A recent report on The State of Small Business Cash Flow states approximately 69% of small business owners have been kept up at night due to cash flow concerns. Any small business owner will agree that efficient cash flow management can be a challenging task, especially when businesses are seasonal, or follow a cyclical sales cycle. Business lines of credit may be a dependable financial tool to help alleviate the pressure.
Unique Characteristics of a Business Line of Credit
A business line of credit is a way to finance short-term needs such as seasonal spending peaks, unexpected expenses, emergencies, cash flow gaps and more. A LOC allows a business to borrow up to a specific amount and pay interest only on the portion of money drawn from the account, which helps to minimize a company’s interest costs. By contrast, a term loan provides a one-time lump sum of cash that must be repaid over a specific time frame used for a specific capital purpose, with principal and interest being paid on the outstanding balance for the duration of the term.
Because LOCs are revolving loans, businesses can repay the debt, leave the account open, and borrow more in the future, if a need arises.
Interest rates for business lines of credit can range dramatically and are often times based on the risk of the borrower and/or industry. Several factors are taken into account to determine the actual interest rate a business will be charged:
- Interest rates for LOCs are typically priced with a spread over an index – either Prime, the most common, or LIBOR (London Interbank Offered Rate). As market rates change up or down, the interest rate on the line of credit will change accordingly.
- The borrower’s credit score, time in business, liquidity and collateral also play roles (find more detail about the criteria used by lenders by reading our post, The 5 Cs of Credit Analysis: How Banks Evaluate Potential Borrowers). Strong credit and solid business performance over long periods, plus the ability to pledge capital/assets, improve a borrower’s chances of obtaining a more favorable interest rate.
Secured or Unsecured Loans?
Lines of credit are typically secured loans. Secured LOCs usually offer borrowers higher credit limits (at lower interest rates) because they require the pledging of collateral (often in the form of AR and inventory.)
Unsecured lines of credit are inherently riskier for lenders as there is no collateral to liquidate in the event the business owner does not repay the outstanding LOC balance. Unsecure LOCs will typically have higher interest rates than LOC secured with collateral due to the increased risk to the bank.
- LOCs are designed to cover short-term cash needs, and amounts advanced on the line of credit should be repaid as short-term assets are converted to cash.
- Depending on the amount of the line of credit and the complexity of the company, a bank can set LOC monitoring requirements to help mitigate risks. For example, a bank may ask a business owner to provide a Borrowing Base Certificate, with supporting AR Aging and Inventory Reports on a monthly basis along with any other required financial information. The Borrowing Base Certificate is used as a tool to ensure that the company’s short term assets are adequate to pay back the outstanding LOC balance.
- Startups, because of the lack of a track record, are monitored more often than established businesses that have a history of strong performance and loan satisfaction.
How to Calculate the LOC Amount
Most lenders look at the borrower’s cash conversion cycle as a way to gauge the overall health of the company and to assist in determining short term cash needs. The cycle is a measure of how fast a company converts its cash on hand into inventory and accounts payable (AP), then sales and accounts receivable (AR), then back into cash.
Calculating the appropriate line of credit amount is typically done by looking at a company’s working capital needs. Working capital needs can be determined by following this basic guideline:
- Take your total estimated annual gross revenue and divide by 365 to determine your daily cash need.
- Add total of accounts receivable (AR) days on hand to inventory days on hand to get your use of funds; subtract (AP) days on hand from that number to identify your usage, expressed as the number of days you need to cover with LOC.
- Finally, multiple daily cash need by usage to get the estimated LOC availability needed for your business.
Here’s an example of an LOC calculation:
(Estimated Annual Gross Revenue/365) x ((AR Days on Hand + Inventory Days on Hand) - AP Days)
Annual Gross Revenue = $1,000,000
Accounts Receivable (AR) Days = 25
Inventory Days on Hand = 35
Accounts Payable (AP) Days = 30
($1,000,000/365) x ((25 Days + 35 Days) - 30 Days)
Using this method to establish a line of credit amount helps lenders avoid supplying excessive or inadequate credit to business owners and matches the line of credit amount with daily operating cash needs.
An LOC is a practical solution for overcoming short-term cash flow gaps and to manage unexpected expenses, while giving borrowers repeated access to capital and requiring interest payments only for the funds used.
Don’t let cash flow concerns stop you from getting a good night’s sleep. Find out if your company may benefit from a business LOC. Set up a meeting with one of our business bankers to discuss all of your financial options.