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If you wish to grow your organization without giving up equity early on, you will require funding. This comes in the form of a loan or a business line of credit. Lenders will be more comfortable with your potential financial behaviorsif you have a solid credit score.
While businesses have used credit lines for years, they are more commonly used by individuals. This may be in part due to the fact that banks do not often advertise credit lines, so potential borrowers do not ask.
With that, let’s dive into what business credit lines are and what affects them.
Table of Contents
Introduction: What is a Business Line of Credit?
A business line of credit is a flexible loan taken from a financial institution or bank. A line of credit (or credit line) is a defined amount of money that your business can access when required and then repay, either immediately or over a period of time.
Like with loans, a business credit line will charge interest when money is borrowed. The interest rate is variable, and hence it can be difficult to predict what amount you will end up paying.
All borrowers must be approved by the bank. Note that the borrower’s credit rating and/or relationship with the bank will greatly affect this approval.
While lines of credit are generally lower-risk revenue sources compared to, say, credit card loans, they can complicate the bank’s earning asset management. This is because outstanding balances cannot be controlled after a credit line has been approved.
Businesses can use a line of credit for short-term working capital needs, including but not limited to:
Repairing vital equipment
Closing a seasonal cash flow gap
Funding a marketing campaign
Buying inventory
Types of Business Credit Lines
1. Secured
Secured credit lines require your business to pledge particular assets as collateral.
Lenders will usually ask for short-term assets such as inventory and accounts receivable, since credit lines are short-term liabilities. Typically lenders do not need capital assets like equipment or real property for securing a credit line.
Note that if you are unable to repay the line, the lender will assume ownership of the abovementioned collaterals and liquidate them to pay the balance.
2. Unsecured
Unsecured lines of credit do not need specific assets as collateral. Having said that, a personal guarantee and general lien will be needed.
To qualify for this type of credit line, your business will probably need a stronger credit profile as well as a good business track record. Furthermore, unsecured credit lines are usually smaller while interest rates might be somewhat higher.
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When Should a Business Consider a Line of Credit?
Generally, you can consider applying for a business line of credit if your business regularly needs funds for short-term capital requirements. For example, if you have a seasonal business that makes most of its sales in the spring, you could use a business credit line during your off-season to help with overhead costs. This will help maintain regular business operations even through fluctuating income.
Another example would be using a credit line to help cover expenses while waiting for a client to make a payment on an invoice.
What Impacts Your Business Credit?
It is important to note that there is no standard scoring model to assess risk when it comes to a business line of credit. Banks, businesses, leasing companies, lenders and suppliers all use different scoring models and reports, depending on the credit reporting agency they use.
Here are a few factors that can impact your business credit:
Credit Capacity
Your credit capacity shows your business’ ability to repay on a credit line or loan. The best way to improve your credit capacity is with a favorable bank ranking, positive payment history with other companies, and a positive cash flow.
Regarding payment history, banks and lenders will want to know how long an account has been opened and the credit limit extended, and how many times the account has been paid late.
Financials
You will likely have to provide documents such as YTD cash flow statements, a year-to-date (YTD) balance sheet, and YTD profit and loss (P&L) statements – as well as the documents for the previous year. As part of the decision-making process, three trade references will probably be required as well.
Ensure that any outdated information or issues are clarified or corrected.
Capital Invested
A factor that banks take into account during a business loan evaluation is the amount of funds that has been invested by the owner in that business. Banks are more likely to favor businesses where the owner has invested a “reasonable” amount.
They will examine your business’ debt-to-equity ratio to better understand the amount of money you are requesting versus the amount of money you have invested in your business. It is better to have a smaller ratio.
Collateral
Collaterals are expensive business assets such as heavy machinery, business equipment, commercial real estate, and inventory can be sold if your business does not repay the loan.
Since lenders consider the loan-to-value ratio differently, you will have to ask your lender how they plan to set a value.
Generally, traditional banks will require collateral when it comes to a business loan.
Registration
It is possible to register your business name with your state. This reserves it so that, within your state, no one else can use that name. The name should be registered with the state where the business is organized.
Although you can operate a business under your own name, it is more efficient to register with a "doing business as" (DBA) name.
Furthermore, depending on the tax system of your state, you might be required to register as part of collecting and paying sales tax. Some states will require registration before you hire employees.
Note that you cannot develop a business credit score until your business is registered.
To get your business registered, go to your state’s business division website and follow their stated processes.
Are There Downsides to BusinessCredit Lines?
As with almost everything, credit lines come with their challenges and drawbacks.
Extra costs: Additional costs will vary across lenders and depend on terms of agreement. Even if there is a low interest rate, you can be charged numerous fees later. It is hence important to do your research and compare lenders’ costs and fees.
Borrowing limits: Credit lines typically come in low borrowing amounts. So if you need money for, say, new equipment, an expansion project, or other costly expense, it may be better to apply for a term loan.
Difficult to qualify: Often, you’ll need at least two years of business history to qualify for a business credit line. Among the documents you’ll have to provide are business and personal tax returns, checking account information, business planning documents, and bank account information. You might even be required to undergo a yearly review for maintenance of the credit line. If you do not wish to go through this process, you can apply for a cash advance, small business loan, or a business credit card, which have fewer requirements.
Misuse: A business credit line should only be used as an insurance policy in the case of shortages in cash flow. Using it excessively is not recommended.
If you are not confident that you will be able to repay your balance or if your business is already in major debt, you may want to avoid taking a business line of credit.
Conclusion
When you apply for business credit, it is crucial to establish banking as well as personal relationships. Generally, it is recommended that you apply for funding with a bank that you already have a relationship with. Remember, the fewer risks you pose to lenders or banks, the higher your chance of gaining funding at good interest rates.
Part of what makes a business credit-worthy is bank reconciliation and credit card reconciliation. Not doing them daily could cause failed bank and tax audits, leading to loss of lines of credit. Reconciliation solutions also enable you to prove your books and dispute bank statement charges.
Luckily, you don’t have to look far for experienced accountants who can do this for you. NextGen is a financial accounting company that specializes in providing solid documentation, matching 100% of bank statement transaction details against your entire general ledger.
If you want to maintain a good business credit score with bank reconciliation services, contact us now!
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