While most business owners are familiar with a business line of credit (LOC), many who are considering leveraging this financial tool for managing cash flow want to understand more, such as how interest rates are determined and how to calculate the most appropriate amount. The goal of this post is to provide the information necessary for businesses to fully understand this option, particularly compared to term loans.
What Makes a Business LOC Unique
A business line of credit is a way to finance short-term needs such as seasonal spending peaks, unexpected expenses, emergencies, cash flow gaps, etc. It allows a business to borrow up to a specific limit and pay interest only on the portion of money being drawn from the line; this helps 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 timeframe used for a specific capital purpose, with interest being paid on the outstanding balance for the duration of the term.
Because LOCs are revolving loans, businesses are able to repay the debt, leave the account open, and borrow more in the future if a need arises.
There are a number of factors that determine the rate a business will pay:
- 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, the interest rate on your LOC is likely to change.
- 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 of time, plus the ability to pledge capital/assets, improve a borrower’s chances of obtaining a more favorable interest rate.
- Many lenders also look at the borrower’s cash conversion cycle as a way to gauge the overall health of the company. 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.
Secured or Unsecured?
LOCs 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).
- Depending on the amount of the LOC and the type of business borrowing, a bank can require that the LOC be monitored; this helps mitigate the bank’s risks. These types of LOCs require borrowers to provide a Borrowing Base Certificate – documentation (usually an AR aging report and an inventory report, in addition to its regular monthly financial reporting) that’s used as a monitoring tool to ensure that the borrowing base is in line with the previously agreed upon advance rates. Startups, because of the lack of a track record, are monitored more often than established businesses with a history of strong performance and loan satisfaction.
- The 5 Cs evaluation performed by the lender may also help determine when a borrowing certificate is needed and when it isn’t.
- LOCs are designed to cover short-term cash needs, and amounts advanced on the LOC should be repaid as short-term assets are converted to cash.
How the LOC Amount is Determined
Identifying the appropriate LOC amount is typically done by looking at the 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 get 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 accounts payable 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 needed for your business
Here’s an example of an LOC calculation:
- With gross revenue of $1 million, ABC Company’s daily cash need would be $2740 ($1 million divided by 365)
- Total AR on hand (25) plus inventory days on hand (35) equals a usage of 60; AP days on hand (30) gets subtracted from that for a total of 30 days needed to be covered by the LOC
- Daily cash need ($2740) is multiplied by the 30 days needed to be covered, for a total of $82,200. An LOC of between $85,000 and $90,000 would likely be adequate in this situation.
Using this method to establish the LOC amount helps borrowers and lenders avoid having “too much” or not enough credit available 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 access to capital over and over again and requiring interest payments only for the funds used. It’s important to stay informed about the financial tools and insights that can impact your business; if yours might benefit from an LOC, talk with one of our business bankers about all your options.