Funds are the backbone of any business, especially at the growing phase for small and medium organisations. Although there are plenty of options available to fund a startup yet the business line of credit is the most popular and convenient method to get access to a fixed amount of money for businesses.
Even if, many other sources of finance available to small businesses or startups, but the lines of credit could be the best and easy to obtain as other options have lots of hassle, requirements and involve numerous complicated procedures.
Hence in this article, we shall go through the meaning, types, functions and requirements of a business line of credit. Let us first understand what exactly the business lines of credit are?
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Business Line of Credit (LOC):
A Business Line of Credit is an agreed-upon sum of money that a financial institution, such as a bank or credit union, can lend you. You can take out money from the line of credit anytime you need it, up to the limit.
Small companies that take a proactive approach to ensure they have access to the tools they need to meet day-to-day working capital requirements and other short-term financial needs will benefit from a business line of credit. It enables them to apply for and qualify for borrowed capital they will need in the future.
Many organizations use a line of credit as part of a broader funding plan. To accelerate growth and finance other revenue-generating ventures, many companies use a business line of credit as part of a broader capital access strategy that includes both short and long-term financing.
Types of business line of credit:
1) Traditional Secured Business line of credit –
The traditional secured business line of credit relies absolutely on collaterals. This primarily means that one has to put something of value in the form of a guarantee to get a line of credit. The valuable virtue may be business assets, real estate, etc., as a guarantee.
The main idea behind the concept of securing a guarantee is to let the lending institution have confidence in the borrower as they can claim on the collateral if the lender consequently fails to repay the amount that they owe to the lending body.
The secured business line of credit may be said to be the best type of business line credit as the risk is lower and the interest is lower as well. The repayment terms are comparatively flexible, and on a successful transaction, one might get a chance to qualify for getting a higher line of credit.
2) Traditional Unsecured business line of credit –
The traditional unsecured business line needs no security or assets as such; they give away loans for much higher interest rates. One can get benefitted from the faster approval process that an unsecured business line of credit provides, unlike the secured business line credit. Interest rates are usually higher than secured lines of credit, and there may be a monthly or annual maintenance fee which the borrower has to pay to the lending body.
According to the SBA (U.S Small Business Administration), unsecured lines of credit can be preferable over secured lines of credit. They place a greater emphasis on creditworthiness than on years of business, and the application process is often simplified.
3) Real Estate Line of Credit –
A real estate line of credit is equivalent to a personal HELOC (home equity line of credit), which is a loan depending on the amount of equity one has in his home. For business purposes, one can count on the equity in their own home or the equity or the equities in other properties they own to secure the loan. Real estate line of credit again comes in two forms secured and unsecured. For the unsecured real estate line of credit, the SBA (U.S Small Business Administration) puts focus on the FICO (Fair Isaac Corporation) score as it is the determining factor of such business line credit.
4) Business Credit Card –
Other than the above-mentioned types, SBA recommends another unsecured option known as a business credit card. A business credit card is identical to a credit card in several aspects, although it offers a few more perks than a credit card. One of them being, no personal or business property is tied up to the line of credit that one wants to get.Business credit cards may provide quick access to cash, while the other types of a business line of credit may take a while to transfer funds. The payment terms are flexible as well when compared to the other lines of credit.
How Lines of Credit (LOC) Works?
The banks and credit unions majorly offer lines of credit, and if one qualifies, he can draw the maximum amount from the lender for a set period. The draw duration is the time during which you have credit and can borrow money. Depending on the terms of the loan agreement with the lender, this stage could last up to ten years.
During the repayment period, one shall pay back the loan’s principal and interest. During the draw phase, however, one will be required to make minimum payments. A part of those fees will be used to lower the interest payments.
The portion of the payments that go toward the principal can be added back to the credit line for potential borrowing, but not all lines of credit have this replenishing impact. Some lenders may only accept interest as payment during the draw time. Another aspect that will be determined by the terms of your credit line agreement is the interest rate.
The banks or the lending institutions often examine the past, assets, current revenues, and other factors before lending it. Some of these are discussed below to give a brief idea as to the requites that one needs to have to qualify for a line of credit :
Time in business –
Lenders only provide business lines of credit to businesses that have been in business for at least two years. This amount of time in operation demonstrates to the lender that the organization has been around for a while and has some experience. Lenders can offer a startup a line of credit if the owner has good personal credit, good collateral, and personally guarantees the loan.
Revenues and profits –
The business must have sales and be profitable to apply for a line of credit. Lenders look at the earnings from the business as the primary source of repayment. As a result, the size of the line of credit must be justified by the sales and profitability. Companies without sales or income are unable to secure a line of credit unless they (or their owners) can offer collateral in the form of a guarantee.
Banks and other financial institutions only lend to businesses that can back up the loan with collateral. Any asset that can be used to repay the loan is referred to as collateral. Banks also pursue collateral in the form of accounts receivable, inventory, equipment, real estate, and financial instruments. Collateral is used to protect the majority of credit lines. If the corporation is unable to repay the loan, it pledges unique collateral. Small companies are often asked to pledge their fixed assets as collateral to obtain a business line of credit.
Financial Ratios –
Lenders often examine the financial ratios of a business before lending a business credit line. This review provides lenders with a fair idea about the performance of the business. At a minimum, a lending body expects abusiness to meet these below-given ratios with their terms-
- Current Ratio
- Fixed Charge Coverage Ratio
- Debt Service Coverage Ratio
- Debt to Equity
A corporate guarantee is required for most business lines of credit, which means that the corporation promises repayment. Lenders typically require the parent company to offer a guarantee if the company is a subsidiary of a larger company. Banks can also request that the line of credit be guaranteed by the company’s owners and major shareholders.
1. https://www.creditkarma.com/advice/i/what-is-line-of-credit (source)