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Should you get a small business line of credit? Pros & cons (plus, 10 questions to ask)

Cash is king.

You need cash to operate your small business, and many successful firms struggle to manage cash flow. You have to pay vendors and serve customers, while managing accounts receivable and collections. Sometimes, the payments don’t come in fast enough, and you need more cash to operate.

A business line of credit may be a solution.

What is a business line of credit?

A line of credit (LOC) is a short-term business loan that allows the owner to borrow up to a specific credit limit amount. The loan is used for short-term needs, such as making payroll or financing inventory purchases.

Small business owners may borrow and repay a portion of an LOC balance several times in a given month. LOCs have shorter loan maturities, compared to a traditional business term loan.

Not all firms need a small business line of credit to operate.

Do you need a line of credit?

Many companies operate successfully without business lines of credit. To determine if you need a credit line, consider these factors:

Monthly recurring revenue

Business owners with a large amount of monthly recurring revenue (MRR) may not need business financing.

MRR refers to revenue that a company can reliably expect each month. If you have a large amount of business from repeat customers, you can open your doors each month and expect a certain amount of business to come your way.

Repeat customers drive more predictable cash flow. If a business has $40,000 in MRR, the owner can forecast a recurring level of cash inflows. This ability to plan cash flow may eliminate the need for an LOC.

If you have a low amount of MRR and your sales vary greatly for month to month, you’ll need an LOC to provide more working capital for the business.

Your firm’s costs are also a factor.

Customer acquisition cost

Businesses that spend less on finding new customers have better cash flow, and may not need an LOC.

Customer acquisition cost (CAC) refers to the cost required to convince a customer to buy your product, and successful companies strive to constantly lower CAC. If you can build brand awareness, consumers are more likely to know and trust your business.

If you like your iPhone, you’re more likely to purchase a new Apple product. Apple’s brand awareness allows them to spend less on marketing, and drive sales based on reputation. A new business, or a firm with less brand awareness, has to spend more on marketing and advertising, and that requires cash.

Highly profitable firms may not need short-term financing.

Profit margins

If you sell goods at a high profit margin, you bring in more excess cash with every sale.

Grocery stores, for example, typically operate on a 1 to 2% profit margin. If you sell $200 in groceries and only earn a $4 profit, you aren’t generating a large amount of excess cash. The business spends $196 to generate the $4 profit, and that requires a large cash outflow.

More profit generates more excess cash, and less of a need for financing.

How long does it take to close a sale?

Sales cycle

Products with a long sales cycle generate inconsistent sales results, and cash flow is more uncertain.

A tech company selling an expensive software product may require 18 months- or years- to make a sale. Sales and profits can vary greatly from one month to the next. These firms need a small business loan, in order to cash flow the business.

So, how do these factors apply to your business?

Assess your business

To analyze your need for an LOC, talk to peers in your industry. Owners who operate established businesses are a great resource. They can tell you if they use an LOC, or if they’ve reached the point where bank financing isn’t necessary.

Find out about their journey, and use that wisdom in your business.

Many profitable firms use business credit for years, because cash inflows in the industry aren’t consistent. A retailer that does 50% of its annual revenue in November and December needs an LOC to purchase inventory before the holidays.

If you’re just starting out, it’s likely that you’ll need an LOC, regardless of your profitability. The next issue to consider is the type of LOC that you set up.

Secured vs unsecured line of credit: Differences

A line of credit may be secured or unsecured, and the type of financing you obtain can have a big impact on your business.

Unsecured LOC

An unsecured LOC is backed by the borrower’s ability to pay.

A traditional credit card balance is an unsecured loan. The credit card company’s loan is based solely on the card users ability to pay. Unsecured lines of credit and credit card balances are not secured by any specific assets.

Borrowing through an unsecured LOC allows the owner to freely buy and sell company assets, without the need to use a particular asset as collateral for the loan.

If a banker considers the borrower to be a higher credit risk, the lender may only offer a secured LOC.

Secured LOC

This type of LOC requires the borrower to pledge specific assets as collateral for the loan.

If the owner defaults on the LOC loan, the lender can sell the collateral, and recover some or all of the balance due. A secured loan puts restrictions on the owner’s use of assets.

If a restaurant pledges commercial ovens, refrigerators, and other assets to secure a loan, the owner can’t sell the assets while the LOC is in place.

Liquidity is the biggest factor that a commercial banker analyzes before issuing a loan.

Liquidity vs. solvency

Companies with a healthy level of liquidity are better positioned to pay a loan balance.

Liquidity is defined as the ability to generate sufficient current assets to pay all current liabilities. When you think about liquidity, think about your checkbook, because this metric has a short-term focus.

  • Current assets include cash, and assets that will be converted into cash within 12 months. Accounts receivable and inventory are current asset accounts.
  • Current liabilities are balances that must be paid within 12 months. Accounts payable, and long-term debt amounts that must be paid within a year, are current liabilities.
  • Working capital is a measure of company liquidity. The formula is (current assets less current liabilities), and financially sound businesses maintain a positive working capital balance.

Solvency, on the other hand, has a long-term focus. Firms that are solvent can generate cash inflows over many years.

Over the long-term, a business may use cash to purchase expensive assets, or make debt payments on a multi-year loan.

Lines of credit provide short-term financing, and the balance is repaid over months, not years. If your firm can generate positive working capital, you can obtain an LOC. The most important factor is the borrower’s ability to produce sufficient cash inflows to repay a loan.

Here are the steps required to secure a line of credit.

How to get a small business line of credit

Start by asking around. Talk to business peers, accountants, and attorneys about finding a bank.

Your banker must be a partner who can serve your banking needs as your small business expands. Small business owners must build trust with a banker, so that the bank is willing to add services and lend money.

Loan approval requires more than a set of financial statements. Ultimately, a loan officer must know you, and trust that you’ll repay the loan on time.

Get your records in order before you apply for an LOC.

Documents you’ll provide

An owner will provide both business and personal records to the bank.

  • You need to have a business track record for at least six months to a year, so that the banker can get a sense of your business. If you’ve succeeded in other businesses, the banker may be comfortable with a shorter track record.
  • A bank will need your financial statements, including a balance sheet and income statement. If you can provide financial data for multiple years, so much the better. You’ll also provide your business tax returns.
  • The bank will check your business credit score, which reflects your firm’s ability to pay vendors on time.

You may be asked to provide your personal credit score, and to document your personal financial status. A borrower’s personal use of credit impacts how they handle a business loan. If you have a solid personal credit score, or you have a large amount of personal assets, you’re less of a credit risk.

Collateral, personal guarantees

If a banker is concerned about your firm’s creditworthiness, you may be asked to provide more security for the loan.

You may need to pledge fixed assets (machinery, equipment), or your accounts receivable balance as collateral for the loan. If you pledge an accounts receivable balance and default on the loan, the bank has the legal right to collect balances from your customers.

A bank may also require that you personally guarantee the loan. This arrangement means that your personal assets (home equity, investment assets, retirement accounts) serve as collateral for the loan.

Think carefully before you agree to a personal guarantee.

The potential of a business failure is tough to consider, but the problem is made much worse if you have to repay loans out of your personal assets. Talk with your family, trusted peers, and an attorney before taking this step.

You may have other options.

  • Sell ownership: If you can raise funds from investors, you may be able to cash flow your business using newly invested dollars, and avoid a personal loan guarantee.
  • Sell personal assets: Some business owners raise funds by selling personal assets, such as an investment portfolio. Selling assets reduces your personal net worth, but you avoid taking on business debt.

Company founders sometimes raise cash by taking out a second mortgage on a home, or by using personal credit cards. This approach is similar to a personal guarantee on a business loan, because your debt increases.

Before taking on personal debt to finance your business, discuss the issue with people that you trust. If you decide to move forward, you’ll need to look for a bank that provides an attractive interest rate.

Best business lines of credit rates

Your bank must provide a high level of customer service, regardless of the rate charged on your loan. Competition and customer expectations have forced banks to be more responsive, and to offer tech tools that make banking easier.

Many lenders base their LOC interest rates on the Prime lending rate. The Prime rate is the interest rate charged to the most creditworthy businesses.

These banks offer a high level of customer services, and attractive interest rates:

  • Wells Fargo offers loans from $5,000 to $100,000, with an interest rates starting at the Prime Rate plus 1.75%. The term of the loan may be up to five years.
  • OnDeck provides loans to businesses with a credit score of at least 600.
  • Kabbage offers loans to owners who have a poor personal credit history. This lender does not require a minimum personal credit score, but the interest rate may be much higher than traditional LOC loans.

Business owners are required to supply information after a loan is approved.

Company performance

You’ll need to provide financial statements to your bank each year that the loan is outstanding, and you may also need to submit business tax returns. These documents help the banker understand how your company is performing, and if you’re generating enough profits to make the loan payments.

So, where do you go from here? To make an informed decision about an LOC, ask these questions.

10 questions to ask

  1. Do you understand why business owners use a line of credit?
  2. Can your business operate each month with current cash inflows and outflows?
  3. How consistently does your business generate sales and profits?
  4. Do other firms in your industry use a line of credit to finance operations?
  5. Do you understand the difference between a secured and an unsecured loan?
  6. Do you have a set of financial statements for each year of business operations?
  7. Do you know your personal credit score, and your business credit score?
  8. Do you own personal assets that you could sell, and use the funds in your business?
  9. Can you network with business peers, accountants, and attorneys, and ask them for a bank referral?
  10. Are you willing to provide financial statements to your bank while the LOC is outstanding?

The answers to these questions can help you make an informed decision about a line of credit. Do your homework about an LOC, so you can get back to serving your customers and growing your business.

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