Business Line of Credit - Pros/Cons and Alternatives

Pros & Cons of Business Line of Credit

Entering into a business line of credit, particularly for the first time, can be time-consuming. However, once a line is up and running the business begins to develop and earn a credit profile of its own. Often the terms, conditions, and restrictions imposed by the line of credit begin to be seen, in time, as essential disciplines. Even a journey of a thousand miles begins with a single step. Corporate giants like Proctor & Gamble, IBM, and GM all started a business line of credit at some point.

What is a Business Lines of Credit?

Business lines of credit generally share these characteristics:

  • Structured as lines of credit in the name of the company. It is possible to repay and reborrow funds up to a certain prescribed credit limit. As such, interest is charged only on funds employed. There are no set repayment requirements (unlike a term loan where a lump sum is advanced at the outset, and then repaid based on an established schedule)
  • Pricing is a floating rate, tied to an index (e.g., Prime Rate) Rates can vary from near Prime to Prime + 3-5% per annum depending on the overall risk profile of the borrower, plus “one time” set up fees
  • Can be used for any general corporate purpose – Payroll, Paying Vendors, Taxes, Rent, other expenses

What are The Benefits of a Business Line of Credit?

  • Designed to provide the necessary working capital
  • Flexibility to pay expenses, and cover other general purposes
  • Scalable to help manage cash flow, seasonal needs, unique opportunities
  • Lenders begin to adjudicate credit decisions based on the financial strength of the company, not just the owner
  • Ease of bookkeeping in reconciling personal vs. business expenses

The downside of a Small Business Line Of Credit:

  • Choosing the “right” lender is critical. The “wrong” lender, even one with an attractive product offering, can ultimately cause more difficulties
  • Can be time-consuming and challenging to put in place
  • Can be difficult to administer

Why Do You Need A Commercial Line of Credit?

A small business line of credit is governed by specific ongoing requirements, such as:

  • Limitations on taking on additional debt
  • Restrictions on dividend payments or other capital leaving the business
  • Limitations on owners’ compensation
  • A requirement the business provide monthly or quarterly financial statements, possibly accompanied by other miscellaneous financial reporting
  • Annual update of the owner’s financial statement

How a Small Business Line of Credit Works?

  • In most cases, the lender files a first lien on all the assets of the business. Exceptions are made for leased equipment (such as photocopiers and other office equipment), heavy equipment used in manufacturing which may already be financed by a vendor or specialty equipment lender, and other assets such as real estate. In these cases, the business line lender typically takes a “second” security interest behind the other lenders. It is a common practice and taken by itself, does not disrupt any existing lease or term lending arrangement.
  • It requires the business owner to personally guarantee the entire debt. Meaning that in the event of a liquidation or cancellation of the line the owner will be required to come up with personal funds to make good on any remaining obligation. In some cases where the business itself is judged to be a high-risk candidate, the lender may require a “collateralized guarantee” from the owner requiring a specific pledge of outside asset support (securities, property, etc.)
  • Lines are normally made available on a “demand” basis, meaning the line is subject to being called or modified at any time. Business lines of credit are administered under a form of loan and security agreement which sets out the general terms of the facility, along with the lender’s remedies in the event of a default. Generally speaking, so long as the business remains in compliance with the terms and conditions of the business line, financial institutions rarely cancel outstanding lines of credit

How Can My Business Qualify For a Business Lines of Credit?

A first-time applicant can expect a rigorous and, depending on the lender, sometimes lengthy process.
Among the documents expected to be furnished:

  • Last three years financial statements of the business (P/L, Balance Sheet, and Cashflow statement)
  • Interim financials year to date for the current year, along with same period from last fiscal year (for comparative purposes)
  • Copies of bank statements
  • Business tax returns for prior three years
  • Personal identification –driver’s license, passport, citizenship status
  • Your personal financial statement
  • Personal tax returns for previous three years
  • Bio including details of prior business history and education
  • Authorization to run a personal credit check, and a background check

How Is The Credit Decision Reached/ Adjudicated?

Institutions differ regarding the process, but most business lines of credit are designed based on an assessment of the following criteria:

  • Length of time in business. A company that’s been around 20 years has most likely dealt with more success and adversity than a company in the industry for three years. History is arguably a proxy for future performance. The longer the track record, the easier the access to credit.
  • The strength of business financials. Most business lines of credit are granted on the strength of the balance sheet and quality of the working capital assets. Are the accounts receivable of good quality? Do client’s pay as agreed? Are there any disputed invoices, or “short pays” from clients? How many days of sales remain uncollected? Does the inventory turn sufficiently often?
  • Collateral. Does the business have pieces of unencumbered assets that can be taken as backstop collateral, or is the business “fully lent”?
  • Personal credit score. Another proxy for how your business will meet its obligations is how you have met yours
  • The strength of a personal financial statement and evidence of worth outside the company.

What Are Other Alternatives to a Business Line of Credit?

There are alternative and easier ways to finance a small business which also deserve consideration, including invoice factoring and purchase order finance. These methods are straightforward to put in place, more comfortable to administer and can provide a range of flexibility suitable to the needs of most growing companies, even start-ups.

Other alternatives, such as “merchant cash advances,” are also easy to establish, but deserve special mention and added caution because of their relatively high notional cost, and difficulty in unwinding.

Aside from traditional lines of credit discussed above, there are several alternative sources of financing for a business that is easier to arrange, simpler to administer, and equally accepted. Arguably more flexible, they may also be suitable for a larger universe of potential business users.

Invoice Factoring

Under Invoice Financing arrangement, a business sells its unpaid accounts receivable to a lender for immediate cash at a discount to face value. Since it’s a sale and not a loan, invoice discounting agreements can be consummated in a matter of days with a minimum of paperwork. Unlike business lines of credit, start-up companies and businesses where the owner has bad, or no credit history qualify for Invoice Factoring.

The cost is higher than a business line of credit. Typically 1-2% per month on uncollected receivable. However, if there is sufficiently sizeable gross margin embedded in the product being sold, then the acceleration of cash flow and ease of doing business can make this a highly attractive technique. Invoice discounting is broadly recognized and used by small and large companies alike.

Purchase Order Financing

Under Purchase order Funding, a lender will help a borrower pay for supplies and materials necessary to fill an order it has received from a creditworthy buyer. The lender is repaid directly by the buyer of the end product. The credit decision rests on the strength of the buyer, so start-up companies, first-time borrowers, and business owners with poor personal credit all potentially qualify.

Costs here are understandably higher than Invoice Funding.

Merchant Cash Advance

MCA is a technique where “lenders” provide a lump sum to a business, and then are repaid daily out of credit card or debit card receipts. Payments are made directly from the credit card processing company to the lender. Technically the structure is not a loan but rather a sale of future credit and debit card payments. It has allowed Merchant Cash Advance companies to operate in a largely unregulated market, charging much higher rates of interest. A possible short-term solution for some companies, it should be considered cautiously.

Caveat Emptor

“Buyer beware.” An overarching consideration in entering into a business loan or funding of any kind, is not just “what am I doing, but with whom?” Service after the sale is no less critical in business financing than in any other commercial interaction. Understanding how your lender or financing source might behave and treat you –in good times, and bad—is essential. Developing a sound business relationship with a good lender can be a rewarding experience, both professionally and personally. Just as a prospective lender takes the time to review your background and experience, you take the time to solicit and review references on them. A lender’s product offering is essential. Customer service and a business-like approach to setbacks and opportunities are critical.

Start Today!

Wondering if a business line of credit is right for your company? Call us today, and we can help begin today.

We have over 20 years of experience and 99% customer satisfaction rating. We will take the time to listen and understand your challenges and opportunities. Moreover, we will suggest the best alternative.

Why talk to us? Because we’re headed the same way, you are—forward.

Ready to solve your cash flow issues? Call 866-598-4295 or use the fast, safe & secure online funding application.

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