Why Have a Credit Line?

The list of reasons is lengthy, but here are a few:

·      Unforeseen expenses

·      Unexpected opportunities

·      Delayed payments from receivables

·      Working capital for an upcoming project 

Businesses could just as easily handle these financial matters with business savings, but with cash in such short supply, most companies don’t have that luxury.  This makes a flexible credit line an essential business tool---as long as it is used properly.

Credit lines should not be used as permanent financing.   For example, a business that needs $100K in financing to purchase equipment with a useful life of five-years, is much better off financing the purchase with a five-year term loan instead of a credit line for a few reasons:

1.     It generally makes sense to match outgoing payments to acquire an asset with the useful life of that asset. 

2.     The interest rate on the equipment term loan should reflect the fact that the loan is secured by the purchased equipment---this means that the equipment term loan should have a better rate of interest than most unsecured credit-lines.

3.     Once the full credit line is drawn to make this equipment purchase, there will be no more funds available for appropriate credit line uses like unforeseen expenses, unexpected opportunities, etc.

Credit lines should be drawn upon when there is a temporary need for cash like an unexpected large job that will require substantial working capital.  Once the business is paid for that work, however, it’s important to have the discipline to pay down the credit line so funds are once again available for the next appropriate use.

Here are some of the features that should be analyzed with any credit line offer: 

·      Draw period- How long is the period during which funds can be drawn from the line?  What happens after this draw period ends?

·      Initial monthly payments – How are these payments calculated?  A small percentage of the balance, interest-only, or are all draws immediately put on an amortization schedule?

·      Interest Rate- What is the interest rate and how is it calculated?  While the interest rate is always a consideration, proper use of a credit line involves a draw followed by payback in a short period of time.  In these instances, the dollar interest tends to be low because of the short time span.  The rate becomes very important for business owners that use the credit line incorrectly as permanent financing.

What do lenders look at when evaluating a business for a credit line? 

·      Banks- Most offer credit lines to existing business customers that are of a certain size with strong financial health.  Generally, banks do a full underwriting including financial statements, credit checks, etc.   Businesses that are large enough to be considered for a bank credit line should pursue that option first---rates will be better and having the credit line at the company’s regular bank adds a layer of convenience to the account.  Unfortunately, most small businesses are not large enough to be considered for a bank line of credit. 

·      Alternative Lenders- The underwriting varies in the alternative space.  Some lenders do a full underwriting similar to banks, while others focus on bank statements and credit checks.  Credit line product features also vary by lender---this is why it is often helpful to work with a commercial loan broker like myself, who knows the landscape well.

In summary, a credit line should be considered an essential business tool but to benefit, the business must be approved.  As mentioned above, businesses of a sufficient size to warrant consideration from a bank, should pursue that option first---but most small businesses will need to navigate the alternative market.  As I said above, I’m more than happy to help.