Every business should be capable of transition especially during uncertain times like business expansion or irregular cash flows. If a business entity requires urgent funds with flexible repayment terms, availing a revolving line of credit could often be the right choice. Hence, out of different credit products available for businesses, a Line of credit is an effective instrument that may be invaluable to a business’s growth and stability. Read further to find out more about Line of Credit, its types, its pros and cons, eligibility criteria, etc. and more.
Line of Credit- Meaning and Purpose
A Line of Credit is a short-term flexible financing arrangement which allows the borrowers to borrow specific amounts pre-approved by the lender, repay it and avail it again for meeting immediate business requirements. It offers a revolving credit facility i.e. the available credit limit renewed once the borrowed sums are repaid that offers uninterrupted access to funds for diverse business needs. Such pre-authorised credit limits are at the discretion of the lender and the borrower has to make repayments with interest only when the amount has been used.
A business line of credit could be relied upon by entrepreneurs to maintain smooth flow of operations irrespective of seasonal fluctuations, irregular revenues, or occasional cash flow related concerns.
Explained with an Example
For instance, where a business XYZ has an approved line of credit for up to Rs. 1.5L. It borrows Rs. 30,000 it is liable to pay interest on only Rs. 30,000 and not the entire limit of Rs.1.5L. As a result, businesses could save unnecessary interest costs without having to worry about instalment payments.
Learn how Line of Credit can support SME growth & Cash Flow Management
Types of Line of Credit
Secured line of credit
A secured line of credit is the credit facility whose repayment is secured through assets such as cash, investments or real estate, etc. to be recovered through sale of the asset in the event the borrower business is unable to make regular payments. Hence, the value of the assets marked as collateral must either exceed or be equal to the total available loan amount.
Secured line of credit is more favored by the lenders leading to relaxed norms for creditworthiness for the borrower. As for the borrowers, it comes with added benefits like lower interest rates and a higher credit limit.
Unsecured line of credit
Unsecured line of credit is a credit facility that lacks collateral to secure repayment in the event of default. Business entities seeking an unsecured line of credit shall hold a solid financial profile i.e. a strong credit rating, a minimum of two years in existence, and consistent revenue growth. Lack of collateral puts the lender at serious risk which could typically fetch higher interest rates.
Revolving line of credit
Revolving line of credit is a flexible financial arrangement which allows the borrower to avail funds, make repayments and repeat the process till a specified limit. The borrower needs to make interest payment only on the amount drawn until the amount is repaid. Timely repayments enable the borrowing company to lower the outstanding balance and renew credit limit. Such a borrowing facility is especially effective for managing cash flow fluctuations and meeting unanticipated business needs.
Non-revolving line of credit
As the name suggests, a non-revolving line of credit availed by the borrower from the lender as a one-time financing arrangement. Therefore, once the borrower repays the amount availed through loan, the lender does not automatically replenish the entire credit limit. It is similar to a regular loan that enables the borrower to receive a certain sum to be repaid over a pre-specified period.
Line of Credit Pros
Flexible Loan Limits –
The primary benefit of availing a line of credit facility is that it allows borrowers to withdraw funds offering more freedom over financing and repayment decisions.
Cheaper Rates of Interest-
Business lines of credit often have lower interest rates compared to credit cards or other short-term financing options. Revolving lines of credit facilities come with reduced rates of interest applicable only on the amount drawn. Naturally, it saves interest costs which could be used for other business expenses.
Assists Businesses to Build Credit Score-
Maintaining a revolving credit line could help start-ups and small-scale businesses to build and improve their credit score. It also helps them to establish financial accountability and increase growth opportunities.
Managing Cash Flow Cycle-
Small- scale businesses often come across issues such as rising business expenses along with limited revenues. Availing and maintaining a business line of credit could help to fulfil their immediate fund needs. For instance, where a company has outstanding bills from the clients but need funds urgently to fulfil operational requirements, they could withdraw funds from line of credit to be repaid once the invoices are cleared.
Easier Terms of Repayment-
Compared to a traditional business loan, the line of credit facility offers flexible repayment terms to borrower businesses. The borrower entity could choose to either repay the entire amount owed or make payments by paying a minimum amount on a monthly basis.
Ideal for Diverse Business Needs-
A line of credit is useful for businesses with short-term funding needs i.e. buying inventory, managing payroll, and payment of salaries, etc. It could also be helpful for circumstances such as delayed payments, seasonal fluctuations as well as grabbing time bound business opportunities.
Line of Credit Cons
Interest Charges-
The line of credit facility offered by lenders to business entities attracts interest charges. Higher rates of interest could bring financial hardship for small-scale businesses with inconsistent revenues. Thus, early-stage businesses need to carefully consider terms and conditions before availing a line of credit facility.
Risk of Debt Accumulation-
Depending on the ability of an entity to manage its finances, there is a higher risk of debt accumulation for the borrower business. Lack of cautious approach towards borrowing, fund management and repayment could lead to businesses getting stuck within a borrowing cycle. It might impair their prospective liquidity, affect business performance and long-term growth.
Lack of Eligibility to Avail Business Line of Credit-
Early-stage businesses with limited or insufficient track record, poor financial records, lack of collateral, etc. start-ups and small-scale industries might not fit into their eligibility criteria.
Impact on Credit Score-
Extensive borrowing or payment delays may negatively impact creditworthiness thereby rendering it difficult to qualify for future loans or bargain better terms from lenders.
Repayment Terms-
Businesses that retain a line of credit with the financial institutions must make repayment at regular intervals. However, businesses encountering cash flow issues or facing unexpected losses may not be able to meet their repayment commitments. It could result in financial distress and strained business relationships between lender and borrower.
Line of Credit Eligibility Criteria for Businesses
- Credit Score – Lenders require a good business credit score for approving a line of credit (i.e. 600 or more) which indicates timely repayments of business loans and sound financial management.
- Age of the Business- The applicant business entity shall be in operation for at least a period of three years or more. Compared to early-stage businesses, established entities with a consistent profit track record enjoy more favourable lending terms.
- Annual Business Turnover- Business turnover and profits are crucial indicators of a business’s ability to derive income. Sustained earnings over a particular duration are appealing to lenders as it demonstrates the ability of the business to manage cost of borrowing. Every lender might have different eligibility requirements in regard to the annual turnover. While some lenders may seek a minimum turnover of Rs. 6L, others might ask for a minimum turnover of Rs. 40L.
- Favourable Financial Ratios- Lenders typically prefer borrowers with favourable financial ratios as negative financial ratios might indicate higher risk of borrowing. For instance, financial ratios such as debt to equity (between 1.5-2.5) and current ratio (1-1.5) are used by lenders to assess the borrower’s risk profile, financial health and ability to manage additional loans.
- Financial Statements and Reports- Lenders also seek documents such as income statements such as income statements and balance sheets, etc. to evaluate the financial health, business performance, and debt management functions of the borrower entity.
- Collateral- Businesses seeking a secured line of credit should have adequate assets to be pledged as collateral i.e. stocks, real estate, etc.
- Guarantee-Adding a personal or business guarantee makes repayment provides additional security to the lenders. Personal Guarantees, especially for smaller businesses with established credit histories, boost the chances of acceptance by holding business owners responsible for the debt.
How can a Business Line of Credit be helpful for SME and Startups?
Small-scale businesses and start-ups might face difficulties managing finances as much as for building innovative products or drawing in new customers. Flexible financing arrangements could be indispensable for such businesses to grab growth and expansion opportunities which may come across at any point in time. Entrepreneurs are increasingly embracing it as a financial instrument owing to its capacity to boost expansion without jeopardizing ownership.
A business line of credit could assist start-ups to cover business expenses such as raw material or equipment purchase, hire staff or manage marketing operations. It could act as a safety net for SMEs ensuring strategic investment growth rather than relying on equity financing or conventional business loans. Additionally, it also helps to smoothen uneven cash flow helping start-ups and SMEs to grab business growth and expansion opportunities.
It empowers SMEs and start-ups access to credit facilities when needed up to a particular limit while interest payments are to be made on the amount withdrawn. It reduces the hassle of fulfilling lengthy paperwork, strict eligibility criteria and shorter repayment duration for borrower SMEs. Smart and effective management of line of credit facilities strengthen business reputation, create prospects to raise funds, and increase investor confidence for sustainable business growth.
Line of credit vs Alternative Means of financing
Line of Credit |
Letter of Credit |
Business Loans |
|
| Meaning | Flexible financial arrangement that allows borrower entities to withdraw out of a specified limit to be repaid within a short period. | It is a financial tool that assures repayment to the seller from the buyer party
post the fulfilment of essential conditions by the seller. |
It is a financial agreement between lender and the borrower business, where the lender grants a lump sum amount to be repaid along with a certain interest amount over an extended period in equated monthly payments. |
| Purpose | To fulfil short-term funds requirements for business operations and cash flow management. | Affording guarantee for repayment particularly in cross-border transactions. | Making long term investments, expansion of business or undertaking larger capital-intensive projects. |
| Access to funds | As and when required up to a certain pre-specified limit. | Allowed only for limited specific transactions. | Upfront approval for the lump sum amount. |
| Interest Charges | Applicable on amount withdrawn out of the total approved limit. | Usually, no interest is levied but a ‘fee’ is charged by the bank for the facility. | Interest charges are levied on the entire approved credit limit. |
| Security/Collateral | May or may not need assets for collateral purposes. | Borrowers should either pledge assets or provide guarantees to secure repayment. | Borrowers should either pledge assets or provide guarantees to secure repayment. |
| Repayment Terms | Repayment is either made in full or the borrower could make minimum payments every month. | Due amount is repaid post fulfilment of transaction between the concerned parties. | The borrowed amount is repaid in month-wise installments. |
| Flexibility | Extremely flexible, constant accessibility and repayment | Varies depending upon the transaction. | Strict terms with little flexibility. |
| Credit Limit | Credit limit is pre-defined and renewed upon repayment. | Varies depending upon the transaction. | Fixed sum only. |
| Credit Score | Utilization and repayment of credit availed affects credit score. | Minimal impact on credit score. | Repayment of borrowed sum impacts credit score. |
Tips to Secure a Business Line of Credit
Define your goal-
It is crucial to have a well-defined business plan prior to seeking a business line of credit. Lack of a clear business objective while looking for a finance solution could result in underusing existing funds or overspending on non-revenue generating items. Clearly state objective and opportunity costs (including annual fees and interests). It will offer a clearer view of the amount required to be borrowed and the financial impact on the borrower.
Collect essential documentation-
Make sure to gather all necessary documents before finally making an application for a business line of credit. Include documents such as comprehensive financial documents, with bank statements, profit and loss statements, business expenses, etc. Preparing such documents will enable a better picture of the financial health of the business to estimate the funding required to achieve business objectives.
Explore potential lending partners-
It would be a good idea to research potential lenders who could be offering an ideal line of credit facilities. Look for lenders specialize in the loan type and preferred lender ties with the bank or other financial institutions. Before making the final decision, it’s critical to assess multiple lenders so as to make the right choice for the financial health of the business.
Conduct due diligence on the lenders-
Research different lenders to choose a lender who is well-known and trustworthy. Look into the lender’s history and review customer feedback or evaluations about the lender and its services. Additionally, examine the specific conditions of their loan officers as well as including interest rates, terms of employment, and additional expenses. Compiling all of the data helps to make an informed choice which best meets the business requirements.
Select and negotiate terms with a lender-
Once you have zeroed down on the lender along with the chosen credit facility, ensure negotiating loan terms to get the best possible offer. It leads to mutually beneficial terms for both the lender as well as the borrowing entity.
Final Words
Therefore, a line of credit is a significant asset for organizations as it helps business organizations to meet their diverse funds requirements. It provides efficient cash flow management through offering an alternative source of funds to meet current expenses while also managing flexible liquidity requirements. Additionally, making prudent utilization of a LOC can contribute to the development of a positive credit profile that may eventually enable credit facilities with favourable conditions. Overall, a business line of credit serves as a financial cushion, offering immediate assistance to organizations to manage expenses, capitalizing on opportunities, while effectively managing their cash flow. To manage your loan better, contact experts like BankKeeping and request a demo.
FAQ’s
Where to find a business credit line?
Businesses can obtain credit lines from financial organizations including credit unions, financial institutions, and digital lenders. Revenue, period of operations and credit history are all elements that influence each lender’s eligibility and terms.
What is the process for businesses to avail a line of credit facility?
Compile tax records, financial documentation, and business data to submit an application for a business line of credit. Complete the lender’s application, demonstrate your creditworthiness, and submit collateral where needed. The lender will assess the borrower’s application on the basis of its creditworthiness and financial health.
What is the required credit score for availing a line of credit facility?
Lenders prefer a credit score of minimum 600 or more to be eligible to grant a business line of credit for borrowers. It may vary depending upon lender terms and conditions. An improved score often boosts the chances of credit facility acceptance along with flexible repayment terms.
When should businesses consider availing a line of credit facility?
A business line of credit is the ideal choice for organizations looking for flexible, short-term funds required to manage changing cash flow, cover unforeseen expenses, or pay constant working capital requirements. It’s particularly helpful in circumstances where funds are urgently required and return is anticipated within a short period.
What kinds of fees and charges are involved with business Lines of Credit?
- Application Fee- The application fee may be levied either as a fixed sum or a certain percentage of the loan amount to process the application.
- Draw fee-Whenever the borrower entity withdraws a certain amount, the lender levies this fee.
- Annual Maintenance Fee- Some lenders impose annual or monthly maintenance fees to keep a line of credit functioning.
- Inactivity Fees- Borrowers may be charged an inactivity fee on failure to utilize the credit facility for up to a fixed duration.