Manufacturing businesses can access a range of financial options to help them tide over cash flow problems. Loans, cash advances, and credit card loans tend to receive much attention. However, a business line of credit is an option that doesn't receive much attention due to the perceived complexities behind applying for one.
A business line of credit is a revolving loan that you can access to help you overcome working capital shortfalls. For instance, if you need cash to purchase inventory, a line of credit (LOC) can help you put cash to work, without overburdening your balance sheet with debt from an overdraft or business loan.
Here are 4 essential facts to understand about a line of credit and how it can help your business.
Different Types of LOCs
There are 2 types of LOCs you must know. The first is a secured line of credit, which as the name suggests, is backed by short-term collateral. Note that lines of credit are a short-term financing option, and lenders will not seek capital assets as collateral.
Typically, current assets such as receivables or inventory are chosen as collateral. If you fail to repay the outstanding amount on time, the lender will use the collateral to recover their money. In essence, an LOC can act as a form of receivables financing. However, this doesn't mean you shouldn't worry about defaulting on payments. Any default will affect your credit score negatively.
The second kind of LOC is an unsecured one. These LOCs don't require collateral, and lenders will place a general lien on your business. Typically, businesses with strong credit and established relationships with the lender receive this option. Despite this, the interest rates attached to an unsecured LOC will be greater than what you will receive on a secured one.
The amount of money you can borrow using an unsecured LOC will also be lesser compared to a secured option.
Different Qualification Criteria
Many business owners think an LOC is similar to a short-term business loan. However, from a lender's perspective, they're completely different products. When evaluating a short-term loan application, the lender is concerned with the business' ability to repay the loan amount, given current performance.
An LOC is a different beast since the business can draw any amount within the credit limit. Current performance is not fully indicative of the business' future ability to meet its obligations. The terms surrounding the LOC are also different, leading to different evaluation criteria.
Typically, a lender allows businesses to carry an outstanding amount on their credit lines, as long as the business pays off the amount at periodic intervals. In contrast, a small business loan must be paid off by the end of its term, with the lender expecting on-time monthly payments.
This fixed nature of a short-term loan versus the LOC's variable characteristics makes them very different. While both options are used by businesses to tide over short-term cash flow holes, lenders view them differently.
Pay for What You Use
LOCs work differently from term loans. Term loan amounts are fixed, and you must pay interest every month, whether you use the funds or not. In contrast, an LOC has variable amounts, and you'll pay interest only on the sum you use.
For instance, if your business has an LOC of $100,000 and you borrow $10,000 against it, you'll pay interest on $10,000 at the end of the month. Thus, your monthly interest costs will vary, which makes budgeting a challenge. You must project cash and working capital needs accurately to make an LOC work well for you. Unexpectedly high monthly interest payments will reduce working capital for the following month, after all.
LOCs also have annual fees attached to them. Depending on your usage, the lender might also charge you transaction fees. Typically, these are a percentage of the amount you borrow.
Best for One-Time or Short-Term Predictable Costs
LOCs offer your business a lot of flexibility, but they must be used correctly. They're best used to plug seasonal cash flow holes and short-term costs. For instance, if your business always suffers a cash flow slump in the summer, you can use an LOC to help you tide over this issue.
If you're looking to launch a one-time marketing campaign to drive demand higher, you can use an LOC to pay for it. Needless to say, you must plan your LOC usage since varying interest costs every month will throw your budgets awry.
LOCs are also great for cash management when you don't receive payments on time and need to pay a supplier immediately. In such moments, an LOC will give you potentially lower interest rates compared to an overdraft.
Intimidating, but Useful
Managing an LOC is a tough task, but with planning, you'll find it a great tool to grow your business. Remember that market conditions often dictate when a lender will call the outstanding balance on your LOC. It's best to periodically pay down your limit and remain in good standing. This will help you avoid any unfortunate surprises.