What is a credit line, anyway?
Every small business experiences cash flow challenges. Since cash flow fluctuations are a natural part of doing business, rather than trying to avoid them, an alternative approach would be to actively manage your cash flow. In this article, we will discuss an important tool for cash flow management—the line of credit.
A line of credit is a given amount of money you can borrow when you need it, and repay back when you don’t. It is different from a loan because you don’t have to use it, but you can use it as a buffer or a fallback option if you have unexpected cash flow issues brought about by late paying clients, unplanned for expenses, or simply by seasonal cycles. They can also be a great way to start building or bolstering your business credit score.
Who is it for—and who shouldn’t use it?
[pullquote]”For businesses that are already on their feet, a credit line offers a safety net.”[/pullquote]For startups, a line of credit can help get your business off the ground, as many new businesses have limited capital needs, and a loan can quickly eat into your profits. For businesses that are already on their feet, a credit line offers a safety net, as well as great flexibility that business owners can use creatively to their advantage. For example, some business owners will offer their customers and suppliers better payment terms in order to gain a competitive advantage, or others may buy inventory when it’s cheaper, or invest in advertising to attract more customers. As with any other financing solution, credit lines come in different varieties, each having advantages and disadvantages.
The bottom line is, do your research and choose the right solution for your business. There isn’t a “one size fits all” solution. Probably the most important advantage of a credit line is that you pay interest only on the money that you actually use, giving you the flexibility to invest when you want to, and meet your financial obligations when you need to.
Once you go through the approval process, you can chose the best time to utilize your credit line, and you can repay it back when you don’t need it anymore to avoid paying unnecessary fees. However, since the organization that is offering the credit line is basically putting money aside for you, some financing providers will charge you a fee just for the right to use the credit line, even if you didn’t actually use the funds. Others will charge you only when you actually draw the money, but these fees might be higher.
How is a line of credit different from a business loan?
Perhaps the major difference is that a business loan is drawn once, usually for a specific purpose. A line of credit, on the other hand, can be used multiple times. As a result, business loans are usually used to borrow higher amounts, and often for one-time purposes, such as buying out a competitor.
Credit lines are often used for day-to-day activities. Another difference is that loan repayments are fixed and paid on a monthly basis, while a credit line can be repaid at any point in time, and if your balance is zero, your payment is zero. Thus, closing costs are also typically higher for loans, but the “maintenance fees” for credit lines might be higher because of the flexibility in repayment terms.
How to apply for a small business line of credit:
First and foremost, do your research and find the solution that best suits your business needs. Then, make sure you’re taking steps to demonstrate that you’re serious about your business. If you are still in startup mode, write a business plan. On top of all the other advantages of doing so, such as ensuring you haven’t forgotten any important aspects of the business, it will also demonstrate to lenders how you will generate the revenue needed to make your repayments. [pullquote position=right]”[Writing a business plan] will demonstrate to lenders how you will generate the revenue needed to make your repayments.”[/pullquote]
You’ll also want to keep an eye on your personal credit score. If your business is new, it’s unlikely it will have a credit score, which means your bank will look to your personal credit score instead. If your score is low, getting approval for a line of credit could get tricky, or result in a higher interest rate.
It’s worth noting that lines of credit do not need to come from banks, and several alternatives do exist. For example, if your cash flow issues can be managed with a small injection of cash, talk to your bank about getting a business credit card instead, or try one of the growing number of alternative credit line providers.
What interest rates can I expect?
[pullquote] “Credit lines provide an amount of flexibility that many other solutions don’t, however, this flexibility has a price tag.”[/pullquote]While business loans seem to have higher interest rates, a business line of credit typically has fees, such as those you pay to keep the line available even if you don’t use it. So effectively, the seemingly lower interest rates of a credit line might still result in you paying slightly more.
Ultimately, credit lines provide an amount of flexibility that many other solutions don’t, however, this flexibility has a price tag. Which you choose will depend upon your business, but take special care to factor in all the fees that a credit line provider will charge when making your decision.
What will I need to do to secure a line of credit?
The requirements for securing credit lines vary among financing providers, but all of them have one thing in common: they look at your ability to repay in order to make a decision. Many banks and other traditional lenders will want to see that your business is profitable and cash flow positive, which is why it’s preferable to secure a line of credit before you need it. Other providers may want to look at factors like your receivables or at your sales history in order to decide.
What if I can’t show the credit line provider that my business is cash flow positive?
Again, there are many ways to secure a credit line. Demonstrating positive cash flow is one way, but it is definitely not the only one. However, if none of the methods described above are viable, see if the financing provider will consider an equity line of credit instead—meaning you use the equity you have in property as collateral—which amounts to a lower risk option for your provider.
What are the best ways to use a line of credit?
As mentioned above, a line of credit is great for short-term financial needs, such as pulling out all the stops to market a new product, or to cover payroll during a dry period. But be warned, don’t overuse your line of credit to tide you over financially. Use as much as you can on revenue generating activities, as this will help balance out the new debt you’ve incurred and deliver the growth your business is aiming for.
How do I find the right credit line provider?
Think of such a provider as any other provider of critical services to your business—they are not only suppliers, but business customers. So, when you choose one, make sure you truly feel comfortable with them. Such a partner will understand your business and your needs, take an interest, and be familiar with the small business environment.
They should be able to recognize the challenges that small businesses face—for example, maybe your business is a seasonal one, or is suffering from slow paying customers. A good provider will be more receptive to creative arrangements and more attentive if you are in dire straits, and will understand these constraints and tailor the best solution for you.
Have you utilized a credit line to help start or grow your business, and did you find it beneficial? Do you have any tips for finding the right provider? Share your input in the comments below.