Have you considered obtaining a line of credit to help fund your next big project? A business line of credit is an excellent financial tool that can give businesses access to additional working capital when cash flow needs arise. It offers flexibility, allowing businesses the freedom to access funds quickly and repay them at their own pace. In this guide, we'll discuss how a business line of credit works, what it's best used for, and its advantages for small businesses.
A business line of credit is an incredibly helpful tool for business owners. Essentially, a line of credit is a revolving loan that allows you to borrow money up to a certain limit. You only pay interest on the amount you borrow, and you can use the funds for any business expenses, such as purchasing inventory or paying employees. Unlike traditional loans, a business line of credit gives you the freedom to borrow and repay funds as needed. This makes it an ideal option for small businesses to manage cash flow more effectively and fund growth projects without relying on long-term loans or taking out collateral.
Most importantly, it acts like an insurance policy during the slower months so that you have the capital needed to keep going without having to turn away potential customers. Instead of getting a lump-sum amount, you receive a revolving line of credit that you can use, repay, and use again over a specified period.
Not sure what your personal credit score is? We recommend checking your personal credit score before seeking funding so you know what lenders you may qualify with. You can check your credit score for free one a year through the three main credit bureaus.
Types of Business Lines of Credit
When applying for business loans, your goal is to get the funding. But the lender's goal is to get repaid at a profit. Lenders, therefore, look at many factors before providing the loan.
While the actual line of credit requirements may vary from one lender to another, here are some general factors they may consider:
Although it's your business that's borrowing, lenders may still look at your credit score for two reasons:
If your score is lower, you may still qualify for a business line of credit. However, your options will be limited and you may go home with a high-interest rate.
Apart from running a personal credit check, many lenders may look at your business credit score and reports. Financiers use this information to determine the risk of lending to your business. If your business is new or doesn't have a credit history, then your personal credit score may be relied upon. Learn how to build your business credit score through reporting your business tardiness. Read the guide →
In addition to looking at your business and personal credit scores, lenders also consider your profit and loss statements and your balance sheet before advancing the loan. And here, lenders use ratios such as debt to equity, fixed charge coverage, debt service coverage, and current ratios to ascertain your ability to repay the loan.
For instance, many lenders calculate your debt service ratio by dividing your net operating income by your current liabilities for one year. Ideally, this figure should be above 1.25 as it means your operating income is 125% of your liabilities.
The higher the ratio, the better, because it means you're more likely to get the funding on favorable terms. And just like credit score, you can still get approved for the loan if you have a lower ratio. However, you may not get favorable terms.
Related Reading: The 3 Financial Statements Every Business Owner Needs to Know
When considering a business for a line of credit, lenders often take into account the amount of time the business has been in operation. This can be an excellent indicator of a business's financial health as well as its ability to stay solvent and weather economic downturns.
Banks and other financing providers may feel more comfortable lending funds to a business that has been established for some time, as this offers assurance that there is a solid infrastructure in place, and that they are more likely to get their money back.
A business line of credit is a loan that can be used for a variety of purposes, including:
One of the main advantages of a business line of credit is that it can be used as needed, up to the credit limit. This flexibility can be helpful when businesses need to cover unexpected expenses or take advantage of opportunities that arise.
Finding Funding for Your Business
A business line of credit is a flexible financing option for small businesses. With a revolving line of credit, you can draw on the funds as needed and only pay interest on the portion of the line that you use. This makes lines of credit an attractive option for funding inventory purchases or covering gaps in cash flow.
Visit the Fundid Capital Marketplace to get connected with lenders based on your business needs so that you can get the financing you need to grow your business. Explore over 15 different funding options to support your business.
Editors note: This blog was originally published on August 3, 2021 and has been updated for accuracy and comprehensiveness.