After working with businesses for 7 years and watching how some managed their line of credit (LOC) I thought it was important to cover this topic on how to use a business line of credit.
Busines Line of Credit Basics
First let’s understand the LOC. They can be secured and unsecured. Many times, the secured LOC will have a lower interest rate and has more upside as far as available limits. The secured versions are typically secured by real estate (although not the most common option), accounts receivable, inventory, a combination of both or a UCC lien that secures all business assets. Unsecured will usually be a smaller availability and have a higher interest rate. Unsecured are exactly that, unsecured.
A typical line of credit will usually renew annually, depending on the bank, may require updated financials at the time of renewal. Most lines of credit will have a payment structure that is a minimum monthly payment and then the total outstanding due at renewal/termination. There may be variations by bank, but that monthly minimum could consist of interest only or interest only and a fixed amount of principal. If the monthly minimum payment is being made there are usually not too many issues. That is where businesses may start to get into trouble.
How To Use A Business Line Of Credit Overview
Most banks look at a line of credit as short-term working capital facility, in many cases to bridge the gap between payables and receivables. The expectation a bank will have is that there will be large swings in the balances of the line. When the payables come due, you draw down on the line to make those payments. When the AR comes in a significant portion if not all of balance is paid down on the line of credit. A properly used line of credit should see its balances constantly moving up and down.
Where things go wrong is when, it is assumed, that because the monthly payments are being made the line is in good order. That may be the case for a year maybe even 2-3 years. When that line is mostly or fully drawn for several years, the bank is going to get concerned about how it is being used. Sometimes without looking at financials they may conclude the line of credit is no longer short-term working capital.
When a line is fully drawn a bank will review the facility and say those funds should have been provided as a loan and not a line. In turn what may end up happening the bank will take the outstanding funds on the line and convert them into a term loan that will be due back over a period of no more than 5 years. Now in fairness to the bank, if they are holding up their end of the deal, someone should be telling the business owner what is coming. I always let clients know we were not thrilled with the line management, and they always had at least a year to get it under control, if not longer.
But this kind of term out scenario could hurt your business cash flow. Imagine having a monthly payment of $100 and then from one month to the next you now have a payment of $500. I use those numbers as examples, but you would have a much higher payment amount if not careful.
So be mindful when applying for the line, how you will use and manage it. It can be a great tool while a business is growing but it could constrain your cash flow if you do not manage it properly.
If you are interested in having some more conversations about applying for a line of credit or other credit facility, please click the link below and visit our partners at National Business Capital.
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