How Does a Business Line of Credit Work?
Business lines of credit are one of the most popular and most misunderstood financing products for small businesses. A business line of credit provides flexibility that a regular business loan doesn’t. With a business line of credit, you can borrow up to a certain limit — say, $100,000 — and pay interest only on the portion of money that you borrow. You then draw and repay funds as you wish, as long as you don’t exceed your credit limit. A line of credit is similar to how credit cards work.
How to use a line of credit
A line of credit is a financing solution that allows a company to draw up to a predetermined amount of money. To get funds, you simply request a draw from the line. Lending institutions restrict how you can use the line of credit. Obviously, since it is a commercial line, it can be used only for business purposes. Additionally, lines may have other fees such as maintenance fees and availability fees. These fees vary by institution. Lastly, many banks require that your company repay the full balance of the line every so often (e.g., every year). This practice, often referred to as “resting the line,” is something to keep in mind if you are considering this type of a product.
Types of lines of credit
There are a number of ways to classify lines of credit. The most common way is based on whether the lenders hold collateral directly or not.
A - Secured lines
A secured line of credit can use personal and corporate collateral to secure the repayment of a loan should the business owner default on payments. This security allows lenders to foreclose on assets if necessary. Lenders can use different asset types as collateral, including accounts receivable, machinery, inventory, cash, certificates of deposit, securities, and real estate. The lending institution usually secures its position by filing a UCC lien (or similar instrument) against the pledged assets.
B - Unsecured lines
An unsecured line, on the other hand, does not have specific collateral that is pledged as security for the line of credit. While this approach gives your assets some protection, the protection is far from perfect. Most unsecured lines are usually guaranteed by the company and by the owner personally. You could argue that the loan is secured by your guarantees. These guarantees often allow the lender to sue your company and the business owner personally in case of default. In reality, no line of credit or business is ever completely unsecured.
Qualifying For A Line Of Credit
The first thing to understand is that qualifying for a business line of credit is not easy. Lending institutions have various criteria that you and your company have to meet in order to qualify. The bottom line is that lenders fund money based on the three C’s: Cash flow, Collateral, and Credit score. You and your company usually must have 1 of those 3 to get any source of funding.
1. Company Assets and Income
Most banks and lending institutions examine your company’s income and assets as the first part of their review process. They can provide a line of credit only if your company has a means to repay it. These requirements vary by bank. However, most banks want to see two years’ worth of operating profits. They also want to see assets such as accounts receivable, machinery, inventory, and real estate. In general, banks can provide financing for up to 50% of your assets.
2. Reasonable Financial Ratios
As part of the underwriting process for the line of credit, the bank reviews certain financial ratios. These reviews vary by situation, but banks usually look at the following:
Debt Service Coverage Ratio: Measures if your company’s income is sufficient to pay the principal and interest of your debt
Fixed Charge Coverage Ratio: Measures if your company is able to pay the interest of your debt after paying for your fixed costs
Current Ratio: Measures your company’s liquidity and its ability to pay short-term obligations. It’s based on current assets and liabilities
Other Ratios: Each financial institution has its own set of underwriting criteria and ratios that they review
Most corporate lines of credit require that they be guaranteed by the company, owners/major shareholders, or both. Guarantees may include that collateral be pledged and usually allow the lender to file a lien on specific assets.
A) Personal guarantees
Many lenders require that business owner or major shareholders guarantee the facility personally. Usually, individuals who own 10% to 20% (or more) of the business have to sign guarantees. The personal guarantee allows the lender to pursue the owner’s personal assets if the business defaults on the line of credit.
B) Corporate guarantees
Lenders require that the company guarantee the line of credit that it’s taking. They may want some or all of the company assets to secure the line. Also, if the company is a subsidiary of a larger company, the lender often requires a guarantee from the parent company as well.
4. Personal Background and Credit Search
As part of their underwriting process, lenders often perform background checks on the business owner and major guarantors. They often check the personal background, professional history, personal credit, and assets of these key individuals. Lenders go through this process to determine the assets and character of guarantors. Character is actually very important. Companies don’t run themselves. They are operated by owners, managers, and employees. How a person conducts their private life often reflects how they conduct their business life as well. As you may imagine, this process is done to exclude business owners who don’t have great credit or who have few assets.
Benefits of a Line of Credit
Lines of credit have some distinct advantages, including:
They can improve your cash flow quickly
They can be flexible as long as you don’t reach the limit
They can be used to pay for important and emergency expenses
They are cheaper than most alternative solutions
Drawbacks of a Line of Credit
However, like any business solution, lines of credit are not perfect and also have a number of disadvantages:
They are hard to get
Once you reach the limit, it’s hard to increase it quickly
Purchase orders are not considered collateral – this restriction can limit growth
Are you looking for financing?
Free To Apply
Apply In Under 2 Minutes
No Financials Or Tax Returns
No Credit References
No Collateral Required
Poor Credit History OK
Flexible Payment Options
$5,000 - $125,000 Lines of Credit