16 Critical Lessons About a Working Capital Line of Credit
Almost every small business owner wants a working capital line of credit and if you don’t now, you likely will. You haven’t been challenged as a business owner if you haven’t had a cash flow problem which has lead to potentially missing payroll or another business emergency.
In this article, we are going to cover everything you need to know about a working capital line of credit so that when you apply for one, you are more knowledgeable.
What is a Working Capital Line of Credit
A working capital line of credit is like an on-demand short-term loan. It is a preapproved amount of money from a financial institution that your business will have access to over a specified period of time if needed. A business line of credit doesn’t have to be used and is often unrestricted meaning you can use it for any reason and can pay it back at any time. A business line of credit is often called a working capital line of credit because it is used for everyday working capital.
A working capital credit line is used by businesses when an important expense must be paid. Payroll, inventory, and rent are all examples of important business expenses that often must be paid on time.
A working capital line of credit, also known as a revolving line of credit, is typically used to address short term issues due to a temporary shortage of cash. It differs from a small business loan in that a small business loan is paid back over years at a set defined repayment terms whereas a business credit line is paid back when you are ready.
What Shouldn’t a Working Capital Line of Credit be Used For
Although some businesses will use their working capital line of credit for longer-term financing like purchasing equipment outright, that isn’t the best use of a credit line. Term loans, equipment financing, accounts receivable factoring, asset-based lending, and other financing options are often a better match for larger business expenses.
Why Would Your Business Need Additional Working Capital
If you are a profitable business then why would someone need additional working capital? Here are some examples below of reasons why a working capital line of credit would be helpful.
- There are seasonal cash flow differences in your business and there are times when you are gearing up for your busy season and other times when you can pay down the credit line.
- Many businesses have times when you need additional working capital while waiting for clients to pay.
- Extra working capital allows a business to take advantage of opportunities to improve such as taking advantage of supplier discounts or purchasing in bulk.
- A revolving line of credit can be helpful to pay for temporary workers or to cover unexpected project-related business expenses.
- Almost every small business is financed by the owners and there are times when the owner needs to get money out of the business for their own personal uses.
What is Your Cash Backup Plan?
Many business owners don’t think about getting a working capital line of credit in place until a problem arises and by then it is often too late. The adage goes – “the time to get a business line of credit is when you don’t need it”. Once you have run into a serious problem a business owner often never forgets the turmoil it caused.
Ask yourself now:
- If I am short on cash where would I get the cash from
- How much cash do I have access to immediately and is it enough
- How long will it take me to get the cash
- How much will it cost me
Is a Bank the Best Place to Get a Business Line of Credit?
Many small business owners have never had to apply for a business loan or a business line of credit from a bank and as a result, believe that it will be an easy process. Banks are some of the most risk-averse financing institutions when it comes to lending money and banks often play by a unique set of lending rules. Let’s cover some critical factors banks use to make their approval decisions.
All banks require collateral. Collateral is an easily sellable personal or business asset that you will pledge to the bank in case of default and this is called a secured working capital loan. Collateral is often the hardest requirement for many business owners to satisfy for many reasons.
There are times when a bank might wave some collateral requirements but that will be based on how long you have been a client, how much of a working capital loan you are looking for, what type of industry you are in, how good your business is doing and how the overall economy is doing.
Note: If you are pledging real estate as collateral, the bank will require anyone else who signed the deed on the property to also sign the working capital loan agreement.
Personal credit score
A commercial or local bank is going to require the person signing the working capital business lines of credit to have at least a 680 credit score along with no bankruptcy issues in their credit history. If you have a business partner(s) the bank is also going to require that person(s) to sign the contract. The bank may also require that person to have a 680 personal credit score as well as a good credit history.
Banks Are Going to Look at your Financials Closely
Banks have a set procedure of what their internal underwriters will look at in your company to be approved for a revolving credit line. The underwriters will look at your net profit, gross profit, yearly revenue, current assets, current liabilities, and a lot more. The bank will also look closely at certain ratios like Debt-to-Cash Flow Ratio (typically called the Leverage Ratio), Debt Service Coverage Ratio & Quick Ratio.
Many business owners believe they have an excellent business and are often very surprised to learn a few months into the loan process that the bank will not approve the business line of credit because the bank found some ratio that concerns them.
What is often a surprise to many business owners is the term UCC filings or (Uniform Commercial Code). A UCC is a filing against the assets of the business that is filed in case there is a default. The UCC basically says that that creditor has first dibs on any assets in case of a default. Banks often will require that they be in the first position and what surprises many business owners is that there are other creditors that have already filed UCCs on your business.
Bank Timeframe to be Approved for a Line of Credit
The bank loan application is often very lengthy and will require both personal and business information. The application will take a week of hard work to fill out. After you submit your application you can expect an answer from the bank in a few weeks and once approved to move forward, another a few weeks to get the working capital lines of credit in place.
Each year the bank will ask for updated documents to renew your line and the same review process will ensue.
If there are concerns from the bank upon renewal or if repayment terms have been missed, the bank can require the working capital line be paid off in full or for the credit line to convert to a long term loan with a monthly payment schedule.
Costs for a Bank Working Capital Line of Credit
Banks will often require a yearly administration fee on the credit line regardless of whether the line is used or not. Other costs might be the first time set up points similar to a mortgage. In general, a small business credit line set up with a bank will cost anywhere from $1,000 to $5,000 depending on the size of the business line of credit.
Once you do have your line in place you will be charged a rate based on the prime interest rate plus some set additional interest percentage when you use the credit line. The prime interest rate changes daily although it may be set at the time the loan is made.
Reviewed or Audited Financials
Depending on your industry and the size of your credit line, a bank might require an accountant to submit yearly Reviewed or Audited Financials.
Reviewed Financials are where an accountant will audit certain high profile items on your financials to make sure they are accurate whereas Audited Financials will require an audit on all items.
Reviewed or Audited Financials are an extra expense to a normal accountants bill and can get very costly.
How Business Credit Cards Should Be Used
Although business credit cards do have a cash advance capability that can be used as a revolving line of credit, it is a good idea to use a business credit card(s) for purchasing instead of as a working capital line of credit.
Business credit card advances are expensive and what most people do not know is that when you use a cash advance on your credit card you are paying daily interest starting the very next day after money is taken out.
In addition, the credit limit on credit cards is often a fraction of what a revolving line of credit is often approved for.
Lastly, the use of a credit card for a small business is always guaranteed by the owner and therefore is reported to the credit bureaus often seriously affecting the personal credit score of the business owner. Regardless if you always pay your credit card bills off each month the amount of use of your credit card will decrease your credit score.
Financing Solutions Working Capital Line of Credit is Easy, Fast and Inexpensive
Financing Solutions provides an unsecured business line of credit that is easy, fast, and inexpensive. The credit line approval requires a business to have annual revenue of $400,000 and a nonprofit needs revenue of at least $200,000.
Easy to Set Up
Financing Solutions’ application is online and takes less than two minutes to fill out. It requires no documents to get an offer and no personal credit check is done for the offer letter. Financing Solution’s approval is based on years of experience working with small businesses.
If you decide to move forward with the offer letter you will be asked for a few documents and your line will be set up in a few days.
It is always a good idea to get your credit line in place before you need it so it is ready to go. Your credit line will stay in place for a year and will be renewed yearly with the same simple process.
When you want to draw on your business line of credit you will log into our secure portal, email us or call us. The money will be wired into your bank account the same day if requested and the balance can be paid off whenever you like.
The Financing Solutions working capital line of credit costs nothing to set up and nothing when not being used. When used it is inexpensive especially when weighed against the problem it’s used to solve. Often, the cost of a Financing Solutions Business Line of Credit is cheaper than a bank and other short-term options.
You can pay the line off at any time or make the minimum payment until you are ready to pay it off.
We believe that every business and nonprofit should have a cash backup plan just in case and that banks make it cost prohibited for small businesses to have an emergency credit line.
Even during the COVID-19 crisis, the Small Business Administration doesn’t actually loan money themselves. The SBA loans money through certified banks and other institutions.
The approval process for an SBA loan is similar to the application one would go through for a bank loan. In the case of an SBA loan, the government has identified certain industries with certain requirements that they are willing to underwrite. The government shares some of the risks with the bank in case of a default.
SBA working capital lines of credit are worth applying for due to the lower costs and potential easier lending standards however be prepared for the application process to be very long.
If an SBA loan is something you are looking for you will want to approach your bank to see if they are an approved SBA lender.
Invoice Financing and Factoring
Invoice Financing or Factoring is really the same terminology and this type of business financing has been around forever. Factoring is when a certain type of lender, called a Factor, will go into contract with your business to purchase your creditworthy invoices. The Factor will advance you up to 90% of a valid invoice and will collect the funds directly from your client. This type of business financing allows you to have capital immediately.
The disadvantages of invoice financing or Factoring is that your clients will know that you Factor and some may not allow it. Factoring is also very expensive and the Factor has the right to reject certain invoices based on the client. Lastly, Factoring is a long term contract and it is very hard to move away from a Factor because they will not release you from a UCC filing until they are fully paid and another lender will not work with you until it is released – this often places you in a no-win situation.
Setting up a Factoring arrangement takes time and to truly understand the cost is complicated. If you are going into a Factoring arrangement be sure you understand all of the costs and conditions – read the contract.
The nice thing about Factoring is that, in general, the Factor doesn’t care about your financials and credit score.
Online Lenders Like Kabbage, Ondeck
There are some online lenders that will provide a cash advance or merchant cash advance to businesses however MCA’s are often very expensive with higher interest rates than a bank or Factor. Loan amounts can vary based on business’s yearly revenue.
Unlike a business line of credit, cash advances must be paid in full regardless it is paid off early. Often the cost of borrowing from a cash advance company will be a 100-200% APR interest rate.
In the current recession, online lenders like Kabbage, Ondeck, and others are not providing new working capital loans due to their own capital sources have dried up.
Borrowing From Friends and Family
Borrowing money for your business from friends and family is always a challenging situation. People who do not own a business often do not understand the idea that you might have an excellent business but yet might have an emergency need for cash. Everyone who has borrowed money from friends/family in the past knows the conflicts it can create.
If you do decide to borrow money from a friend/family then here are a few key tips:
- Don’t ask someone unless you know they have the funds
- Put a payment schedule in writing and don’t miss payments
- Pay the person off earlier if you can
- Pay the person interest that makes it a good deal for them
- Don’t make it a common occurrence
- Look for other financing options in the meantime
Because Financing Solutions Working Capital Line of Credit costs nothing to set up and is easy to get in place, there really isn’t a need to ask a family or friend for money.
Startup Business Financing
Unfortunately, no reputable or cost-effective financing institution is going to provide a working capital line of credit unless you have collateral. This isn’t always a bad thing. Managing cash flow is a huge part of building a business and the sooner you can learn how to build a profitable business with good cash flow the sooner you will be on your way to building a business that lasts.
Once you have cash flow, which means that you are billing clients for your services, you will find more financing options. Factors are often a good start for newer businesses because they are often less concerned with your financials. Read above about how Factors work.
The number #1 rule of starting a business is to keep your expenses low while trying to figure out a profitable business model. Business financing can mask a poor business model so if you can, avoid getting business financing until your business cash flow is solid and you know your business model works.
HELOC as a Working Capital Loan
A HELOC is a home equity line of credit that can be taken out and used for any purposes. It uses the equity in your home as collateral to support an unrestricted line of credit. Business owners will then use the HELOC as a business line of credit. The nice thing about a HELOC is that it is pretty easy to get from your bank and also the term is often several years before it needs to be renewed.
The problem is that under the Trump tax changes, the interest charged on a HELOC cannot be written off any tax returns unless specifically used for improvements to your home. Also, many business owners like to separate business risks from personal risks in case the business has to close down. A HELOC would still have to be paid back regardless of whether the business declares bankruptcy.
Asset-Based Lending as an Alternative to a Business Line of Credit
Asset-Based leading or financing is when your business will put up assets, generally accounts receivable and inventory, that is then used as collateral. There are companies outside of banks that specialize in this type of financing. The deals are often complicated and will involve extensive due diligence by the lender to approve your company. ABL’s are always more expensive than a bank but if you need a very large line of credit for working capital then looking into an ABL might be a good option.
Working Capital Missteps
When you are running a business there is often a lot of cash flow running through your bank account. If you were to spend $10,000 in your personal life you would monitor it very closely but often with a business expense, you are less likely to be concerned with it depending, of course, on the size of your business.
If you are struggling with a working capital look at your expenses first and see what you might be able to cut back on. Second, talk to your accountant and ask him/her what they think about your business problem. Third, investigate your competitors and see what their gross profit and margins are like to see if you are below industry standards.
Small businesses often do not charge enough for their services and increasing what you charge while lowering your expenses goes a long way toward improving cash flow.
However, it is still a good idea to get a Line of Credit from Financing Solutions as a cash backup plan. Their line of credit costs nothing until used making it a cash backup plan that every business should have in place.