All businesses are cyclical, meaning that there will be occasions when you may need to borrow to meet your short-term needs or goals. In these situations, a line of business credit can make all the difference. But what exactly is a line of credit, and how do you establish it?
In simple terms, a line of credit is an arrangement between a customer and a financial institution such as a bank that enables borrowing to be drawn down and repaid at any time, subject to an agreed limit. The advantage of this approach is obvious: interest is only paid when money is actually borrowed, whilst the customer enjoys the security of having credit on hand. However, in some cases the line of credit may be considered a demand loan, meaning that the outstanding balance must be paid immediately when requested by the finance company.
How you can use a line of credit
Lines of credit can be used to finance quite a number of different things. In many cases, they assist a company with short-term funding for day-to-day operations, including paying salaries, purchasing products, freeing up working capital and increasing inventory. They are also ideal should you encounter a cash flow problem, such as a major customer’s payments going into arrears or a sudden increase in sales. Cash flow is inherently unpredictable, and the knowledge that you have a line of credit is extremely comforting.
Apply when the business is doing well and you have a positive cash flow, and you will be in a position to negotiate good terms and interest rates. There’s an old joke that a bank is an institution that lends you an umbrella when it’s dry and then demands it back when it’s raining – and there is a great deal of truth in this. Applying when you are desperate for credit places you in an awkward position and makes you much less likely to be accepted unless you are considering alternative finance.
Why a line of credit is a useful tool
Even the most successful business can benefit from having some extra cash on hand. If you take on a major new client, you will need to purchase substantial inventory before being paid. If a supplier needs to offload large quantities of a key component at a discounted rate, you will need to act quickly. A line of credit is just what you require in these circumstances, and you will only have to pay for it when you use it.
To put it another way: what will you do if you don’t have a line of credit in place? Surprisingly, many businesses turn to credit card borrowing as the first resort. Corporate credit cards certainly have their uses, but they are notorious for attracting high fees and crippling interest rates. In contrast, a line of credit offers the same flexibility as a credit card, but without the fixed payments and the high interest rates. In most cases, you’ll be able to pay the balance off whenever you want, just as with a card, though sometimes banks will insist on a minimum six-month loan period.
Above all, a line of credit will give you peace of mind. Worrying about whether a customer pays on time is counterproductive and pointless when you can simply have an affordable credit facility on hand to cover such issues. A line of credit is almost like an insurance policy for cash flow blips, though this method of borrowing is not suitable for dealing with serious and ongoing deficits within a business.
What will a line of credit cost?
This will depend on what you can negotiate, but you can typically expect an interest rate of about 1% to 3% above base rate, with interest charged only when you borrow. There may also be set-up fees and maintenance fees for the facility, so it can help to compare terms from more than one institution.
The amount you can borrow will depend on your business and its circumstances, you can use a business loan calculator to give a clearer picture, but you could typically expect a limit of anywhere between about $10,000 and $500,000. When using your facility, you should bear in mind that most banks like to see the account paid down regularly, as a line of credit is not a direct substitute for an overdraft or bank loan, both of which may see large sums outstanding for months or years at a time.
Plan today for peace of mind tomorrow
Whether your business is seasonal or predictable, steady or rapidly increasing, there will always be occasions when you need to make a sudden hiring or bulk purchase, deal with a major customer paying late, or make an additional investment to power growth. A line of business credit will help to ease your cash flow, with very competitive rates – unlike credit cards, which offer the flexibility you need but at an eye-watering rate of interest.
Carl is a business recovery specialist. He started work in the Business Recovery profession in 1990 and has continued to pursue an ethos of working with distressed businesses to help them overcome their financial problems. As Managing Director of Cashsolv, he offers advice and support to overcome cash flow problems and identify possible underlying problems that can be addressed to ensure a positive future for your business.