What is a business line of credit and how does it work?

A business line of credit is similar to a credit card, but you don’t pay the vendors. When a company needs money, the company borrows money from the line of credit by drawing down the line.

Author: Brad Nakase, Attorney

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Is a line of credit a good idea for a small business, example?

A line of credit is a good idea for a  small business when the company is short of cash-flow. Jack is starting his own small business, a grocery market that specializes in organic and vegan food. Unfortunately, opening his dream store has been expensive. He has had to pay rent for the space, stock inventory, and hire employees. Jack worries that the first several months of business will be difficult; in particular, he is worried about paying his vendors in time. As a result, Jack is considering applying for a business line of credit. He hopes that this line of credit will provide the funding he needs to get the business on its feet and allow him to accumulate a profit. Once the business is profitable, he will not need the line of credit any more to support the market. However, he wonders if a line of credit is a good idea for his small business.

Applying for a Line of Credit as a Small Business

A business line of credit is useful for many small business owners because it allows them to afford expenses such as payroll, marketing, and equipment. This additional financing can help a new business find its feet, setting it up for future success.

Unfortunately, established businesses receive preference when it comes to applying for a line of credit. That said, it is still possible for a new business owner to qualify for this kind of financing.

This article will review how to get a business line of credit so that an entrepreneur can get started growing their business with the help of financing.

What Are Revolving and Non-Revolving Lines of Credit?

Revolving credit lines let a business owner borrow money from a credit union, bank, or lender up to a specific limit. This is different than a term loan, where an entrepreneur borrows a set amount of money and makes equal-sized payments until it is paid back.

When it comes to a revolving line of credit, interest only accrued on the amount of money that is being used. This means that an owner will not have to pay interest when he or she is not using the line of credit. Thus, this is a more affordable option than a non-revolving line. Some lenders charge a fee to maintain the account, but there is generally no cost for a business owner who does not use the line of credit.

Another option for line of credit is known as non-revolving lines of credit. This is where there is a lump sum product. After a business owner pays back the amount, the account is closed. This means that if a business owner wants a line of credit for expenses that are ongoing, this may not be the most appropriate financing option for their company.

In the end, a new business could benefit from either line of credit. If a business owner is not sure how much financing he or she will require, or for how long they will need it, then the better option is a non-revolving line of credit. This way, the owner can close the account once he or she pays off the debts.

How to Apply for a Business Line of Credit as a New Business

It is very easy to apply for a business line of credit. Most lenders will let a business owner apply for financing online, so there is no need for an in-person appointment.

Online lenders ask for a comprehensive picture of how the business operates. They will require documents such as the following:

  • Personal and business tax returns
  • Financial statements from the business’ checking account
  • Business registration documents
  • Credit approval
  • Annual revenues
  • Business plan that has information regarding time in business, services or products, and industry

If the company is a new business, then it is important that the owner provides as much financial data as possible. He or she should include records of any past transactions, including invoices paid to vendors or outstanding accounts receivables. The point of the credit application, after all, is to convince the lender that the business will repay its debts on time and in full.

Lines of credit for small businesses tend to come with different repayment terms, credit limits, interest rates, and application processes. A new business owner has the task of choosing the right line of credit to increase the chances of approval. This is especially important for new businesses.

In general, lenders prefer to lend money to businesses that have been in operation for at least half a year. Also, they will want to see evidence of the following:

  • Steady cash flow
  • Long financial history
  • Strong credit history
  • Business longevity

That said, if the lender observes that the business owner has a record of paying off debt on time and managing money well, then he or she may be able qualify for a line of credit as the owner of a startup.

How to Qualify for a Line of Credit as a Startup?

New entrepreneurs can improve their chances of getting a business line of credit in the same way they would petition for any other kind of small business loan. One method is to offer collateral, creating a secured line of credit.

In this situation, the collateral does not have to be a significant asset like a home, car, or equipment. Rather, for a short-term line of credit, a business owner will have to pledge alternative forms of cash. For instance, a lender may ask that an owner offer the value of his or her accounts receivables. This is called invoice financing.

Another option is to build up personal or business credit prior to applying for a line of credit. One could pay off business credit cards, for example, to show lenders that they do not carry any business debt. Improving one’s personal credit score can help as well, especially if the lender asks for personal credit checks during the application process.

If an entrepreneur waits to look for financing until the business has been established, he or she can pursue an unsecured line of credit. By showing that his or her finances are strong and maintainable, a business owner will not need to submit collateral.

Other Available Financing Options

While lines of credit are legitimate funding options for small businesses, there are other methods of funding that one should also consider. These include the following:

  • Small business loans
  • Business credit cards
  • Merchant cash advances
  • Invoice financing
  • Equipment financing
  • Commercial real estate loans
  • Bridge loans
  • SBA loans
  • Business grants
  • Crowdfunding

Conclusion

Depending on the lender, the line of credit application process will vary. It is important, therefore, that a business owner explore his or her options for lines of credit to see which is best suited to their business.

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