By Paul Long
October 15, 2017
Lines of Credit are great tools for small businesses!
Lines of credit are for businesses who want to borrow money on demand for short term purchases. Do you need funds quickly to purchase inventory or need some extra funds to make payroll, then use a line of credit. Lines of credit have more favorable repayment terms than term loans (payments based on interest only to 1-2% of the loan balance) as well as interest rates can sometimes be less than a loan. Best of all if you don’t owe anything on your line, then you don’t have a payment. The bottom line is they are very flexible.
What type of business SHOULD have a line of credit?
I do not recommend that all businesses have a line of credit. If you are a cash based business where your clients pays you upfront in full then a line of credit is not suggested. If you are a business where your clients pay you in 30-60 days after you provide a service or product then you should have a line of credit. Lines of credit (when used properly) are primarily used for short term purposes until your clients pay you for the service. I see time and time again cash based businesses receiving a line of credit and they use it for long term assets because they payments are cheap and never pay the line back. When this happens banks call this a “term out” which is when the bank chooses to turn off your line of credit, raise your interest rate and have you make large monthly payments until it is paid in full.
What banks use to collateralize a line of credit?
In fully transparency there are banks out there that offer lines of credit for your business with no collateral and just use your personal guarantee. These lines of credit have higher interest rates and annual fees because of the risk to the bank. You must have A+ credit, been in business over 2 years and have solid business income to receive one of these products.
Most banks will want some sort of collateral as well as to know to why you need the line of credit. Most Lines of Credit are secured with your businesses Accounts Receivables. For example, you may typically have $90,000 in accounts receivable owing in any given time from your clients who will pay you in the next 30 days. A bank will typically lend you 75-80% of your accounts receivable in the form of a line of credit ($72,000). Once your client pays you in 30 days you will pay that toward the line of credit that you advanced from to cover day to day costs when during those 30 days. This cycle continues over and over.
Definition: Accounts receivable is a legally enforceable claim for payment held by a business against its customer/clients for goods supplied and/or services rendered in execution of the customer’s order. These are generally in the form of invoices raised by a business and delivered to the customer for payment within an agreed time frame. Accounts receivable is shown in a balance sheet as an asset.
The same goes for Inventory based lines of credit. If you need to purchase inventory for your business you can advance up to 50% of the value of your inventory in the form of a Line of Credit. For example, if you have $75,000 in inventory usually you can borrow up to $37,500 from your line to purchase additional inventory. Once you sell the product then you will pay back your line of credit.
These examples are primary reasons for needing a line of credit, you may think of other reasons why you need a line of credit. Make sure you talk with your banker to make sure you are set up properly.
Banks usually put a resting period on a line of credit, this is a time where the line of credit is not used. It may range from 10 days up to 30 days. The point of this is to make sure that you are using a line of credit properly which is use it, pay it off, use it, pay it off… Yes, the banks is enjoying the interest you are paying during this time, but at some point we want to principle to be paid back too. The rule you need to always have when you make an advance from a line of credit is will I pay this back in 60 days, if not then you may want to consider a term loan for your purchase.
It is important that you know some of these basics before you get a line of credit. This is a tool in your financial backpack you can use, make sure you use it correctly. You wouldn’t use a calculator to fix your car would you?