain important financial ratios from the financials you have provided such as Debt to equity ratio, current ratio, Debt service coverage ratio, inventory turnover ratio etc.  to estimate your business performance.  Hence, the financial statements are of crucial importance.

Proof of Revenue/Customers etc: To ascertain the business health and fact check on your financial transactions, you could also be asked for proofs of your revenue as well as customers.

Guarantee: Should your business be applying for a line of credit, by being a subsidiary of an existing company, the lenders may warrant the parent entity to give a corporate guarantee for your subsidiary before extending the line of credit.  In case you are an independent business owner, you may also be asked for a personal guarantee to secure the line of credit.

Options to apply for Business Line of Credit

Should you be looking for a small business line of credit which is unsecured, credit unions, online banks, online lenders, community banks are the ideal option.  Credit limits can be applied for as low as $ 5,000 and can go as high as $ 250,000.  Large banks however would not offer such low credits of $ 5,000, but conventionally they offer unsecured credit lines up to $ 100,000.  You can also apply with banks that are having partnership with various US Small Business Administration lending schemes (SBA).  The US SBA schemes provide businesses meeting their criteria with four different types of credit for your temporary working capital requirements.

So, if you are thinking of applying for a line of credit, start planning for it by getting your business’ bookkeeping and recordkeeping up to date, verify your business credit score, and assure engaging a bookkeeping service like GJM & Co.. We will have your books up to date and provide all the financial statements and reports that you need for your application.

We trust this article was helpful to you in understanding in brief how to proceed with planning for your business line of credit.  Should you have any queries or need consultation with your application, Schedule a Call today or write to us at info@gjmco.in.