Why Small Business Owners Should Consider a Line of Credit

Why Small Business Owners Should Consider a Line of CreditOne of the most common challenges for new and small businesses is having sufficient cash on hand, or assets that can be easily converted to cash, to ensure you have both the working capital to invest in new opportunities and the flexibility to deal with unexpected expenses.

Managing cash flow can be particularly difficult for new businesses without an established track record of revenue and expenses and for seasonal businesses with significant sales and income fluctuations throughout the year. Slow payment by clients can also create significant challenges for small businesses. “All businesses, but especially small businesses, sometimes need to engage in a juggling act when income lags slightly behind expenses,” according to information from SCORE.  A business line of credit can help you even out cash flows.

Money when you need it

Applying for a line of credit well before you need it can provide the flexibility (and confidence) to ride out gaps between invoicing and revenue realization, invest in inventory in anticipation of future sales or deal with an unexpected expense. Where a business loan provides a set amount of money for what you believe you will need (and which could be too little or too much), a line of credit gives you a certain amount of credit you can draw on as needed and then pay back as soon as you have the cash available to do so. You only pay interest on the amount you actually take out. It’s similar to a credit card, which may also suffice in a pinch, but a line of credit is likely to provide access to significantly larger sums.

Establish your line of credit

The bank where you have a business account is one of the first places to look to establish a line of credit. Most lenders rely on the basic “five Cs of credit” to determine eligibility and the amount of loan you will receive. These include your Capacity (ability to pay); Character (credit history); Capital (earnings and savings); Collateral (what you can put down to secure the loan); and Conditions (the purpose of the loan and strength of the economy). Consider these tips when pursuing a line of credit.

  • Evaluate your personal financial position. For new businesses without a strong track record, many banks will expect you to personally guarantee repayment with personal assets. That doesn’t mean you should forego establishing a line of credit, but that you want to be careful to safeguard your personal assets and not over-extend yourself.
  • Be prepared with standard financial documents. When you go to your bank or other lender, they will expect to evaluate your business based on basic financial statements that follow generally accepted accounting principles. This should include pro-forma (forward-looking) cash flow statements that demonstrate your ability to pay the money back. The lender will also pull your credit reports to see how you’ve managed debt in the past.
  • Evaluate fees involved with the loan. As you explore several lending sources, you will want to compare interest rates of course, but also origination fees, or possible maintenance or draw fees that kick in when you open and use your new account.
  • Read the terms carefully. If you have an established relationship with a local banker, you may feel more comfortable opening a line of credit with them and being able to talk through the details in person. Online lines of credit are also an option; however, interest rates are sometimes higher and the loans do not always offer the option to repay earlier and avoid the full amount of interest owed.
  • Consider a Small Business Administration (SBA) Loan. The SBA offers its CAPLines program for loans up to $5 million to help small businesses meet short-term and cyclical working capital needs. You can check them out here.

Considering debt of any kind requires striking a balance between investing to grow and avoiding over-extending yourself. Used wisely, a line of credit can help you staff up to meet a big order, maintain business operations when customers are slow to pay, buy inventory when available on discount, meet a needed capital expenditure and make sound investments to grow your business even if you don’t have the money on hand to do so today.