Business owners who need financing often look for a line of credit. Lines of credit are very flexible and can provide your company with working capital when needed. They can be useful if your revenue is seasonal or if your business is growing quickly and you need money to pay for expenses. Furthermore, lines of credit are usually affordable – at least compared to alternatives. Learn more about how business lines of credit work.
However, getting a business line of credit is not easy. Even lines that are backed by the Small Business Administration (SBA) can be challenging to get. Securing a business line of credit is difficult because, above all, banks lend only to companies and owners who have cash flow, collateral, and a good credit score.
This article discusses:
- Business and personal requirements to qualify for a line of credit
- The role of the Small Business Administration
- Alternatives that work as well as a line of credit but are easier to get
Business Qualification Requirements
As part of its due diligence, the bank or lending institution examines your business to determine if it qualifies for a commercial line of credit. The bank looks at your assets, past and current revenues, as well as other items. This process is usually extensive and can take weeks. Here are the most important requirements to qualify for a business line of credit:
1. Time in business
Lenders extend business lines of credit only to companies that have been operating for a minimum of two years. This time in business shows the lender that the company has some longevity and experience. However, lenders can provide a line of credit to a startup if the owner has good personal credit, solid collateral, and personally guarantees the loan.
Banks and lending institutions lend only to companies that have collateral to back the loan. Collateral is any type of asset that can be used to repay the loan. Banks often look for accounts receivable, inventory, machinery, real estate, and financial instruments as collateral.
Most lines of credit are secured by collateral. The company pledges specific collateral to back the loan in case it cannot repay. The lender often secures this collateral by filing a UCC Lien, which gives them priority if they need to collect. It’s common for lenders to ask small businesses to pledge all their assets as collateral for a line of credit.
3. Revenues and profits
To qualify for a line of credit, your company must have revenues and must be profitable. Lenders consider your revenues as their principle means of repayment. Therefore, your revenues and profitability must justify the size of the line of credit. Companies that don’t have revenues or are unprofitable are not able to get a line of credit unless they (or their owners) can provide collateral as a guarantee.
4. Financial ratios
As part of their due diligence, lenders examine the financial ratios of your company. This review gives lenders an idea of how your company is performing. Each lender uses its own ratios. At a minimum, you may need to comply with these ratios:
- Fixed charge coverage ratio: Can your company pay its debt after paying its expenses?
- Current ratio: Is your company able to pay short-term obligations?
- Debt service coverage ratio: Does your company generate enough revenue to pay its debt?
- Debt to equity: Does your company have too much debt?
Most business lines of credit require a corporate guarantee, meaning that the company guarantees repayment. If the company is a subsidiary of a larger company, lenders usually require that the parent company provide a guarantee as well. As the next section describes, banks may require that company owners and major shareholders guarantee the line of credit as well.
Lines of credit usually have lending covenants. Covenants are the rules that your company must follow in order to keep the line of credit active. Defaulting on a covenant can result in extra fees and could lead to your line being terminated. Each bank or lending institution has its own set of covenants. Some covenants state that your company must:
- Comply with financial ratios (see #4)
- Maintain a certain net worth
- Maintain a certain liquidity
- Not exceed a certain level of debt
- Repay the line in full periodically (e.g., once a year)
- Agree to a confession of judgement
- Advise the lender of any material changes
Owner and major shareholder requirements
Most lenders also evaluate business owners personally to ensure that they are good credit risks. Obviously, they are running the company, so evaluating their experience and other factors is important.
However, there is another reason for this evaluation: banks often ask business owners and major shareholders to guarantee the business line of credit personally. This personal guarantee means the owners and/or shareholders become personally liable if the business defaults on the loan. The personal review helps the bank determine if the business owner can pay any debts.
1. Professional experience
Lenders review your past professional experience to determine your ability to operate a business in your industry.
2. Personal credit
As part of their underwriting process, banks examine the personal credit of the business owner and all guarantors. Reviewing your credit lets the bank determine if you are responsible and willing to pay debts. Remember that businesses do not run themselves. They are operated by their owners and managers. How an owner manages their personal life is often a good reflection of how they manage their businesses finances. Reviewing your personal credit helps lenders make this determination.
In some cases, the bank may extend a personal line of credit that is to be used for business. For example, with business credit cards, the lender checks your personal credit but issues the card in the name of the business. However, you are ultimately responsible for payment.
3. Personal assets
If your bank requires a personal guarantee, they may also review your assets. This review allows the bank to verify both the existence and market value of the assets. Banks look for cash, stock securities, investments, and real estate as assets for collateral. From the bank’s perspective, a personal guarantee is only as good as the assets that are backing it.
4. Background investigation
Lastly, lenders usually run a background check to determine if there are any potential issues, such as past criminal behavior, that could affect their decision to give you a business loan.
Can the SBA help you?
The Small Business Administration offers a number of programs to help business owners get financing. The most popular program is the 7(a) Loan Program. One common misunderstanding is that the SBA provides the loan or line of credit. This notion is incorrect. Loans are provided by commercial lending institutions who get a guarantee from the SBA.
Keep in mind that the guarantee of the SBA is designed to protect the lender – not necessarily you. The SBA acts as a guarantor of last resort and can cover up to 90% of the line of credit value. However, the SBA steps in only after the bank has tried to collect from all corporate and personal guarantors. Keep this important detail in mind if you plan to apply for an SBA-backed loan or line of credit.
Financing alternatives that are easier to get
As you have seen, qualifying for a line of credit can be difficult. Most business owners won’t be able meet the requirements, even with SBA backing. Fortunately, two options provide many of the benefits of a line of credit, but are easier to get:
a) Accounts receivable factoring
One of the reasons that business owners look for a line of credit is to smooth out cash flow. Most cash flow problems happen because clients take 30 to 60 days to pay invoices. However, companies need to get paid sooner so that they can pay for their own expenses. You can improve your cash flow by using invoice factoring, also known as accounts receivable factoring.
Factoring provides you with funding that uses your slow-paying invoices as collateral. The factoring company can finance from 70% to 90% of the value of the invoices, providing you with immediate working capital. Invoice factoring has many of the benefits of a line of credit, but it is much easier to get. The most important requirement to qualify for factoring is to have creditworthy commercial clients. Most factoring lines can be set up in a week or two.
b) Asset based financing
Asset based financing is a more sophisticated product than factoring and is available to larger companies that could not get a line of credit or could not meet bank covenants. An asset based loan allows you to finance the assets in your balance sheet, including accounts receivable, inventory, machinery, and real estate.
An asset based financing line can operate like a line of credit or a term loan, depending on which assets you are financing. Lines that are backed by accounts receivable and inventory can provide most of the benefits of a line of credit. Lines backed by machinery and real estate operate like term loans.
Qualifying for an asset based loan is easier than trying to get a line of credit. The process can be completed in a couple of weeks. You can learn more here.
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