One of the most popular, yet misunderstood financing products for small businesses is a commercial line of credit. In this article, we’ll explore how this financing option works, as well as how to qualify. This will help you determine if this is the best solution for your business. We’ll also explore three alternatives to a commercial line of credit that has many of the same benefits but are easier to get and more flexible.
How Does a Line of Credit Work?
Most simple lines of credit work like a conventional credit card. You can spend up to a certain amount of money. Then, as you pay off what you used, your available credit/funds increase. Most lending institutions put limits on how the line of credit can be used. Since it’s a commercial line of credit, it can only be used for business purposes. This type of funding is often used to cover short-term needs.
Costs associated with using a commercial line of credit vary based on the risk and the size of the credit line. You will pay a financing fee on the outstanding balance, which is typically tied to the prime rate and is variable. In addition, there may be other fees such as availability fees and maintenance fees, which vary by institution.
Finally, in many cases, you may be required to pay the full balance of the line every now and then. This is referred to as “resting the line”.
Types of Credit Lines
There are several ways to classify credit lines, with the most common one being whether or not there is collateral involved.
Secured
A secured line of credit may use personal or corporate collateral to secure repayment if the business owner defaults. This allows the lender to foreclose on assets. There are several different types of assets that can be used, including equipment, certificates of deposit, real estate, accounts receivable, inventory, securities, and cash. The lender typically files a UCC lien against the assets to secure its position.
Unsecured
An unsecured line of credit does not have specific collateral as part of the contract, which protects your assets- but this protection isn’t perfect. In most cases, unsecured lines are guaranteed by the business and the business owner. Therefore, the borrower defaults, the lender can sue the business and the business owner. If the lender wins the suit, it can foreclose on the business and/or personal assets.
The truth is, even with this distinction, no credit line is 100% unsecured.
How to Qualify for a Commercial Line of Credit
Unfortunately, it’s not easy to qualify for a commercial line of credit. Lenders have certain criteria that must be met credit score, cash flow, and collateral- all three must be present.
How is the SBA involved?
Most commercial lines of credit are backed by the SBA and offered through the SBA 7(a) program, which helps small business owners operate/grow their businesses. The SBA does not issue the loans but acts as a guarantor to the lender. Most business owners falsely believe that this protects them if they default.
The SBA provides second-level protection for the bank. If the business defaults, the bank will first try to collect from the business and the owners. This is typically done by pursuing collateral or other avenues. The SBA guarantee pays up to 90% of the loan if the lender is unable to collect from the business and owners.
Company assets/income
The first step of the review process is to examine your income and assets. The bank will only extend a line of credit if you have the ability to repay it. The specifics vary from one bank to the next, but in most cases, they want to see two years’ worth of profits. In addition, you may have to show other assets including real estate, equipment, accounts receivable, and inventory. As a general rule, a lender can finance up to 50% of your assets.
Reasonable financial ratios
The lender will also review certain financial ratios as part of the underwriting process, such as:
- Debt service coverage ratio: determines if the business makes enough to pay the principal and interest on the debt
- Fixed charge coverage ratio: determines if the business can pay the debt plus interest after paying fixed costs
- Current ratio: based on assets/liabilities, determines the liquidity of the business and its ability to pay short-term obligations
- Other criteria/ratios: some lenders may have other criteria/ratios they consider
Guarantees
Most lenders require that a commercial line of credit be guaranteed by the business, the owners/shareholders, or both. These guarantees may require collateral and typically allow the lender to file a lien on certain assets.
Personal Guarantee
In some cases, the lender requires that the business owners/major shareholders personally guarantee the loan. Typically, anyone owning at least 10% of the business must sign the guarantee, which allows the lender to pursue personal assets if the business defaults on the loan.
Corporate Guarantee
Lenders require the business to guarantee the line of credit and may require the business to offer some or all of its assets to secure the line. If the business is a subsidiary of a larger corporation, the parent company must also sign a guarantee.
Background and Credit Check
Lenders will also perform a background and credit check on the business owners and major guarantors, which includes personal background, personal credit/assets, and professional history. This information is used to determine the character and assets of the guarantors. After all, companies do not run themselves- they are run by people and the way a person conducts themselves personally typically indicates how they handle their business. This process is done to weed out those who have few assets and little to no credit or bad credit.
Understanding Loan Covenants
Commercial lines of credit have covenants or rules that must be followed to open the line and keep it running. These covenants vary based on the lender, with the most common being:
Net worth
Some lenders require a minimum net worth which keeps your assets from dropping to low, preventing the lender from receiving their payments.
Monthly certification
Some lenders require monthly certification, which means the business must disclose the current state of accounts, various assets, and inventory. The availability of funds is tied to this certification.
Confession of judgment clause
This stipulates that the bank can file a judgment without going through the court, which facilitates collection efforts.
Liquidity
Many lenders require that the business complies with minimum liquidity ratios such as the cash conversion cycle, current ratio, or quick ratio.
Debt
Most lenders require that the business performs above certain minimums for the fixed charge ratio, debt service coverage ratio, and others.
Material changes
Finally, most lenders have a catchall clause involving material changes, which covers events that could negatively impact your business.
Advantages & Disadvantages of a Commercial Line of Credit
There are several advantages associated with a commercial line of credit:
- Quickly improves cash flow
- Flexible, as long as you don’t reach the limit
- Can be used to cover important/emergency expenses
- Cheaper than other options
On the other hand, there are also some disadvantages:
- Difficult to qualify for
- Not an option for startups or businesses with under 2 years of history
- Difficult to meet covenants
- Once limit is reached, it’s hard to increase
- Purchase orders are not collateral, which limits growth
If your business does qualify for a commercial line of credit, using it depends on your business objectives. In most cases, the decision to use the line of credit depends on cost versus flexibility. This option is inexpensive but doesn’t have the flexibility needed by most growing businesses. On the other hand, other options are more expensive but have more flexibility.
Alternatives to Commercial Line of Credit
The biggest issue with a line of credit is the qualification process. While government-backed lines of credit are easier than traditional financing, they still are not easy to get. If you do qualify, its often difficult and time-consuming to increase the line. The two best alternatives are:
Invoice Factoring
Many times, poor cash flow is due to the fact that most commercial clients require net-30 or net-60 day payment terms. Invoice factoring can solve this issue by advancing you a portion of the invoice total. Then, once the customer pays, they will issue you the remaining balance minus their fees. This provides you with immediate funds, so you don’t have to wait to get paid. This option is flexible and will grow with you, as long as your customers are creditworthy.
This type of financing is a lot easier to qualify for, as long as you are working with creditworthy customers. This option is perfect for small, growing businesses that don’t qualify for traditional loans.
Sales Ledger Financing
This is a type of credit line that is tied to the accounts receivable of the business. The company can draw funds when needed up to the limit. This is typically an option for small businesses that outgrow factoring but are still unable to qualify for traditional financing.
One advantage to this type of financing is that it’s flexible and grows with your business- but you must invoice $250,000+/month and have a decent customer portfolio.
Do You Need Financing for Your Small Business?
As you can see, a commercial line of credit is a great option if you can qualify- but there are other options if this isn’t ideal for you. Contact Commercial One Group to learn more about your options.