As businesses open back up and hit the ground running, many are finding themselves strapped for cash. The pandemic often resulted in businesses running barebones operations or closing altogether, and after a year of hardship, many small business owners are finding themselves with no cash left to “play with” to drive post-COVID-19 growth.
Because of this, small business owners are looking for the best ways to quickly obtain affordable and flexible funding that can bridge their cash gap and help them execute their reopening plans and strategies.
A business line of credit works to do just that: they provide flexible, affordable, and quickly accessible short-term working capital pools that small business owners can tap into when they need cash to pay for general business expenses and have sudden capital needs.
In this article, we provide a quick overview of what business lines of credit are, how small businesses can take advantage of them, and how they can help small business owners drive growth and smooth cash flows.
What is a business line of credit?
A business line of credit can be thought of as a cross between a traditional business loan given by your traditional bank or online lender and a business credit card. Like traditional loans, a line of credit provides a small business owner with financing that can be used for whatever that financing is needed for. However, in stark contrast to a term loan, lines of credit don’t come with a lump-sum disbursement of the loan amount to your business bank account.
Just like a business credit card, a business line of credit provides a pool of capital that you can flexibly draw from whenever you need financing. When you apply for a line of credit, your lender will work with you to define a limit, like the credit limit on your credit card(s), which typically range anywhere between $25,000 and $250,000.
The payments made and interest accrued on a line of credit are only subject to the amount that you’ve drawn/borrowed. In some cases, if the lender sees giving a line of credit to a certain business as particularly risky, they may charge origination fees, maintenance fees, or availability fees. Additionally, banks often require that businesses pay the full balance either annually or at another pre-defined interval. This is known as “resting the line”.
Lines of credit come in two distinct forms. The first category is a secured business line of credit, where the lender will hold either personal or business collateral that protects them should the business owner default on payments. The second category is unsecured business lines of credit, which requires a business or business owner to guarantee the amount lent. These types of credit lines expose you to much more risk, as default could lead to the bank suing either you or your company for assets to recover their losses.
In summary, with business lines of credit you get the best of both worlds when it comes to different types of business financing:
- Quick Delivery of Much Needed Funding: You get access to working capital that you can use to pay business expenses and drive growth.
- Flexible Funding: You can draw as much or as little cash as you want depending on your needs, up to the limit of your line of credit. Other flexible credit instruments often don’t allow you to secure cold, hard cash. Lines of credit do!
- Lower Interest Rates: Flexible credit tools, like credit cards, typically have very (very) high interest rates. Lines of credit can have higher interest rates (up to 23%), but typically are lower than that of credit cards (can go as low as 5%!). This is especially true for businesses with a strong history of annual revenues and a high business credit score.
What are the pros and cons of business lines of credit?
Pros of Lines of Credit
- They provide a flexible source of cash that can be used whenever necessary
Business opportunities aren’t served to you on a silver platter with plenty of forewarning. They’re often unexpected and time-sensitive in terms of your ability to take advantage of them. If you don’t have the cash to make the moves necessary to secure a new business location, land a particular client, invest in critical new technology, or fulfill a huge influx of orders, you’ll miss the boat. Traditional loans won’t work here: they take too long to secure, and you can’t easily change the borrowed amount.
Lines of credit provide a flexible working capital pool that can be used for these types of situations. At any time, as long as you haven’t drawn up to the predefined limit, you can borrow whatever cash is necessary for a sudden situation and you only need to pay back (with interest) what you ended up borrowing.
- Lines of credit are an excellent (and inexpensive) way to build credit
When businesses are just starting out, securing loans and other financing options often require the small business owner to make personal guarantees, use personal credit scores, or give up huge collateral due to a lack of credit history. Building up credit requires a history of successfully managing credit, but if you can’t secure any, you’re stuck in a Catch-22!
One of the easier forms of credit to obtain to start building history is a business credit card, but their extremely high interest rates can cause them to become extremely expensive if mismanaged or if they need to be used for sudden expenses.
Lines of credit are a happy medium between the typically stricter requirements of a traditional loan and the risk of a business credit card. Small businesses can start with very small lines of credit and establish a positive history by using the cash available and making on-time payments.
- Allow businesses to “smooth” cash flow during down seasons
One of the biggest advantages of a business line of credit is the ability for small business owners, especially in seasonal markets and industries, to smooth cash flow throughout the fiscal year.
Restaurants, clothing retailers, resorts, landscapers, food truck owners, tutors, outdoor tour guide services, personal trainers, and a host of other businesses run on seasonal cycles of revenue. They’ll make most of their money during their “peak season” and then during the rest of the year will make considerably less. For example, personal trainers will see an influx of clients between January and the summer months and then will have much less business in the fall and winter.
This can present a problem for businesses that have year-round expenses like rent or payroll. They often find themselves in cash crunches at the same times every year due to changes in their cash flow. You can’t just stop paying because you don’t have any revenue coming in and managing your surplus revenue from the “peak” season throughout the year can be difficult in changing business environments and markets.
Lines of credit provide a tool that can help make your “peak” and “down” seasons meet in the middle, so your financial situation is normalized across the entire fiscal year. Instead of making 80% of your cash in the first quarter and 20% in the rest and having to deal with how to spread that out over the year, you can use a line of credit to simulate a smoother cash flow situation so you can continue to comfortably pay staff, engage in pre-peak season marketing activities, pay rent, or engage in whatever other activities are necessary throughout the entire year.
Cons of Lines of Credit
- Debt is debt, no matter how advantageous
Lines of credit are still a form of debt, no matter how you spin it. The money you borrow must be paid back, with interest, in a timely manner and this adds another liability to your small business’s financial statements. This extra debt can cause future financing to be more expensive as it can raise your “current ratio” and other financial metrics, which could reflect poorly on future loan applications.
As with any loan or source of financing, carefully consider your business’s credit needs to understand if a line of credit is truly necessary. Other forms of quick financing, like invoice factoring or merchant cash advances, can be equally useful forms of quick cash for your small business.
- Business lines of credit aren’t typically large enough for big purchases
If you’re looking to launch a major product or need a very large cash infusion, which may well be the case as you look to bounce back from COVID-19’s effect on your business, lines of credit won’t be enough. Financial institutions are hesitant to provide very large flexible financing options as they’re inherently riskier and tie up capital that could be used to provide other loans.
Lines of credit typically have relatively lower total amounts on borrowing limits as compared to investor capital or traditional loans and it’s very tough to negotiate higher limits from a bank.
- There is very high (but low probability) downside risk when lines of credit are mismanaged
As we discussed before, lines of credit require either a personal guarantee or giving up collateral in the form of business or personal assets. If you end up defaulting on the credit line due to a business failure or other misfortunes, the bank has every right to seize the collateral or sue the borrower or the borrower’s business to recover their losses. This can result in business closure, personal and/or business bankruptcy, or other catastrophic outcomes.