Are you one of the 67 percent of small business owners that are optimistic about revenue growth in 2019?
Whether you are optimistic or not, all small business owners want revenue growth.
How are you going to achieve revenue growth this year? Increased sales, refreshed marketing materials, or a new product offering? Whatever your strategy, you should consider how a business line of credit could help you grow your business.
What Is a Business Line of Credit?
A line of credit is a lending agreement between you and a lender. Lines of credit are structured to be short-term products – meaning they expire within 12 months. If you’ve used a line of credit properly, the lender may renew the line for another year.
The lender sets a maximum credit limit that you can draw against in amounts determined by your needs. Often you can pay only interest on the balances of the line of credit. When you pay back principal, you then have access to those funds again.
This is the typical revolving nature of lines of credit. Why is it described as revolving? Think of a revolving door – you can go in and out and in and out and in and out. Let’s take a closer look.
How Does a Business Line of Credit Work?
You have a new project coming up that will require more materials and labor than your usual project and you want to be prepared for any cash shortages. Then a couple of weeks into the project, you need an extra piece of equipment if you’re going to meet the deadline.
Your bank approves a $20,000 revolving line of credit for your business. Typically a variable interest rate is the bank’s prime rate of 4 percent plus 5 percent for a total of 9 percent rate. At Express Capital we determine an interest rate based on ability to pay and credit score.
The first month you draw $1,000 from the line of credit. When you receive your first billing statement, it shows a principal balance of $5,000 plus interest charged at 9%. You are only required to pay the interest of $450.
Let’s say you continue to draw on the line of credit for the next 4 months until the LOC (line of credit) is ‘maxed-out’ at $20,000. You are now paying interest of $1,800 a month and you do not have access to any more funds until you pay down principal.
If you pay down $15,000, then you have freed up $15,000 of your LOC and your interest payment is now based on a $5,000 balance. Basically, you are only expected to pay back what was drawn out.
You may be saying to yourself – this sounds a lot like my credit card! Why not just use my credit card?
What’s the Difference Between a Business Credit Card and Business Line of Credit?
While both a small business line of credit and a business credit card are revolving and have variable interest rates, the similarities end there. Read below to see how a small business line of credit differs from a business credit card in important ways.
Lines of credit will typically have higher credit limits than credit cards. Generally, credit cards are expected to be used for small ongoing business purchases. For example, you may use a credit card to gas-up your trucks on a daily basis.
You simply don’t need the same level of credit on a credit card that you do for a line of credit. The maximum amount of credit on a line of credit differs based on a number of variables about your business.
While both credit cards and lines of credit have interest rates, the rates on lines of credit are going to be lower than interest rates on credit cards.
Secured or Unsecured
To be approved for a line of credit, a lender will not just review your credit report but will review your financial statements. Part of the review will look for ability to pay in order to secure the line of credit.
The stronger the ability to pay, the better the interest rate.
To get cash from a line of credit, the lender typically wires the funds to your bank account. The interest rate on a draw from a line of credit is always the same. This is different from credit cards where cash advances are charged at a higher interest rate.
How Do You Get a Business Line of Credit?
To approve a small business for a line of credit, most lenders require the business to have been established for at least one year.
It’s important for lenders to see a whole year of cash flow to better understand the needs of the business. Lenders want to provide the appropriate amount of credit on the appropriate terms so that the borrower can be successful in using the line.
Small business lines of credit are offered by your local bank and by online lenders. Each institution has different application requirements, but the following documents are common to most:
- Bank Statements
- Personal or Business tax returns
- Profit & Loss Statement
- Credit Report (personal and business)
- Accounts Receivable
- Accounts Payable
In addition to these documents, the lender will have an application requesting basic business information. When the lender has all the documentation in hand, they will underwrite the loan request. Underwriting refers to the process that leads to approval or denial of a loan request.
The process includes calculating ratios to compare against industry standards and the lender's standards for particular industries. For example:
The Debt Service Coverage Ratio shows the lender if your business is generating enough current income to cover your current debts. It’ s calculated by dividing your annual net operating income by your total debt payments. Lenders will need a debt service coverage ratio of at least a 1.0.
The Loan-to-Value (LTV) Ratio shows the lender that the collateral securing the loan is worth more than the loan itself. Lenders typically do not lend 100 percent LTV - meaning that if your A/R is worth $10,000, the lender might give you 80 percent LTV and lend you $8,000.
For younger businesses, lenders like to see a business plan as well. External link SBA. A business plan helps a lender see your sales and marketing strategies; it helps a lender get comfortable that you are thinking ahead and that your line of credit will be used properly.
How To Use A Small Business Line of Credit Effectively
What is meant by using a small business line of credit effectively? It means using the line of credit responsibly.
If you borrow a line of credit to invest in a special discount on an inventory purchase, but on your way home from the bank, you decide that leasing a fancier car would also be good for business, you may be headed down the wrong road, so to speak!
Best Uses for a Small Business Line of Credit
Lenders developed lines of credit to meet a specific need of businesses.
Term loans are great for large capital investments that can be paid back over a long period of time. Credit cards are great for smaller day-to-day purchases. Lines of credit are a perfect in-between product that supplements the working cash flow of a business.
Short-term Working Capital
Lines of credit are a great way to fill gaps in cash flow. You may have a constant gap based on your A/R and A/P cycles. A line of credit helps you cover gaps in your working capital cycle.
Safety Net for the Unexpected
Or you may have an unexpected gap due to a few unusual expenses or the unanticipated loss of a big customer’s revenue stream.
Great Purchasing Opportunities
One of your suppliers might offer you a one-time discount on inventory if you buy in bulk. Having a line of credit to take advantage of this opportunity makes good business sense.
Offer Trade Credit to Customers
Your customers ask you for trade credit - just like you ask your suppliers for trade credit. Cash on delivery is not realistic most of the time. One-third of businesses have invoices in A/R that are over ninety days.
Use It or Lose It
If a lender extends a line of credit to you, they want you to use it. Some business owners might interpret this as maxing the line out and only paying interest until the lender demands payment of principal when the line expires.
Some other business owners might never use the line. This isn’t a good idea either. When the time for renewal comes around, the lender might not renew because they aren’t making any money on the loan.
Neither of these situations is ideal. Lenders want you to use the line by spending up, paying down and spending again. This is a win-win because you establish a strong repayment track record with the lender and the lender is making money.
Zero It Out
This is a term that lenders use to mean paying off the line of credit to zero. Sometimes your line of credit agreement will have specific terms about ‘zeroing out’ the line periodically. This demonstrates that you are using the line of credit as intended – for short-term cash needs.
Is a Business Line of Credit Right for Your Business?
A small business line of credit is a flexible form of financing that can help you grow your business. If you wondering if you would qualify, the only way to find out is to contact a lender.
As a small business owner, you need to adapt to changing market demands. Change often costs money. Having immediate access to cash can make the difference that sets you apart from your competitors.