When You Should (and Shouldn’t) Use a Line of Credit (Part 2)

A line of credit is one of the most common and helpful financing tools used by small businesses. Its versatility, though, can be a double-edged sword, because using funds from a line of credit for the wrong reasons can get you in financial trouble. So it’s important to know when a line of credit should be used to meet a financing need — and when it should not.

In a nutshell, funds from a line of credit should be used primarily for short-term needs, such as plugging temporary cash flow gaps, funding accounts receivable, or purchasing additional inventory.

Conversely, a line of credit should not be used for longer-term financing needs, such as the purchase of equipment or property, acquisitions, or major business expansion. A term loan is usually the most appropriate type of financing for these needs. The best uses for a line of credit generally include the following.

1. Improve cash flow. The most common use of a small business line of credit is to even out the inevitable cash flow peaks and valleys that may be caused by seasonal or industry-specific ups and downs. For example, a company that manufactures Christmas decorations will need cash in the summer to buy materials and then again in the fall to ship goods, although it may not receive payment from its customers until January. The company could use a line of credit to cover its cash shortfall during this time.
2. Meet short-term working-capital needs. There are times when companies experience cash shortages due to an unforeseen circumstance: a slowdown in collection of receivables, for example, or unanticipated one-time expenses. A line of credit can provide the funds needed to meet day-to-day working-capital requirements on a short-term basis. If your cash flow shortage is longer term (more than a year), your banker may recommend some kind of long-term financing plan instead.
3. Take advantage of supplier discounts. Sometimes it makes sense to borrow money to take advantage of prompt-payment discounts offered by suppliers, and a line of credit may be the perfect financing vehicle with which to do it. If your cost of funds is less than the discount, then consider drawing down a line of credit to make payment early and then replenishing the line as soon as your cash flow allows.
4. Take advantage of unexpected opportunities. What if your company has the opportunity to purchase a large quantity of raw materials at fire-sale prices, but you don’t have enough cash on hand to make the deal? Or suppose a customer approaches you with an order for 100,000 widgets but needs them in a week, and you don’t have sufficient resources to fill the order? In these and other scenarios, a line of credit enables you to act quickly.

A line of credit is something you’ll want to have in place before you absolutely need it. If you have a healthy, cash-strong business, now is the time to establish your line of credit.

Tips for Getting a Business Line of Credit (Part 1)

A  line of credit is one of the best financing tools available to small businesses. It’s commonly used to meet short-term working capital needs, such as plugging cash flow gaps, funding accounts receivable, and buying seasonal inventory.

In the current tight credit environment though, getting and keeping a small business line of credit takes a little more time and effort than it did in the past. Here are five ways to improve your chance of receiving approval on your line of credit application.

1. Start with your accountant. Before approaching a bank to talk about obtaining a line of credit, it’s a good idea to first talk to your accountant about your specific financing needs. This will prepare you to explain why you need a line of credit and exactly how you plan to use it.Different banks tend to cater to different kinds of businesses, so it’s good to start out with a bank that specializes in companies of your size and in your industry, if possible.
2. Prepare your financial statements and tax returns. Depending on your company’s history and credit rating, the bank will require various levels of financial statements and documentation to help it analyze your credit request. Unless yours is a very established business with a long history of strong credit, you’ll probably need to provide: 1) current and year-end financial statements from the past two to three years; 2) business and personal tax returns from the past two to three years; 3) a personal financial statement; and 4) accounts-receivable aging schedules and current inventory reports.
3. Consider your collateral. Unless your business possesses the highest credit rating, you will likely be asked to pledge some sort of collateral. Banks accept three primary types of collateral: accounts receivable, inventory, and business assets (equipment, computers, furniture and fixtures, etc.). The bank may also require a personal guarantee for the line and/or the pledge of a personal residence as additional collateral.
4. Update your business plan. If you have a business plan but it has been sitting on a back shelf for the past few years, now would be a good time to dust it off. It doesn’t have to be a 100-page opus. A simple, concise document with a well-written executive summary and appropriate and timely supporting documentation will go a long way toward showing a banker that you’re serious.
5. Demonstrate your sources of repayment. Not surprisingly, a bank’s primary concern is how its loan will be repaid. So be prepared to show specifically where the funds will come from to repay the line. The bank will want to see that you can repay the line from cash produced via the conversion of assets generated in the normal course of your business. In other words, be prepared to show the bank that your business is profitable enough to maintain normal operations while still servicing the debt, and be prepared to demonstrate that cash used to repay the debt will not be diverted to other uses, such as purchasing new assets. In that case, a term loan would be more appropriate.