One of the biggest mistakes you can make as a business owner is to put off securing a line of credit. Sales are growing, product is flying off the shelves and business couldn’t be better.
It may not seem like it, but it’s actually an ideal scenario to sit down with your bank and discuss a line of credit, says Ben Fargo, Vice President, Capital Finance at Bridge Bank.
“The best time to get a line of credit is when you don’t need it,” Fargo says. “When you’re profitable and your balance sheet and income statement are strong, you’re going to be able to negotiate the best terms for your line of credit.
“Think of it as an insurance policy for your business. When you wait and you get into a situation where you’ve gone from being profitable to losing money and you’re trying to figure out how to turn that corner, you’re going to have a much more difficult time.”
Smart Business spoke with Fargo about what to consider when pursuing a line of credit and what it should be used for once you get it.
What are the most common reasons to seek a line of credit?
Typically, a line of credit should be used for working capital purposes and short-term needs. A good example would be consulting companies. They have employees they need to pay today, but often they are not going to be paid by their customer for 30 days. These companies can leverage a line of credit to make that payment today.
One of the worst things you can do is to use a line of credit to purchase new equipment. Let’s say you have a $1 million receivable-based line of credit and you leverage that on day one to buy $1 million worth of equipment.
Now you have that $1 million debt outstanding — and not revolving or amortizing – and a real need arises to cover a critical expense in your business. This unexpected need is exactly what a line of credit is designed to cover, but your line was used to buy equipment — and you no longer have the borrowing capacity.
What are important considerations when negotiating a line of credit?
Think about the size of the line of credit and whether it’s something that will accommodate the growth of your business.
Does the borrowing formula that the bank is proposing allow you to maximize the amount that you can borrow against the asset — whether that’s accounts receivable, purchase orders, inventory or some other type of asset? As a borrower, do you understand what’s being considered as eligible for you to borrow against?
Say your company has $1 million worth of receivables. At an 80 percent advance rate, this would imply $800,000 of availability. But what is considered eligible versus non-eligible? Does your business pre-bill customers and send an invoice before you’ve delivered a product or service?
If you’re not going to deliver for 30 days, is the bank going to consider that receivable eligible in your borrowing base? Depending on the eligibility criteria, the amount that you can borrow may be drastically different than the amount of the commitment.
Another question, believe it or not, is whether you can actually borrow on the line of credit. Is that $1 million of receivables really $1 million of borrowing capacity or would drawing on the line of credit potentially cause a covenant default with a term loan?
Maybe the increased draw on the line creates an increased interest expense which impacts your company’s ability to meet a required debt service threshold, or perhaps the draw would cause overall debt levels to be too high, causing a breach of a leverage covenant.
What’s an important piece of advice to avoid problems with your line of credit?
Make sure you absolutely understand the terms and conditions of the line of credit. Whether that’s financial covenants or the computation of the borrowing base and what you’re allowed to include versus what isn’t included.
That will ultimately impact how much you can borrow. Don’t be afraid to talk to your banker about how the line of credit is structured. Make sure the bank understands your business so the line of credit is legitimately adding value and can help your business versus hinder it. ●
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