How Does a Commercial Line of Credit Work?

Commercial lines of credit are one of the most popular and most misunderstood financing products for small businesses. This article helps you understand how a line of credit works and gives you an idea of the qualification requirements. More importantly, it helps you decide if a business line of credit is the right solution for your business.

The article also discusses three alternative solutions that have many of the benefits of a line of credit. However, these solutions offer more flexibility and are easier to get.

How to use a line of credit

A line of credit is a financing solution that allows a company to draw up to a predetermined amount of money. To get funds, you simply request a draw from the line. You can pay the line back at any time, which increases your funds availability. Most simple revolving lines of credit operate much like a conventional credit card operates.

Lending institutions restrict how you can use the line of credit. Obviously, since it is a commercial line, it can be used only for business purposes. Companies use these facilities to cover short-term needs such as paying suppliers, covering payroll, and handling other corporate expenses.

The cost of using a line varies based on the size of the line and the risk. The financing fee is paid on the outstanding balance. It is usually variable and tied to the prime rate. Additionally, lines may have other fees such as maintenance fees and availability fees. These fees vary by institution.

Lastly, many banks require that your company repay the full balance of the line every so often (e.g., every year). This practice, often referred to as “resting the line,” is something to keep in mind if you are considering this type of a product.

Types of lines of credit

There are a number of ways to classify lines of credit. The most common way to classify them is based on whether the banks hold collateral directly or not.

a) Secured lines

A secured line of credit can use personal and corporate collateral to secure the repayment of a loan should the business owner default on payments. This security allows lenders to foreclose on assets if necessary.

Banks can use different asset types as collateral, including accounts receivable, machinery, inventory, cash, certificates of deposit, securities, and real estate. The bank or lending institution usually secures its position by filing a UCC lien (or similar instrument) against the pledged assets.

b) Unsecured lines

An unsecured line, on the other hand, does not have specific collateral that is pledged as security for the line of credit. While this approach gives your assets some protection, the protection is far from perfect. This last point is very important and is often missed by business owners.

Most unsecured lines are usually guaranteed by the company and by the owner personally. You could argue that the loan is secured by your guarantees. These guarantees often allow the bank to sue your company and the business owner personally in case of default. Obviously, if the lender wins the lawsuit, it could foreclose on your corporate and/or personal assets. In reality, no line of credit or business is ever completely unsecured.

Qualifying for a line of credit

The first thing to understand is that qualifying for a business line of credit is not easy. Lending institutions have various criteria that you and your company have to meet in order to qualify. The bottom line is that banks lend money based on the three C’s: Cash flow, Collateral, and Credit score. You and your company must have all three.

Role of the Small Business Administration

Most small business lines of credit are backed by the Small Business Administration (SBA) and are offered through the SBA (7a) Program. These programs are designed to help small business owners who need funds to operate and grow their businesses.

The SBA itself does not make loans. Instead, it acts as a guarantor to lending institutions, who, in turn, make these loans. Most business owners think that these guarantees protect them from problems if they default on the loan. This notion is incorrect.

The SBA guarantee acts as second-level protection for the bank. If the business defaults on the line of credit, the bank first tries to collect from the business and the owner. This collection can be done by pursuing pledged collateral and through other avenues. The SBA guarantee makes the bank whole (up to 90% of the loan) only if the lender is unable to collect from the client.

1. Company assets and income

Most banks and lending institutions examine your company’s income and assets as the first part of their review process. They can provide a line of credit only if your company has a means to repay it.

These requirements vary by bank. However, most banks want to see two years’ worth of operating profits. They also want to see assets such as accounts receivable, machinery, inventory, and real estate. In general, banks can provide financing for up to 50% of your assets.

2. Reasonable financial ratios

As part of the underwriting process for the line of credit, the bank reviews certain financial ratios. These reviews vary by situation, but banks usually look at the following:

  • Debt service coverage ratio: Measures if your company’s income is sufficient to pay the principal and interest of your debt
  • Fixed charge coverage ratio: Measures if your company is able to pay the interest of your debt after paying for your fixed costs
  • Current ratio: Measures your company’s liquidity and its ability to pay short-term obligations. It’s based on current assets and liabilities
  • Other ratios: Each financial institution has its own set of underwriting criteria and ratios that they review

3. Guarantees

Most corporate lines of credit require that they be guaranteed by the company, owners/major shareholders, or both. Guarantees may include that collateral be pledged and usually allow the lender to file a lien on specific assets.

a) Personal guarantees

Many lenders require that business owner or major shareholders guarantee the facility personally. Usually, individuals who own 10% to 20% (or more) of the business have to sign guarantees. The personal guarantee allows the lender to pursue the owner’s personal assets if the business defaults on the line of credit.

b) Corporate guarantees

Lenders require that the company guarantee the line of credit that it’s taking. They may want some or all of the company assets to secure the line. Also, if the company is a subsidiary of a larger company, the lender often requires a guarantee from the parent company as well.

4. Personal background and credit search

As part of their underwriting process, lenders often perform background checks on the business owner and major guarantors. They often check the personal background, professional history, personal credit, and assets of these key individuals.

Lenders go through this process to determine the assets and character of guarantors. Character is actually very important. Companies don’t run themselves. They are operated by owners, managers, and employees. How a person conducts their private life often reflects how they conduct their business life as well. As you may imagine, this process is done to exclude business owners who don’t have great credit or who have few assets.

Understand loan covenants

Business lines of credit usually have covenants. Covenants are rules and conditions that your company has to comply with if it wants to open the facility and to keep it operational. These vary by bank, but here is a list of some common covenants:

a) Net worth

Some lenders may require that your company keep a minimum net worth. This requirement protects lenders from having the assets of your company go too low, which would prevent lenders from recovering their funds.

b) Monthly certification

Some business lines of credit require a monthly certification process. In this case, your company needs to disclose the current state of accounts, inventory, and other assets. Funds availability is tied to the assets listed in the certificate.

c) Confession of judgment clause

This covenant stipulates that the bank is able to file a judgment without having to go through a trial. As you can imagine, this clause facilitates the lender’s collection efforts. Read more information here.

d) Liquidity

Lenders may require that your company comply with the minimum performance of a number of liquidity ratios such as the current ratio, the quick ratio, or the cash conversion cycle.

e) Debt 

Most lenders require that your company perform above certain minimums for the debt service coverage ratio, the fixed charge ratio, and similar ratios.

f) Material changes

Lastly, many lenders have a material changes clause that acts as a catchall clause. Basically, it covers a number of events that could have a negative impact on your business.

Benefits and drawbacks of a line of credit

Lines of credit have some distinct advantages, including:

  1. They can improve your cash flow quickly
  2. They can be flexible as long as you don’t reach the limit
  3. They can be used to pay for important and emergency expenses
  4. They are cheaper than most alternative solutions

However, like any business solution, lines of credit are not perfect and also have a number of disadvantages:

  1. They are hard to get
  2. They are not an option for startups or companies with less than two years of trading history
  3. Covenants can be hard to meet
  4. Once you reach the limit, it’s hard to increase it quickly
  5. Purchase orders are not considered collateral – this restriction can limit growth

Assuming your company qualifies for a line of credit, the decision to use one comes down to your main business objective. If you cannot meet the qualification requirements, obviously a line is not an option.

Often, the decision is a matter of cost vs. flexibility. Lines of credit can be inexpensive, but they often lack the flexibility that growing small businesses need. Other options tend to be more expensive but are also more flexible.

Are there better alternatives?

The problem with lines of credit is that few small and growing companies can get them. Government-backed lines of credit, such as 7(a) loans, may be easier to get than conventional financing. However, they are not easy to get. And even if you can get a line, increasing the limit is often difficult and time consuming. Here are three alternatives that can help growing companies that need financing:

1. Invoice factoring

Invoice factoring allows you to finance slow-paying accounts receivable. Most companies have low cash flow because commercial clients take 30 to 60 days to pay their invoices. Small businesses owners often can’t wait that long for payment. They risk running low on funds and being unable to pay company expenses.

You can improve your cash flow quickly by factoring your invoices. This solution finances invoices that are payable in up to 90 days. Instead of waiting for a payment, you get funds directly from the factoring company. This funding provides you with immediate working capital.

The transaction settles once your client pays their invoice on their regular schedule. The line is flexible and can grow with your business, as long as your commercial clients are creditworthy.

Qualifying for a factoring line is easier and faster than qualifying for a commercial line of credit. The most important requirement is that you must work with creditworthy commercial clients. This requirement is important, as your client’s ability to pay invoices is what supports the transaction. This solution is ideal for small and growing companies that can’t qualify for conventional loans. Learn more about factoring.

2. Purchase order financing

One area where lines of credit don’t work well is if your business is growing rapidly. Before long, you have reached your credit limit. This scenario can occur if your business starts getting more purchase orders. Asking the bank to increase your limit seldom works because purchase orders are not considered assets by lending institutions.

Companies that have this problem should consider financing their purchase orders (POs) using a PO funding line. This type of financing pays for supplier expenses directly associated with a purchase order. It allows you to book and fulfill large orders that you could not otherwise handle. Learn more about purchase order financing.

3. Asset based lending

Larger companies that have some assets but who don’t qualify for a business line of credit or can’t meet financing covenants should consider asset based lending. This solution can help companies finance existing assets such as accounts receivable, inventory, machinery, and real estate.

Asset based lines that have receivables and inventory as underlying assets work much like revolving lines of credit. The credit limit of the facility can increase quickly, as long as your company has the accounts receivable (and other assets) to back them. This feature makes asset based lines an ideal option for small businesses that are growing quickly. Learn more about asset based financing.

Are you looking for financing?

We are a leading provider of factoring, purchase order financing, and asset based lending. For an instant quote, fill out this form or call us toll-free at (877) 300 3258.

Editor’s note:

Given the complexity of how lines of credit are offered and marketed, this document is not guaranteed to be 100% accurate or cover every potential option. However, we make every effort to provide the best information. If you have comments, suggestions, or improvements, contact us via LinkedIn.