Pros and Cons of Receiving a Business Line of Credit
What is a Business Line of Credit?
A business line of credit is sort of like a credit card in that you can use it whenever you need it, as long as you don’t exceed the limit. The exception is that with a line of credit, the borrower can draw down cash to cover whatever expense he or she needs to pay for. This makes a business line of credit different from a credit card because the borrower gets cash to cover costs that couldn’t otherwise be purchased with a credit card.
The Pros of a Business Line of Credit
Working capital is defined as your current assets minus your current liabilities. In other words, it’s the amount of cash (or cash equivalents) that you have, minus your short-term debt obligations.
Whether you know it or not, if you own a small business, you’re going to have times when working capital is tight – and that’s a real issue. Working capital enables you to operate your business, allowing you to afford payroll, maintain inventory, and pay for other business needs. Below, we’ll explain some of the benefits a business line of credit can provide to your small business.
Evens out cash flow: For many businesses, a line of credit is the ideal tool for balancing cash flow. Of course, this is more applicable for some businesses than others.
For example, a retail store that’s heavily reliant on sales during the holiday season may not have the cash on-hand to make payroll. Because you can’t use a credit card to pay your employees, a business line of credit is the logical solution.
Pay for what you use: When you receive a line of credit, you only pay interest on the amount that you use. Also, depending on your arrangement with the lender, you may be able to pay off the balance at any time without a prepayment penalty.
Improved business adaptability: Sometimes, you have a limited window to take advantage of opportunities. For instance, let’s say you’re a manufacturer and your supplier’s cost is significantly reduced. You’ll want to take advantage of that limited-time opportunity, but you might not have the cash to do it. With a business line of credit, you won’t risk missing out.
Build business credit: Another positive aspect of a business line of credit is that it can help build your business credit history. To get the best terms on personal loans, you need a long personal credit history. The same goes for business credit, and a business line of credit can be instrumental in this pursuit.
The Cons of a Business Line of Credit
As with any capital source, a business line of credit has its downsides. Without downplaying the cons of lines of credit, many of the big problems only arise when borrowers are using the business line of credit irresponsibly.
With that said, the cons of a business line of credit, begin with the fees.
Extra Charges and Fees: While the pay-as-you-go option may make a line of credit seem like a no-brainer, fees and extra charges quickly add up. This extra cost will vary from lender to lender, and it will depend on the other agreement terms. Ultimately, don’t be drawn in by a low interest rate, just to be slapped with numerous fees.
Difficult to Qualify For: According to the Small Business Association, a business line of credit requires financial statements, business and personal tax returns, bank account information, business documents, and more. You’ll also undergo a yearly review to maintain your line of credit. In addition, the Small Business Chronicle reports that, in most cases, you’ll need two years of business history to qualify for a line of credit.
Potential for Misuse: A business line of credit is as useful as you make it. Thus, it should only be used as an insurance policy for cash flow shortages. Using it excessively is a recipe for disaster, but for many it’s a real temptation.
As with any decision to take on debt, weigh your decision to obtain a business line of credit carefully. It can be an extremely useful tool for savvy small business owners. And, one word to the wise from Entrepreneur is to apply for a business line of credit when you don’t need it. That way, when you do need it, you aren’t negotiating with your lender from a position of weakness.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.