What is a Revolving Line of Credit?
In reality, businesses often seek financing to make ends meet, especially in the short term or during periods of growth. There are many financing products to choose from, but one option that may be a good fit for your business is a revolving line of credit. In this post, we’ll explain what a revolving line of credit is and how it can benefit your operations.
Revolving Line of Credit Explained
In a nutshell, a revolving line of credit is an open-ended financing product that operates similarly to a revolving credit card. It carries with it a max line of credit, and funds may be drawn up to this max amount, as needed. Once your business gets an influx of cash, the draws are then paid back, either all at once or in regular payments. As the line balance is paid off, the credit becomes available again. If your business maintains a good standing with the lender, the line can often remain available indefinitely.
Advantages Compared to other Financing Options
You may be wondering why business owners choose a revolving line of credit as opposed to other financing options. Here are some of the top advantages:
- Compared to business credit cards, revolving lines of credit usually have a more competitive interest rate, often just a few points above the prime rate for borrowers with good credit.
- A revolving line of credit can be more cost-effective than a term loan, as term loans require proceeds to be paid out in a lump sum at closing, whereas lines are only drawn upon when needed. This means that interest is only charged on funds while they are being used on a line.
- Typical business loans cannot be added to and do not allow the credit limit to be “reused,” even after paid off. With a revolving line of credit, the available credit increases as payments are made, giving it more flexibility than an installment loan.
Benefits of a Revolving Line of Credit for Businesses
Probably the most widely stated benefit of a revolving line of credit for a business is having cash available when there is a short-term cash flow deficiency. Whether your business experiences unforeseen expenses, slow paying customers, or need to purchase inventory, having a revolving line of credit can be invaluable.
In addition, if you want to expand your business, you’ll likely need additional cash to start this project. With a revolving line of credit, you’ll have funds available for buying equipment, marketing materials, inventory purchases, and other expenses. Then, once the profits from the expansion begin to roll in, the line can be paid back.
Another benefit of having a revolving line of credit is that you can potentially negotiate a better deal on purchases when you “pay cash” or take advantage of deep discount situations that require fast payment. The revolving line of credit gives you almost instant liquidity, while still retaining the flexibility of repayment over time.
How to Apply for a Revolving Line of Credit
Most revolving lines of credit for business are offered through traditional banks or finance companies. Before filling out an application, consider these components:
- Credit Score: Revolving lines of credit can sometimes be a harder to qualify for, so do your research to determine what your business and personal credit scores are. If you have items that can be resolved, do it before applying. For things that cannot be removed from your credit report, write a professional letter of explanation for the delinquent item, so that the lender understands what happened and how it will be resolved.
- Cash Flow: While lenders understand that a business can have ebbs and flows in their cash flow, they usually won’t lend to a company that is constantly “cash poor.” When applying for a line of credit, show historical trends for cash flow, and have a plan for paying back any draws that you plan to use. For example, a retailer that needs lots of inventory in September may show that sales during the holiday months of November and December will provide the required amount needed for payback.
- Line Amount: A mistake that many businesses make is requesting a line amount that isn’t realistic for their revenues. While it may seem like a good idea to ask for as much as you can get, this can often end in a decline notification. Generally, lenders like to issue revolving lines of credit with limits equal to about 20 percent of the business’ yearly revenues. That means that if your business earned $200,000 of gross revenues last tax year, a reasonable request would be in the $40,000 range or less.
- Use of Funds: Before applying, consider how you’ll utilize your business line of credit. While revolving credit lines are flexible and great for many uses, the lender might want to know how you’ll use the funds. If you are buying equipment or inventory, have specifics ready to show. On the other hand, if cash will be used for marketing, prepare a simple marketing budget. If you’re prepared to explain your plans, it will likely help you get approved for a line of credit.
Revolving lines of credit can be a great financing product for businesses to consider. While it won’t be the perfect fit for every situation, it can be a viable alternative to expensive financing options, or charging all purchases to a business credit card.
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.