How to Get a Business Line of Credit
It’s an all-too familiar scenario for a small business owner. A hefty chunk of accounts receivables is late, with no arrival in sight. Meanwhile, suppliers are banging on the door demanding payment.
And, without cash flow, what is the small business owner supposed to pay them with?
The answer may be a small business line of credit. An unsecured small business line of credit is a popular way for businesses to access money to address cash-flow issues and any other expenses that arises.
A general rule of thumb for any business is to have enough cash in reserve to cover six to 12 months of expenses. This especially holds true for new businesses, since uneven and unpredictable cash flow is typically more of an issue within the first three years of the business.
During those periods when the business isn’t taking in enough money to cover its bills, its only two options are to spend a portion of the cash reserve or use credit. Many businesses choose to use a line of credit to get through these periods of depressed cash flow. A line of credit provides a maximum amount that a business can borrow. It can tap into this amount at any time, as long as it stays under the maximum. Unlike a small business loan, the borrower only pays interest on the amount that it borrows; not on the entire amount.
What are Business Lines of Credit?
A business line of credit – also known as a corporate line of credit — is an example of revolving credit. In this arrangement, the lender gives the business a maximum line of credit, which can be used to finance capital expansion or to protect against periods of low cash flow.
A non-revolving line of credit is typically an installment loan. In this scenario, the business can borrow up to the principal amount of the loan. The loan is then repaid in agreed-upon installments over a period of time.
Line of credit borrowing limits – which range from $1,000 to $250,000 – are typically smaller than a term loan. A line of credit also provides more flexibility than a loan,
The proper size of the line of credit varies according to the business. But another good rule is that a business typically needs to have $1.25 of income to support every one dollar of debt service. A business needs to be confident that it can handle the debt that will result from tapping into its line of credit.
Lower interest rates are an advantage of a business line of credit compared to other credit vehicles. Business credit cards, for example, can charge more than 20 percent APR for purchases and even more for cash advances. Line of credit rates vary according to size and type of line – and lender – but are often substantially less. Rates range from five percent to between 22 and 23 percent and are tied to the prime rate. But a business needs a good credit rating to qualify.
The actual cost of using a line of credit depends on its size and risk involved. The lender may also charge maintenance fees and availability fees.
Lines of credit can also be a good way to help small businesses build a good credit profile. Businesses that start a small line of credit and pay off the debt as soon as possible can strengthen their credit rating and better position themselves for future financing.
For companies considering a line of credit, it’s important to note that many lenders require that companies repay the full balance of the line annually or at other regular intervals. This is called “resting the line.”
Secured vs. Unsecured Lines of Credit
The most common classification of business lines of credit is based on whether a lender holds collateral (secured line) or not (unsecured lines). In effect, all lines of credit are secured to some degree. Unsecured lines can expose the business and its owner to legal action in the event of default. Because of this, secured lines pose less of a risk to its borrowers.
Business Line of Credit Best Practices
Good personal and business credit are essential to qualify for a business line of credit, as is a proven ability to generate a consistent cash flow.
When entering this arena, a sensible strategy is to apply for a lower line of credit and maintain a positive repayment history. This creates leverage for a business to access a large line later. It’s also a good idea for a business to apply for a line of credit before it actually needs one, so that it’s already in place and ready to use during a down cycle.
Qualifying for a Line of Credit
Most traditional lenders, such as banks, require businesses to have a strong history of revenue for a few years to qualify for a line of credit. Larger lines may require collateral.
A strong credit score can also be a necessity for a business line of credit. Many lenders require a score of at least 670. For others, the minimum score required is 700. Having a score of 700 or above designates potential borrowers as a prime borrowers, which means they are low risk.
There are cases where companies in certain industries as a whole can find it difficult to get financing through the loan process. For example, conventional lenders are hesitant to make loans to insurance agencies. This is because current financial records and asset don’t accurately reflect the potential value of a growing insurance agency.
Whether it’s to finance an upgrade in the agency’s operations, address issues with cash flow or fund an acquisition, an insurance agency line of credit can be a good option. But, since banks are reluctant to issue credit to insurance agencies, an alternative lender may be an agency’s best option. The same can apply in numerous other industries, including restaurants, certain retail stores and the transportation industry.
A. Income and Assets
Income and assets are the first stop for lenders in reviewing an application. Most banks want to see two consecutive years of operating profits. They also want to see assets such as real estate and inventory. In general, banks can provide financing for up to 50 percent of the assets of a business.
Applicants will typically need to provide personal and business tax returns, bank account information and business financial statements, such as profit-and-loss statements and a balance sheet.
While online lenders may have looser qualifications than banks, they also may have lower credit limits and may charge higher rates.
No matter the lender, businesses at a minimum will need to be operating for at least six months, $25,000 in revenue and a credit score of at least 500 to qualify for a business line of credit, although some online lenders offer a business line of credit with no credit check.
B. Financial Ratios
There are certain financial ratios that play an important role in the application process. These are:
- Debt service coverage ratio. Indicates if a company has sufficient income to pay the principal and interest of its debt.
- Fixed charge coverage ratio. Measures the ability of a company to pay the interest of its debt after paying for its fixed costs.
- Current ratio. Measures the liquidity of a company and its ability to pay short-term obligations. This ratio is based on current assets and liabilities.
In addition, all lenders can also have their own additional underwriting criteria and ratios as part of their own specific review process.
Most business lines of credit require a guarantee from the company or its ownership. These guarantees can include material or financial assets of the business.
Secured lines of credit can use personal and corporate collateral to secure the repayment of a loan should the business default on payments. In this scenario, a lender can foreclose on these assets.
Collateral such as real estate, account receivables, inventory, equipment, securities or savings accounts may be used. Such an arrangement can also help a business receive a larger line of credit. How large depends on the type of collateral. Real estate, for instance, can potentially secure a larger line than a company vehicle.
The lender will typically file a UCC lien or similar instrument against the pledged assets in order to secure is position.
Unsecured lines don’t involve the use of specific assets to secure credit. While this situation does protect a company’s assets to some extent, it also opens the door to much greater risk for the business and business owners. That’s because unsecured lines, for the most part, are guaranteed by the company and its owner personally.
In the absence of pledged assets, these guarantees can allow the bank to sue a company – and its owner personally – in case of default. Should a lender win such a lawsuit it could foreclose on the assets of the company and the personal assets of its owner.
D. Personal Background and Credit Search
It’s not uncommon for lenders to do background checks on business owners and their associates. This involves investigating their personal and professional histories, personal credit, assets and liabilities of those associated with the business. In doing so, lenders are trying to assess the character of those involved in a business. This process helps filter out business owners who lack great credit, have few assets or who conduct their private in ways that are inconsistent with successfully managing a business. Gambling issues are an example of a trait that could compromise the profitability of a business.
Line of Credit Covenants
Business lines of credit typically have covenants. These are rules and conditions that a company has to comply with if it wants to open and stay in business. While these can vary by lender, here are some of the common covenants a business owner can expect:
- Net Worth. Companies can be expected to maintain a minimum net worth. This mandate protects lenders from having a company’s assets drop too low, which could jeopardize the recovery of their funds.
- Monthly Certification. Business lines of credit may need to go through a monthly certification process. This requires the company disclosing the current state of its accounts, inventory and other assets. The availability of funds is tied to the assets listed in such a certification.
- Confession of Judgement Clause. This clause allows the bank the ability to file a judgement without having to go through a trial, which greatly aids the lender’s collection efforts.
- Liquidity. Lenders may stipulate that a company comply with the minimum standard of various liquidity rations, such as the current ratio, the quick ratio or the cash conversion cycle.
- Debt. A company may be required to perform above certain minimums for the debt service ratio, the fixed charge ratio and similar ratios.
- Material Changes. This is a clause that covers a wide variety of issues that can negatively affect a business, but aren’t specified in other covenants.
Business Lines of Credit: Pro and Con
As with any lending instrument, there are advantages and disadvantages to a business line of credit. The most attractive aspects of a line of credit are:
- Rapid improvement of cash flow;
- Flexibility as long as the business stays under the credit limit;
- Ability to pay for important and emergency expenses;
- Less expensive than alternate solutions.
Of course, lines of credit also have drawbacks, just like any funding solution. Among the most notable are:
- Difficult to qualify;
- Covenants can be hard to abide by;
- If the limit is reached, it can be problematic to increase it quickly;
- Startups or companies with less than two years of operation are ineligible;
- Purchase orders cannot be considered collateral.
Since purchase orders are key asset for a business, excluding then from the application process can limit the amount of the line and, thus, limit the growth of the company.
The decision on whether to use a line of credit comes down to two items: the main objective of the business, and a preference of cost or flexibility. While they may be inexpensive, lines of credit commonly lack the flexibility that a growing small business needs. Flexibility is available through other lending options, but can be costly. But the main problem with lines of credit is that small and growing companies – in other words, those that typically need a line of credit the most – can find it hard to qualify for one.
Alternatives to Lines of Credit
Lines of credit can be difficult for startups and small, growing companies to qualify for. While small Business Administration lines of credit, such as 7(a) loans, may be easier to get than conventional financing, they can still be inaccessible for a small company. Fortunately, alternatives for financing are available for these companies. Here are a few examples:
1. Invoice Factoring
Commercial clients typically take 30 to 60 days to pay their invoices, which causes low cash flow in many companies. As a result, they run the risk of not being able to pay their expenses. Invoice factoring allows you to finance these slow-to-pay accounts receivable and receive working capital immediately.
Invoice factoring finances invoices that are payable in up to 90 days. The business gets funds directly from the factoring company. Once the invoice is paid by the client, the transaction is over.
It’s easier to qualify for a factoring line than a commercial line of credit. One of the most important criteria is the ability of clients to pay the original invoice. Their ability to pay is the foundation of this transaction.
2. Purchase Order Financing
A rapidly growing business is not an ideal candidate for a line of credit since it can quickly reach its credit limit. And, if the business accumulates more purchase orders, trying to get a lender to increase the limit is a lost cause because lenders don’t consider purchase orders to be assets.
That’s where purchase order financing can help. A purchase order funding line pays for supplier expenses that are directly associated with a purchase order. This allows a business to book and fulfil large orders that it couldn’t handle without help.
3. Asset-Based Lending
Asset-based lending is a potential credit solution for larger companies. An asset-based line can help finance assets such as accounts receivable, inventory, machinery and real estate. Companies that don’t qualify for business lines of credit, or cannot comply with financing covenants, can benefit from this solution.
Asset-based lines use existing assets like receivables inventory to work like revolving lines of credit. The credit limit of the business can increase quickly, but only if the company has accounts receivable and other assets to support it. As such, asset-based lines can be a good option for small businesses that are growing quickly.
4. Line of Credit Business Loans
The Small Business Administration (SBA) offers line of credit business loans, called CAPLines, all of which fall under the SBA 7(a) loan program. These loans offer up to $5 million for short-term working capital needs. The objective of these loans are to help businesses take on more public and private contracts and purchase orders. Funding can be used as often as it’s repaid. Interest rates for SBA CAPLines typically range from five to 10 percent.
The SBA itself doesn’t issue the CAPLines itself. Its role is to provide the lender with a guarantee that it will cover a portion – normally 75 percent to 85 percent — of any potential losses from a business defaulting. The four CAPLines are:
- Revolving line of credit. This CAPLine works similar to inventory financing or invoicing financing. The amount of the line of credit is determined by the value of a company’s assets or account receivables.
- Seasonal line of credit. Businesses that need to stockpile inventory for an upcoming busy season can benefit from this CAPLine.
- Contract loan. This CAPLine is designed to help businesses fill contracts or purchase orders.
- Builders line of credit. This CAPLine is useful for businesses looking to build or refurbish a commercial or residential property.