A line of credit can be an invaluable tool for many small business owners throughout the United States; however, not many small businesses may have opened a line of credit. They might have some questions about this type of financing. Is a business line of credit a good choice for my business? What are the requirements for a business line of credit? Let’s get in to it.
What is a business line of credit?
Firstly, a business line of credit is a revolving line of credit that one can draw against on an as-needed basis. It's usually used for short-term working capital to help improve cash flow, or to finance the costs of surprise expenses. A small business line of credit is revolving, and this is the major distinguishing characteristic. Another characteristic is that a subsequent draw(s) taken after the initial funding are only restricted by the approval amount and not a pay-down requirement. In other words, the small business can access the line of credit as long as the small business has not hit its high credit limit.
How does a small business line of credit work?
A small business line of credit is very much like a credit card in the way funds are accessed; however, the way it is paid back usually differs greatly from the way a credit card is paid back. There is also a significant difference in the way interest is calculated. The merchant is approved for a specified high credit limit. The limit is not a lifetime one, as is the case with certain term loans, but rather the highest dollar amount a merchant can borrow at one time. Another way of looking at the high credit limit is the highest level and balance it can reach. At that point, no more funds would be available until the balance is paid down. Unlike a term loan (where a specific amount is paid back over a defined term), a line of credit allows the small business owner only to borrow the amount needed at any given time. This type of funding helps mitigate the ups and downs of cash flow, especially while waiting to collect on receivables.
The flexibility of a line of credit is attractive, but it doesn’t mean that it always makes sense to establish a line of credit. A small business line of credit has a few drawbacks. For example, the most obvious disadvantage is the amount of funding. A small business line of credit will usually have a lower amount offered than a small business loan. If a business owner or owners need access to a large amount, a working capital loan or term loan will probably make more sense. A small business will generally qualify for a small business loan amount between 25 and 75 percent higher than with a line of credit. In other words, if a small business is offered $60,000 on a line of credit, the small business loan approval will generally be approved for between $75,000 and $105,000.
Are there different types of lines of credit for small businesses?
Just like most products in our economy, there is more than one type of small business line of credit. Generally, these lines are categorized as either secured or unsecured. A secured line of credit is backed by collateral. This collateral could be inventory, equipment, real estate, or some other asset with a market value high enough to justify the credit limit. The other, a probably more popular type of line of credit, is an unsecured line of credit. This type of small business line does not require any assets of value to be pledged to establish the credit line. An unsecured line of credit is based on the cash flow and debt ratio of the small business, as well as the credit of the business owner or owners and the business credit of the entity itself.
When and why would a line of credit be a good option?
A line of credit is a great option, especially when a small business has multiple projects going on simultaneously but with different start and completion dates. For example, a construction company that needs to pay for supplies and payroll on multiple products can use a line of credit to help ease the strain on cash flow while awaiting payments for completed or near-completed projects. A line of credit also is a great idea for a business that has some seasonal highs and seasonal lows. A line of credit might not be as viable of an option for a small business that is working on a long term projected.
So now that we have an idea of the small business funding products currently on the market, the different types of lines of credit available, and when a line of credit is the best option, it is time to examine the requirements for a small business line of credit. Both a secure line of credit and an unsecured line of credit look at the same underwriting requirements, other than the assets (or lack thereof) being used to secure (or not secure) the funding. The other requirements are similar. So, for the remainder of this blog, we’ll focus on the requirements for an unsecured small business line of credit.
Requirements for a business line of credit
Time in Business
The first requirement for a small business line of credit is the business’s age. The longer the time in business, the lower the risk grade and the great probability of being approved funding. For any company with less than one year in business, there are some good micro-lines of credit, but options are somewhat limited. For a business with more than 12 months under its belt, but less than 24 months since the date of its inception, there are good options for starter lines of credit. A starter line of credit will generally have a lower high credit limit and possibly a slightly shorter payback term. If the business has had a longer history, the more options are at its disposal. So, as long as an entity has been established for at least 24 months, an underwriter is not restricted in programs or terms offered.
The next requirement for a small business line of credit is revenue. For a business that is smaller in scale (less than $200,000 in gross annual revenue), the best options are probably micro-lines of credit. For a small business between $200,000 and $500,000 in gross annual revenue, a smaller revolving line is a possibility. For companies with greater than $500,000 in annual revenue, a flexible line of credit is obtainable if all other criteria or requirements are met. One thing to keep in mind is the greater the revenue, the greater the potential high-credit limit.
Financial standing concerning debt
The next consideration is the overall debt picture and the debt-to-revenue ratio of the small business. A company with $2 million in gross annual revenue, but a high level of debt load and debt payments, will have a more difficult time meeting the requirements. On the other hand, a small business seeking a line of credit with $1 million in gross annual revenue but little or no debt will have a much easier time qualifying. The amount of overall debt will be weighed heavily in underwriting decisions.
Profit and cash flow
Similar to debt ratio requirements, most lines will have a profitability or cash flow criteria. This is not exactly the same as gross revenue. Net revenue or net profit might be reduced based on accounting methodology. Cash flow analysis examines the affordability of the line of credit for the business. Underwriters are most concerned with whether a small business can afford its payment. If the business can do so, underwriters will also want to know how much of the payment it can afford to pay, given their current levels of revenue and cash flow stability.
Industry and use of funds
The next consideration is the business’s industry and use of funds. A line of credit program requires that the industry not be restricted, as some of these programs place restrictions against funding for certain industries. Also, the terms offered and cost of funds might differ across industries based on the perceived risk associated with that particular industry. The use of funds will also play a role in persuading an underwriting decision, especially when there is a consistent and aggressive return on the use of funds with short turn-around time. An underwriter is also likely to consider if the use of funds is consistent with the industry and proposed use. Essentially, you have to be allocating and using the funds for expenses which are relevant to your industry.
Last but not least, creditworthiness is a crucial factor. The credit of the business owner(s) will be examined. This is not the same examination and process as it would be for a consumer loan. The credit is not examined because the line of credit will report to the consumer (personal) credit bureaus. Rather, credit score, depth and history are examined to make sure business ownership is creditworthy. Recent bankruptcies, foreclosures or repossessions will likely kill an application for a line of credit. Also, late payments or defaults on credit cards are likely to hurt the possibility of obtaining a small business line of credit.
An additional factor for qualification is business credit. Business credit is required for an application to be approved. Regardless of personal credit, a line of credit is more likely to be approved if a business has better credit. That being said, it’s always good to strive to have good personal credit. A company that is past due or in default on vendor debt is not likely to be approved, even if the owner has a stellar personal credit score. The overall creditworthiness of the business and ownership structure is highly regarded as an underwriting requirement for a small business line of credit.
The Bottom Line
Obtaining a small business line of credit is a potentially important aspect of financial health and growth for a small business. A line of credit is great for short term uses without affecting the leveraged position of a small business. Realistically, the requirements are not too different from the qualification for other business financial products. To put yourself in a good position to obtain a business line of credit, ensure your business has been around for over a year, brings in a decent amount of revenue, shows a good profit, cash flow and strong credit. If you have put yourself in a solid position with these factors, you should be in good shape to acquire a business line of credit.