How Does a Business Line of Credit Work

William Anderson

Running a business requires a constant and regular flow of cash to finance many of its core activities. While it is ideal that all the cash that the business needs is derived from sales of its products or services, that is not always the case. That is why it is very common, necessary even, for business owners to apply for various funding options including small business grants, and one of the most popular and useful ones is the business line of credit. But what is it exactly and how does it work?

What is a business line of credit?

A business line of credit is a form of financing that enables a business owner to withdraw any amount from a fixed credit limit, provided he or she does not exceed that limit. It is very similar to a credit card facility, except that with a business line of credit, the client can withdraw cash. As with credit cards, business owners only need to pay interest rates on the amount they withdraw at any given period.

Unlike regular business loans, business lines of credit are funds that are not usually allotted for a single purpose. It is usually acquired by business owners as a general fund source to be used depending on a specific need of the business at a certain period. In short, it is considered a standby fund that can be used when the need arises.

But in the same manner that it is similar to credit cards in enabling multiple withdrawals or uses, in a business line of credit, the interest rates for every withdrawal that overlaps roll over and can accumulate, just like with the best small business credit cards. So, if left unmonitored, fees associated with a business line of credit can become costly very quickly.

Unsecured and secured business line of credit

A business line of credit, just like a regular business loan, can either be secured or unsecured. An unsecured business line of credit means your application can get approved even without collateral, which can be properties you own like your house or a vehicle. Bank and lending institutions have different ceiling amounts of when they begin asking for collaterals as part of the application, but generally, amounts below $100,000 are usually granted even without collateral, and anything above that amount can fall within secured business line of credit.

How does one acquire a business line of credit?

The application process for a business line of credit differs slightly from one lending company to another, but generally, it is very similar with applying for a regular business loan. Banks or lending companies would usually require submission of documents such as tax returns, business registration papers, bank statements, among others. They also usually require that the business has been running profitably for a certain amount of time before being eligible for a business line of credit, as this reduces the risk of late payments or account defaulting.

How does a Business Line of Credit Work

Advantages and disadvantages of a business line of credit

Business lines of credit are one of the most useful funding sources for many businesses. But as with other financing options, there are inherent advantages and disadvantages to choosing a business line of credit as your option. Here are some of them:

Pros

Standby credit

business owners usually conduct financial planning often, either at the start of the year of after a production batch to predict at which point the business would need additional funding or probably experience a less-than-ideal cash flow. But there are many factors or situations that can be impossible to predict, such as accidents, natural calamities, or even sudden economic shifts that can greatly affect business operations. This is where a business line of credit can be incredibly useful.

With regular business loans, a business owner would have to go through the entire application process every time he or she needs additional funding, which can take months to finish. In business-critical situations, this is just not an option. With a business line of credit, you can immediately get cash you need to stem any financial needs that may arise. For many businesses, this form of financial security is critical to its survival, especially for enterprises that rely on cash transactions on a regular basis.

Cash savings and flexibility

With a business line of credit, you only pay interest rates for the amount you withdraw at any given time, and not on the entire amount. So if you have a $100,000 line of credit and you withdraw only half of that for a purchase or expansion project, you will only pay interest rates for $50,000. This is not the case with a regular business loan. If you get approved with a loan of $100,000, the bank or lending institution will not care whether you actually use the entire amount or not. They will charge you interest rates for the entire amount. This means the business must be really accurate with the amount they would apply for, which is often difficult because as mentioned, there are many factors beyond the control of the business owner. Business lines of credit offers an alternative that affords businesses the financial flexibility in using their cash.

Building a good credit rating

If you apply for a regular business loan and you are diligent with paying its monthly payment terms, then you will have a positive record on your credit rating for just one account. With a business line of credit, however, every time you pay off your withdrawal amount, it is indicated as a positive record on your credit history. And with business owners having the ability to withdraw multiple times as long as they do not go over their credit limit, they can significantly improve their business’ credit history. For businesses, more so than for individuals, a good credit history is very important in order to qualify for other funding options in the future. And the fact that you only need one application for a business line of credit for this benefit is certainly a big advantage for businesses.

Cons

Cost

while a business line of credit can be cheaper in the long run, it can also be more expensive if the business owner was not able to create a sound financial plan. This is because most banks and lending institutions require an upfront payment for opening a business line of credit, and in some cases, they also charge a maintenance fee. While these fees are certainly smaller than having to pay interest rates for a lump-sum amount as you have to with a regular business loan, these fees can accumulate if left unmonitored. So, it is best to be diligent with payments and you should also make sure to be well aware of the fees included in your business line of credit.

Difficulty of approval

Since a business line of credit offers lower interest rates than a regular business loan, banks and lending companies are generally stricter when it comes to getting approved for a line of credit. Aside from the business documents that they usually require, even business owners can also be asked for their financial documents such as tax returns and credit history. Also, if you do get approved for a business line of credit, banks and lending institutions usually conduct annual credit reviews on your account. So, if at any point you miss a payment or paid late, then it can be taken against you in the assessment, and your business line of credit can be revoked.

Easier to mismanage

Because business lines of credit offer an easy and very convenient way to augment your business funds, it is also very easy to rely on it for less-than-necessary business expenses. For example, you might be tempted to withdraw from your business line of credit to increase your rate of production and buy more equipment instead of trying to stick to your financial plans and wait until your sales pick up. This scenario can financially cripple an organization in the long run if they become too aggressive with their spending just because they already have a business line of credit. A business line of credit can also render a financial forecast useless as it provides an illusion of extra cash, when in fact, it is actually a liability and debt. This can be dangerous if companies fail to realize that they do not actually own the cash that the limit of their business line of credit indicates.

Risk acquisition

Despite its numerous advantages and obvious uses for businesses, a business line of credit is, at the end of the day, is a risk that the business is taking on. Some businesses are better at calculating risk than others, and for them, a business line of credit would be a very effective tool. But for others that are too aggressive and are not diligent with their research and planning, a business line of credit can be significant financial burden. Also, if your business acquired a secured business line of credit, the property that was submitted as collateral can be sequestered in the event that the business defaults on the payments.

When you fail to pay on time, your business line of credit can negatively impact your credit rating and, depending on the structure of your company, the business owner can even be personally liable for the loan. This means that even if the company declares bankruptcy or closes without paying off its business line of credit, the business owner might still be required to personally pay it off, as would be the case if the business in question is under sole proprietorship.

How does a Business Line of Credit Work

Tips when acquiring a business line of credit

Do your research

Doing your research as to which bank or lending agency offers the best terms on their business line of credit will pay huge dividends in the long run. Do not go ahead and apply for a business loan with the first lending company you see online. There are plenty of options and many different fees and term structures available, so study them carefully first and make sure they align with your business’ current financial situation to make the most out of your business line of credit.

Plan ahead and apply for a business line of credit even before you need it

The beauty of a business line of credit is that you only pay for what you use, so it makes sense to apply for it even before the time that you will actually need the funds, provided that you have a comprehensive financial plan in place. As mentioned, you will still have to pay minimal fees with a business line of credit, but if you can anticipate with relative accuracy when you will probably need additional funds, then you can have an available source of fund when that time comes. In this manner, you would not have to scramble and rush your application, which gives much less leverage to negotiate.

Make sure there are rules in place to prevent mismanagement

As mentioned above, your business is taking on additional risk when acquiring a business line of credit. So, it is imperative for business owners to put in place rules and guidelines in the use of the business line of credit so as to prevent it from being misused. The accounting or finance department must be well-informed and aware of the limits of the line of credit, and for what purposes it can be only used for. This assures that the convenience the business line of credit offers is not going to be a disadvantage to the company and cannot be used for unnecessary expenditures.

Used judiciously, a business line of credit can be one of the most effective financial tools a business can have and, in some instances, can even save a business from closing due to financial problems. You just have to make sure that you know the ins and outs of this loan facility so you can maximize its advantages outlined above and minimize its inherent risks as much as possible.

William Anderson
Senior Business Consultant

William Anderson has been working with small business owners for the past 10 years. He got his start at an investment bank, but felt that he was too detached from where real people were making decisions that affected local economies. As a result, he took his experience and his MBA degree to work helping local small businesses.