When you hear “business financing” what comes to mind? We’re not psychic, but we’d be willing to bet that the first thing you thought of was a traditional term loan. That makes sense as they’re a commonly used option.
However, you should also know about a business line of credit and how it’s used to manage cash flow. A versatile way for small to medium-sized enterprises (SMEs) to get the working capital they need — its use-what-you-need-as-you-need-it structure is what makes it distinct.
How a business line of credit works
Think of a business line of credit (revolving line of credit) as a hybrid between a loan and a credit card cash advance. To begin, you work with a business lender to get approval for a fixed sum of capital.
The next part is the biggest divergence from a traditional term loan:
- Although you can use up to the full amount for which you’re approved, you don’t have to.
- You can make what’s called a “draw” — borrowing an amount you choose.
- You only pay interest on the amount you take from the full line of credit.
- Once you’ve paid back any amounts drawn, they’re available again for future use.
- When you need capital, you simply draw against your approved credit line. Draw up to your limit or just a specific amount — it’s up to you.
How to apply for a business line of credit
Qualifying for a business line of credit isn’t as difficult as many other business funding products. Generally, these applications require less paperwork and financial history than term loans.
Many of the lenders who offer other types of business financing — both banks and online lenders — also offer business line of credit products. (Banks are more selective than online lenders, as expected.)
Requirements vary from lender to lender:
- Some lenders care more about your revenue and personal credit score.
- Others, about your time in business.
- In general, a combination of these three factors is used to evaluate your risk as a borrower and determine your eligibility and terms.
Prior to applying for a business line of credit — or any business funding — you’ll need to know a few things solidly:
- First, your personal credit score, which will play a big part in the approval process.
- Next, basic business financials: At a minimum, your revenue and your business bank account balance.
- Most importantly — you need to have a thorough sense of the cash going into your business and the cash going out.
Cash flow is among the best indicators of a business’s financial health, so lenders will be looking. Our cash flow forecasting is a powerful tool to get your cash flow picture — and it includes a risk score based on your current financial data.
How a business line of credit is set up
Hearing like a business credit card might make you think that these financing tools aren’t powerful.
But, business lines of credit can go into the millions of dollars — and major corporations have different types of business credit lines at the ready. For instance, Facebook established an $8 billion line of credit before it went public in 2012. (Sure, that’s not quite the same stratosphere — but you see what we’re getting at.)
As an SME, you’ll work with a lender to get approved for an amount that makes sense for your business.
- Many lenders establish a line of credit for as little as $5,000.
- Because you don’t receive any money up front, many business lines of credit are unsecured.
- For larger amounts (sometimes upwards of $100,000, though this is dependent on your lender), lenders will occasionally issue a blanket lien to collateralize your loan.
Where to get a business line of credit
To get a business line of credit, you can either:
- Go through a bank that will have stricter financial requirements but better rates. It also might take slightly longer than an online lender but will still be faster than a term loan.
- Use an online lender that will be more lenient requirements but charge higher interest. If you’re qualified, you could see approval in fewer than 24 hours — which means access to funds in just a few days.
An example of how a business line of credit can be used:
Maybe you own a boutique fitness studio, and the carpet in one corner of your main exercise room is worn away. Replacing the carpet overnight will cost $1,400.
With a line of credit of, you can draw:
- $1,400 for the full cost.
- $1,000 and take the other $400 from the cash you have on hand.
- $1,500 just in case the job cost goes over.
Basically, the draw is at your discretion. Whichever you decide, you’ll only pay interest on the amount you draw. The unused amount on your line of credit isn’t subject to any interest and is still accessible at any time.
Your lender will assess repayment terms when you’re approved for your business line of credit. That includes an interest rate as well as a period in which your draw must be repaid, plus that interest. Generally, that time frame falls between six to 12 months (again, it’s specific to your lender).
A business line of credit is revolving credit
Most business lines of credit are what’s called “revolving.” This means that once you’ve repaid the full amount you’ve borrowed, they re-up. You’ll have access to the full amount again. This makes them a fantastic tool to keep in your back pocket, so to speak.
5 advantages of a business line of credit
1. It works with other business financing options
Because many business lines of credit are unsecured, SMEs are able to use them in tandem with other secured loans.
With other kinds of business financing tools, taking out multiple collateralized loans — what’s called “stacking loans” — is not only bad for your credit as a borrower, it can also violate the terms of your initial secured loan. That means you automatically default.
A business line of credit, however, is designed to work with other types of business funding products. By definition, it’s an extremely flexible financing product for working capital.
It works well alongside a term loan you’ve taken out to build an additional location or to supplement additional unforeseen expenses. Or, if you use invoice factoring to release money tied up in trade credit, a business line of credit is the logical partner to accomplish whatever you need to during cash flow crunches.
2. It has interest rates you can work with
No one likes paying interest, of course. But, it’s much better to pay a little interest rather than a lot.
We mean that in two ways: First, as a borrower, you won’t pay interest on anything more than you draw. As you monitor your cash flow with cash flow forecasting, you can make informed decisions about how much interest you’ll be able to handle. And then, of course, only draw funds based on what you’re certain you can repay. (Assuming you’re using your money for an investment, not an emergency, naturally.) This calculated approach isn’t only great for building credit, but it’s also the mark of a financially responsible business owner.
Secondly, even though interest rates will vary depending on your lender and creditworthiness, generally, your business line of credit annual percentage rate (APR) will be less than the one on your business credit card. Having access to a business line of credit will save you money in the long run so you’ll never have to carry an expensive credit card balance.
3. It’s a credit-building tool
One thing SMEs know better than anything: Credit rules everything around you. Or, at least, enough that you have to make certain your credit report is as good as possible — and, if it isn’t, that you’re constantly trying to improve it.
A business line of credit can contribute substantially to building your credit. By borrowing against your credit line and paying back the amount in full and on time — the same way you would a credit card bill — you help prove responsibility with debt. That incrementally raises your credit score (risk profile) and will help you open doors for your business.
4. Once it’s approved, the cash is always available
Once you’re approved for your line of credit, you don’t even technically have to use it. Sounds strange to say, but it’s true. It’s unlike other types of business financing in which once you’re approved, your clock starts ticking on your repayment and your interest starts collecting on your entire sum.
Many business owners have a business line of credit simply to know they have it. That way, they can pursue whatever they need and not have to worry about their cash flow situation. In a way, it’s similar to invoice factoring — a resource you know you always have at your disposal, but don’t need to tap into unless you choose to. And, if you do so strategically, can be a savvy move.
5. It’s useful for growth or emergencies (or both)
A business line of credit is arguably the most flexible financing product on the market. Since it’s a working capital loan, you’re not tied to one use case for the money. Essentially, if you have an expense, a business line of credit can likely address it.
That means it’s as useful for financing investment and growth opportunities as it is for addressing disasters. For instance, if you run a tutoring center, you might draw from your credit line to hire new staff to add services for STEM programs, including computer science and robotics tools and applications. But, you can just as easily use the money to buy a new window ASAP when a robot war gets out of and casualties ensue.
A few closing thoughts…
As ready as you might be to spring into action and apply for a line of credit, make sure you’ve done due diligence… on yourself. You know lenders will be scrutinizing every last decimal place of your financials, right? Then you better be doing the same.
Open up your own tool chest and use the best possible equipment you have to get a sense of what kind of assets you have — and what kind of borrowing risk you’ll pose. As we mentioned, cash flow is the best place to start so you can understand how likely you’ll be to pay off your loan balance.
See how the money is flowing in and out of your business and how potential lenders view your business in terms of risk. Getting started is easy: Simply create a PayPie account then connect your business accounting software.
PayPie currently integrates with QuickBooks Online. Additional integrations are coming soon.
This article is informational only. It does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
Images via Pexels.