Many lenders offer business lines of credit to small businesses. These types of loans allow a lender to set aside a maximum amount of funds and businesses can use these funds as needed. Interest only accrues on the monies that are used.
Different from a business cash advance, a line of credit is a short-term business loan. It is similar to a credit card, where businesses only pay back the money they use and once the principal is paid back, the money is made available for future purchases.
These types of loans are ideal for handling ongoing working capital, allowing businesses access to short-term cash flow. For example, businesses can use lines of credit to pay payroll or rent if scheduled account receivables are late. These types of loans are also superb for financing seasonal expenses, such as cyclical business fluctuations and inventory purchases. Some companies simply use a line of credit to pay invoices early so they can receive discounts.
Lines of credit do not have the same application fees that are associated with credit cards and only accrue interest on outstanding monies. Businesses should not use a line of credit for long-term financing, as this can put a significant drain on operating expenses.
Lenders look at a business’ cash flow when granting a line of credit. Companies that have strong account receivable contracts in place, good credit history and are able to secure their line of credit have a higher likelihood of receiving this type of loan. However, there are hard money lenders that will provide these types of loans without strict criteria, charging higher interest rates in return for sub-par collateral.
The amount of the line of credit depends on the business’ specific assets and financial needs. Generally, businesses suggest that using 75-80 percent of their credit to help cover average operating expenses, with the remainder of the line of credit available for emergency purposes. Businesses need cash flow to pay down debt to zero for a minimum of one month annually. If businesses are unable to do so, they have borrowed too much money and this can be an indication that sales and receivables are down.
The best time for a business to obtain a line of credit is when they do not need one. Lenders are more likely to provide businesses with a line of credit when their cash flow is strong. This allows businesses to tap into money well before temporary or seasonal fluctuations. Companies and startups with negative cash flows have a more difficult time obtaining lines of credit. It is best to be proactive and obtain a line of credit before a company does not qualify or is high-risk.