The following is a guest post by Tiffany Rowe. Tiffany is a Marketing Administrator at Seek Visibility, where she assists clients in contributing resourceful content throughout the web.
Most entrepreneurs know about the typical types of funding: loans, investors, venture capitalists, bootstrapping, and the like. Most even know a bit about business lines of credit – but few know nearly enough to effectively acquire a line of credit, let alone use it successfully to build their businesses.
Lines of credit are outstandingly beneficial resources for businesses, especially startups and small businesses eager to grow. However, obtaining and using a line of credit isn’t as easy as most expect. This guide will help business leaders understand what a line of credit is, how to get one, and how to use it to the greatest effect.
The Purpose of a Line of Credit
The easiest way to explain business lines of credit is to compare them to personal or business credit cards. Like credit cards, lines of credit allow businesses to recurrently draw from a maximum credit allowance and make small monthly payments to their lenders. With a small business line of credit, you have more control over the size of your loan, which ultimately gives you greater control over your business expenses.
There is a wide variety of types of credit lines used in business. For example, you might need an asset purchase line of credit to help you buy equipment or property necessary to expand your business. Alternatively, you might want a working capital line, which will help you bridge the cashless gap between completing projects and receiving payments from clients. Additionally, lines of credit can vary in terms, from short, high-APR lines to long, low-APR lines. It is important to understand the available terms from possible lenders before you take out a line of credit.
Typically, the purpose of a line of credit is to help your business quickly acquire sums of cash that will immediately be reinvested into the business. Lines of credit are best when you are relatively certain a boost to your capital will cause business growth. Usually lines of credit aren’t particularly advantageous for a brand-new startup or a business trying to stave off failure because both will struggle to make monthly payments on the credit line. Still, lines of credit are invaluable tools for business leaders who need a moderate cash infusion to get ahead.
Getting and Keeping a Line of Credit
Unfortunately, there is a pervasive myth that lines of credit are exceedingly easy to acquire – which is why new entrepreneurs and other inexperienced business leaders like to turn to them in times of need. A lender uses three criteria to evaluate a business’s creditworthiness: credit, cash flow, and collateral. A business that lacks any of these elements is simply ineligible for a line of credit.
Entrepreneurs must have good personal credit reports. Lenders use the personal credit scores and histories of business owners to determine whether they have good character. If your personal credit isn’t fantastic, you might not obtain the terms you want from your line of credit.
Businesses must have healthy cash flow. Lenders don’t make money if they aren’t repaid, so it is vital to them that your business have at least the income necessary to make regular payments. Furthermore, lenders will typically only consider businesses that have at least two years of operating history, precluding new startups from applying.
Entrepreneurs or businesses must offer valuable collateral. It is possible to use personal property, business equipment, and other valuable assets to back the line of credit. However, it is always possible that you will lose your collateral, and you must remember that while you make your deal.
Keeping a line of credit can sometimes feel just as daunting as acquiring one. Loan agreements tend to include covenants, or rules, that hold the business to certain standards, such as maintaining particular financial ratios, making minimum monthly payments, or using the line in prescripted ways. Failing to uphold your covenants is grounds for dissolution of the line – though you will need to pay back whatever amounts you already used.
Still, lines of credit aren’t impossible to manage. As long as you have healthy finances and a strong business plan, your business should only benefit from the availability of cash provided through a line of credit. Over time, you can increase your line of credit to add even more capital to your business, ensuring its continued growth. All businesses need funding, and lines of credit are excellent options for the informed business leader.