A line of credit is one of the most common and helpful financing tools used by small businesses. It allows a company to draw on preapproved funds to meet routine operating expenses like filling short-term liquidity needs and making seasonal inventory purchases.
Once approved for a line, you can borrow up to your limit at any time, sometimes simply by writing yourself a check. In other words, you don’t have to reapply each time you want to borrow money. As you repay your line, more funds become available for you to use as needs arise.
Lines of credit are considered short-term loans, with interest generally due on outstanding amounts every 30 days. They may be secured by collateral or unsecured, depending on your company’s borrowing history. Most lines are structured to mature in one or two years, and before that maturity date, the bank may ask you to demonstrate your ability to “clean up” the line by paying it down to zero for a predefined period of time, typically 30 consecutive days. The bank may then renew the line at its discretion.
However, some lines are structured as “demand” lines of credit. These don’t have a maturity date. Rather, the bank has the right to demand full repayment of the line at any time. Be sure you understand the differences and the potential implications on your business before you sign up for one of these. Lines due on demand will normally be reviewed by the bank on an annual basis.
In a secured line of credit, a bank will loan a percentage of the value of the collateral you put up. Banks accept three primary types of collateral: accounts receivable, inventory, and business assets (equipment, computers, furniture and fixtures, etc.). The bank may also require a personal guarantee for the line and/or the pledge of a personal residence as additional collateral.
If you’re considering inventory as collateral, you should know that there are three primary classifications of inventory: raw materials, work in progress (or WIP), and finished goods. Banks value these types of collateral in different ways. WIP is the least valuable because there’s not much demand for unfinished goods. For example, there aren’t many potential buyers for a half-built machine tool or lawnmower.
Banks may lend up to 50 percent of the value of raw materials and finished goods, and less (if anything) for work in progress, depending on how marketable the WIP may be. So if your business can pledge $100,000 worth of raw materials and inventory as collateral, you might be approved for a line of credit up to $40,000 or $50,000.
If you pledge accounts receivable as collateral, banks will lend up to 80 percent of their value, but there may be some exclusions. The bank may not want “aged” receivables (e.g., those more than 60 or 90 days past due) or receivables concentrated on one customer (e.g., receivables from a customer that represents 75 percent of your business’s gross receipts).
If your business has very good credit, the bank may approve you for a signature line, in which case you can simply write yourself a check for an amount of money up to your preapproved limit. Or it may require completion of a borrowing base certificate each month or upon each draw. The borrowing base certificate provides a recap of your current collateral status. It shows the bank how much you currently have in outstanding accounts receivable and how much is eligible to be included in your margined collateral base. By backing out your outstanding balance, you can then see how much money you’re eligible to borrow at that point in time.
Read Part Two: “Tips for Getting a Business Line of Credit.”
Read Part Three: “Managing and Protecting Your Business Line of Credit.”
Read Part Four: “When You Should (and Shouldn’t) Use a Line of Credit.”