The line between a business line of credit and traditional types of small business loans isn’t exactly clear. A business line of credit is usually recommended for short-term working capital needs, but it can also be used to cover long-term investments like marketing campaigns and bridge the gap between busy and slow seasons. Immediate access to funds is said to be a major advantage of a business line of credit, but many other business funding programs can now be approved in a matter of days. It seems that in order to understand whether you’d be better suited for a business line of credit or another option, there are various factors to consider aside from convenience and the purpose of the desired funds.
A little more research will reveal the real criteria to keep in mind before making this decision. It’s the guidelines you must follow in regards to both approval and repayment that truly differentiate a business line of credit from other business funding programs.
1. You must have a clear picture of your future
The businesses that benefit most from business lines of credit are constantly prone to cash flow shortages or dips in revenue. They might regularly need extra working capital to sign new customer contracts or finance large projects. These businesses do not, however, wait until one such shortage to apply for a business line of credit. Unlike almost every other business funding program, a business line of credit is designed to be approved and distributed well before the funds are actually needed (at least a few months). When they apply, potential borrowers should be able to demonstrate strong cash flow and consistent revenue. This will earn them access to the maximum-sized lines of credit.
Your cash flow or revenue probably won’t be as strong right before you plan on using the funds. If this was not the case, you wouldn’t need a business line of credit in the first place. It can therefore be argued that a business line of credit is for businesses that are more concerned about their future than their current financial health.
2. You might have to pay off the full balance at a specific time
Anyone who has seriously looked into debt financing knows that every business lender has different requirements. This is especially prevalent when comparing a business line of credit from a bank to a business line of credit from an alternative business lender. Banks, for example, may charge fees for opening the line of credit or making certain transactions. There might be no annual fee for the first year but the second year could be different. Depending on your business credit, some business lenders might require you to pay off your entire balance at a specific point in time.
Business lenders tend to do this to assure themselves that the borrower’s business is making enough money to sustain itself without the help of the credit line. But regardless of whether or not your business lender imposes this rule, you should plan on being able to pay off your entire balance at some point in the near future. After all, a business line of credit is a revolving program, which can only be taken full advantage of by repeatedly paying the balance down to $0.
3. The collateral is usually short-term assets
When most people hear the word “collateral,” they think of their car or their house. Like a traditional small business loan, your ability to provide collateral will likely give you access to a business line of credit with lower interest rates and larger credit limits. But unlike a traditional small business loan, a business line of credit is for short-term needs. This is why the collateral used for a business line of credit is not capital assets, like expensive equipment or real estate. Instead, business lenders ask for short-term assets like inventory or accounts receivables.
If your business is unable to offer any short-term assets as collateral, focus on building business credit and improving cash flow. Demonstrating strength in either area may give you access to similar interest rates and credit limits as a secured business line of credit.
4. Don’t use a business line of credit for operating losses
As stated earlier, many borrowers use business lines of credit to cover monthly expenses during a rough patch. But this doesn’t necessarily mean a business line of credit should be used by any company that is having trouble paying its bills. Business lenders will rarely approve a business line of credit to cover operating losses. This refers to operating expenses that exceed the business’s revenue. Companies that are trying to cover losses from past operations will likely be unable to pay off the balance as quickly as the business lender prefers. If your main priority is immediate expenses, you are much more likely to be approved for a business line of credit if the expenses will directly lead to an increase in profits.
Business lines of credit are clearly geared towards companies that can look far into the future. They have a plan for how the line of credit will cover certain expenses at certain times. More often than not, that plan involves additional revenue. Keep this in mind when your potential business lender asks you to prove that you will be able to make period payments without obstructing cash flow.