Being able to access capital in today’s tough economic environment could mean the difference between success and failure for many businesses.
For those business owners, one of the most common sources of capital is a short-term working capital line of credit, capital that is still available — even in this economy — to qualified borrowers.
Having a profitable history with your lender is the best attribute you can bring to the table when applying for or renewing a short-term line of credit.
“Short-term lines of credit come in a number of different forms, so you need to know which one is the best for your business,” says William W. Carroll, vice president with Fifth Third Bank. “The right type of credit may provide the most flexibility to run your business profitably.”
Smart Business spoke with Carroll about the benefits of using short-term lines of credit and the different types of credit available.
What are the benefits of using short-term lines of credit?
Short-term lines of credit may help you survive, and maintain and grow your business. Without one, cash will have to be supplied by stakeholders, which may not always be available, and may be more expensive.
Many mature businesses, especially those with risk-averse owners, may be able to survive without a short-term line of credit by relying on existing cash balances. But for the majority of businesses, the short-term line of credit is an integral part of business operations and success.
What are some key things you should know about using short-term lines of credit?
Short-term lines of credit are for a period of one year or less. These may be revolving, so the loan balance rises and falls with the ebb and flow of cash collections. You can also take draws and make paydowns manually, as cash and time permit.
Sweep lines of credit may be more desirable than manual lines, as they are more efficient with cash usage. These do not leave idle cash on hand that could instead be used to reduce the line of credit and save on interest expense.
The loan balance for the sweep line of credit is tied to your commercial checking account, so draws and paydowns happen automatically. This does not require an employee to take time to monitor the balance and guess when outstanding checks will clear and expected collections will actually occur.
How can you maintain the quality of your short-term assets to increase borrowing capacity?
You need to make sure both your accounts receivable and inventory are of high quality, since the lines of credit are typically secured by these accounts. That means monitoring accounts receivable to make sure they are under 90 days from invoice date.
Inventory should also be current, with quick-turning products that are not obsolete in the marketplace. Letting the receivables or inventory go stale may cause the lender to exclude these assets from the collateral base, which would reduce the amount you can borrow.
Having a collections person or department is usually a sound investment in order to maximize the amount you can borrow under the line of credit. This makes sure you collect your money in a timely manner and are paid for the product or service you have already provided.
What are the different forms of short-term lines of credit?
A seasonal line of credit may be appropriate for companies with highly fluctuating sales and collection periods. For example, a retailer that records the majority of sales during the holiday season may only need access to the line of credit in the middle of the year when inventory is building in preparation for the fourth quarter sales period.
Once the heavy collection period ends by mid-January, the company will use cash to pay off the line of credit and fund operations until mid-year.
These lines of credit will typically have a cleanup period required by the bank, during which the line of credit balance is required to be zero for several months. This is a good indicator to the bank that you are properly managing the cash collection cycle and utilizing the short-term line of credit to fund short-term cash needs only.
How can you ensure you are using your credit line properly?
This is critical for a growing business. If sales are growing, accounts receivable should be growing, as well. As you sell more products, you need to replenish supplies to build inventory.
Buying supplies and paying employees takes cash, which you may not have until after you collect on your receivables. This typically will not happen for 45 days or more, so you may have to cover the costs of your employees, overhead, interest expense and other areas before you collect from your customers.
Using a line of credit to cover these expenses can be one of the uses of a short-term line of credit. The line of credit then gets paid down once receivables are collected, and the cycle starts all over again. Your lender will be watching to make sure the line of credit balance moves up and down in conjunction with your collection cycle.
If it doesn’t, that may indicate to the bank that the short-term line of credit is being used to fund operating losses. This may be a sign of weakness in the underlying business and could cause concerns for the lender.
William W. Carroll is a vice president with Fifth Third Bank. Reach him at (513) 534-4788 or William.Carroll@53.com.