Many businesses have a traditional working capital business line of credit with their bank but haven’t sat down with their lender to really understand how the credit line should be used.
Generally, lines of credit are short-term loans (one year or less) that should be used to finance current assets on your balance sheet. A good rule of thumb is that short-term debt should always be used to support short-term assets. Long-term debt should be used for purchasing assets that have a life of one or more years.
Specifically, the assets most financed using business lines of credit are accounts receivable (A/R) and inventory. Since both A/R and inventory fluctuate from month to month, they often require more cash in your company to support them. This can be especially true of seasonal and cyclical businesses.
As sales go up, so does accounts receivable. More goods often need to be purchased (if your business handles inventory). Service and professional businesses often have a lag between the time it takes to collect their A/R and their biggest expense which is often payroll. It isn’t unusual for this lag to be 30-45 days.
Banks that make line of credit loans normally expect you to be able to have enough equity in your business to handle most of your day to day costs of covering working capital but make traditional business lines of credit available to companies that need to support seasonality and growth.
When it comes time to borrow, you will normally be asked to complete a borrowing base certificate which shows the value of your company’s A/R, inventory, and any other assets you may be borrowing against. You may also be asked to print a summary of your A/R aging summary depending on the size of your line of credit.
Once your line of credit is up and running and you are using it, managing your outstanding balance becomes important to keep your borrowing costs down and to make sure you keep credit is available.
Here are some tips:
- Remember not to use a working capital line of credit to buy equipment or other long-term assets; use long-term financing or leasing.
- Do draw on your line of credit when you can take trade credit discounts from your vendors. As soon as it is comfortable, draw the line of credit down again.
- Don’t let your line of credit balance creep up on you. Have a plan for how you are going to use it, then follow your plan. Your plan should include knowing how you are going to pay it down once you have cash to pay it down.
- Lenders like to see your line of credit go up and down with your needs. They also like to see your line of credit rest a few times a year. If you can allow your line of credit to rest, which means paying the balance down to zero several times a year it helps you save interest as well as demonstrating to the bank that you can manage the line with discipline.