What Is a (Business) Line of Credit? And Should Your Business Have One?
Lately I’ve been working with a lot of small businesses that are growing rapidly. It’s awesome to watch this unfold, but one thing I’m learning quickly is growth comes has a cost. Whether you’re selling products, providing a service or manufacturing something, in order to grow, you need to invest in the business.
As I’m sure you’re painfully aware, business doesn’t happen in a neat timeline. Cash flow timing issues are very real. For example, there’s the furniture designer who is bringing on more staff, expanding to be a bigger storefront and signing new accounts. There’s the retailer who needs to make a purchase from the manufacturing company and the larger order comes at the best price. And then there’s wedding photographer who needs to pay her tax bill during the slow season. A line of credit may be an option to help bridge the gap.
What is a line of credit?
It’s access to cash. Like a small business loan, the line of credit is a predetermined amount. For example, a retailer named Darla might have access to a $60,000 line of credit from the bank her business uses. When she draws on the line of credit, she is borrowing cash that she must pay back.
The maximum amount of cash Darla can borrow is $60,000. Unlike a small business loan, you can draw upon the line, in amounts less than the predetermined amount. So let’s say that Darla was planning to purchase artisanal, handmade eclipse glasses to resell to her customers. Maybe she even allowed her customers to pre-order them online and she’s sold 2,500 already.
Unfortunately, she needs to place the order today (Friday) because of lead times. And today is the same day she’s running payroll and making a large credit card payment. She has funds coming, but they won’t hit her account until Monday because of settlement dates with Stripe and also I’m making this up so maybe there’s another reason. Darla needs $10,000 today to get the best deal from the manufacturer, get the order on time, run her payroll and pay the credit card. One possible solution for Darla is drawing on the line of credit she was approved for three months ago.
Secured Vs. Unsecured Lines of Credit
A secured line of credit is a line of credit backed something valuable. The valuable thing is called collateral. And if the money borrowed from the line of credit isn’t paid back, the bank or lender will come and take that valuable thing away from you. This is also known as foreclosure. The valuable thing can be real estate or machinery or accounts receivable (money owed to you by your customers).
An unsecured line of credit doesn’t have a specific collateral pledged as security. But here’s the rub: usually an unsecured line of credit is secured by the business and the owners personally. So if you think you can get away with not paying back an unsecured line of credit, you are wronger than wrong.
How to get a commercial line of credit?
Step 1: The Application
You complete an application with a lender or bank. You'll need to provide financial statements and possibly bank statements.
Step 2: The Underwriting Process
The lender wants to make sure that your company is a good company to take a risk on. They make this determination through the underwriting process.
The process includes closely examining your company’s assets, income and debt. They’ll take a look at the firm’s credit history and credit score. They’ll also make sure that your company is healthy financially by examining different financial ratios.
Here are a couple examples of the ratios they might look at. There’s the debt service ratio. This ratio measures how if your company’s income is sufficient to pay the principal and interest of your debts. There’s also the current ratio. This ratio measures your firm’s liquidity and it’s ability to pay back short-term obligations.
Fun stuff, these financial ratios. Each financial institution will vary on what ratios they use and how they evaluate the risk they’re taking by extending a line of credit to your company.
The Pros + Cons
- A line of credit is a quick tool to improve the company’s cash flow.
- There is flexibility if you don’t borrow the maximum or reach the limit.
- They might be cheaper than some other options like credit cards with high interest rate.
- They give you cash instead of credit. For example, if you need to make a big credit card payment.
Commercial lines of credit are not easy to get, especially if you’re a new company. If your company is less than two years old, there’s a chance you won’t be approved for a line of credit just based on the lack of credit history. That makes sense from the lender’s perspective. A business that young is still fragile. A few unfortunate events and it could shut down and the lender may never recover the money they lent.
The company might not meet stringent requirements. Commercial lines of credit usually have covenants. Covenants are conditions and rules your firm must comply in order to have access to a line of credit. Of course they vary by lender, but here are a couple of examples.
A net worth covenant is a requirement that the firm maintain a certain net worth. Net worth is the value of the company: the assets (what you own) minus the liabilities (what you owe). Other covenants may require your company to keep certain financial ratios within a certain range. Some of these required covenants can be pretty restrictive.
After you reach the limit, it can be hard to increase it quickly. So while the line of credit is usually the cheap option in terms of interest rate, you may sacrifice flexibility when it comes to increasing how much you can borrow. You have to weigh what your business goals are to determine if this trade off is ultimately worth it.
You might have to sign a personal guarantee. This basically states that if your company can’t make payments on the line of credit that you are personally responsible for repayment. This is a really, really, really shitty drawback. One of the benefits of have a company is that it’s liabilities are it’s own and not yours. Signing a personal guarantee erases that benefit.
Where can you get a line of credit for your business?
Always start with financial institutions that you have a relationship with. I would start with the bank you do business with. They have access to your financials so the application process might be less annoying than going with a different lender.
Kabbage offers lines of credit up to $100,000. You don’t need to meet a personal credit score requirement. Their approval process is so fast because you give Kabbage access to your accounts like your Quickbooks, checking accounts or Square.
In order to qualify you must have been in business for at least 1 year and have at least $50,000 in gross annual revenues.
Once approved, you’ll pay a fee of between 5% and 12% of your chosen loan amount and the payback period will be either a 6-month or 12-month term. You can repay the loan early without any penalties. Each monthly payment repays a portion of the loan, plus the fee.
Fundbox offers lines of credit and invoice financing. For lines of credit, you can get approved in as little as a day. With Fundbox’s invoice financing, you can borrow up to $100,000 and get 100% of the value of invoices that you’re waiting for customers to pay.
In order to qualify for lines of credit, you need to be in business for at least six months and have a minimum annual revenue of $25,000.
Repayment plans are 12 or 24 weeks via auto debit. Each week, you pay back part of the drawn amount plus a fee. With each weekly repayment, the amount you repaid (minus the fees) becomes available again. If you pay back early and Fundbox will waive all the remaining fees.
A line of credit isn’t your only option. Credit cards and small business loans are common ways small businesses smoothen out their lumpy cash flow. Some other options you may or may not have heard of are invoice factoring/financing, asset based lending and purchase order financing.
There’s personally securing a line of credit and using that to invest in your business. There’s definitely a good amount of risk with this one because you’re now personally borrowing money and investing it in your business.
Apply Before You Need to Buy
This is a clutch ass move right here. You should apply for a line of credit before you’re in that desperate moment when you need it. Planning ahead of time gives you leverage. You can shop around and have banks and lenders compete for your business. You can compare interest rates, application fees and fees for making draws or fees for having an unused line of credit. If you wait until you need the cash, there’s a chance you won’t even be able to qualify for the line or if you do, the terms might be onerous.