Business Lines Of Credit
Business lines of credit have become very popular over the last few years. Previously lines of credit were lending options from the big banks and SBA. But now alternative lenders have entered the market and with their entry, they have loosened qualification standards and have also made adjustments to the terms.
Let’s start by discussing what a business(commercial) line of credit is and how it is used. A Business line of credit is a financing solution that allows the business owner to keep available funds at their fingertips. They can request any available amount and get the funds they need when they need it. As you pay back the borrowed funds the money becomes available again for reuse. And this procedure will continue for the agreed term of the credit line. Many say that it operates like a conventional credit card, which is partly true but there are some variants that you will be able to resolve through this article.
Since this is a business line, usage is restricted to business purposes only. It can be used for cash flow shortages to pay bills, make payroll, buy equipment, etc.. Using the line for personal use can be risky, if discovered by the lender they will close the line and may even call it immediately due and payable. There are personal lines of credit available for any use at all. Keep business and personal separate!
The initial cost of a business line of credit varies by the lending facility. There may be draw fees (a fee charged when you withdraw money), maintenance fees, underwriting fees, etc, which will be charged and deducted from the account. These lines also work on an interest-only payment schedule with anything added above and beyond that goes to paying down the principal. The interest is usually a variable and is calculated off a formula that is tied to the prime rate.
The one biggest difference from the comparison to a credit card is that many lenders and banks will put a term limit on the line where they want the advances to cease and the line paid off. Once the line is paid off the lender will require updated information to re-establish a new line of credit.
There are various types of lines available but for all the differences they fall under two categories.
First is the secured line of credit where a business owner can use personal and corporate collateral as an asset to secure repayment if they should default. These assets may include equipment, property, receivables, or anything else that can be easily converted to cash.
Pledging these assets as security may allow a business that cannot normally get approved can obtain the financing they need or those that may need more money may obtain the higher loan amount.
The second is the unsecured line. But this is not what it sounds like. Many lenders’ sales agents use this term to dupe the business owner into thinking that if they were to default that nothing bad will happen, maybe a ding on his credit. These unsecured lines are often personally guaranteed by the owner or the company, which will allow the lender to come after the owner personally or after the assets of the business. Of course, this is based on the amount of the unpaid balance and the communication between the lender and business owner. The process for the lender to legally go after assets or the business is too involved and costly, so they try to resolve the problem by working with the owner. Everyone must understand one principle of lending! Lenders are in the business of lending money! They lend money and want it paid back with interest, and with little or no problems. They are not in real estate, auction, liquidation, or any other business. They just want to be paid back. It’s that simple!
As we discussed earlier, alternative lenders have started appearing in the market offering alternative style business lines of credit. The qualification requirements have been eased but this has been reflected in tighter term restrictions.
Alternative lenders base their approvals, for smaller funding amounts, on the monthly bank statement deposits, average daily balance, and ending balance. What they are looking for here is how much money is the business able to retain after paying all its bills, and based on that amount will decide an affordable funding amount for maximum exposure. They also review the credit with some lenders going down to 550 FICO. The credit report must not include any judgments or new collection accounts.
Although more flexible, the terms are usually shorter and limited to a 12 or 24-month term with weekly payments instead of the normal monthly payments.
The National and Local Banks
Today it is hard to find a local bank that is dedicated to the success of their community. These local banks are on the decline, but can still be found in some rural areas. They are more likely to work with small businesses throughout their community and may have flexible underwriting guidelines compared to that of the national banks.
But if you don’t have the luxury of living in an area that has a small local bank, then most likely you will not have success with the big bank unless you are a larger business. The fact is that most small community-based businesses have less than 15 employees, and this is where the problem exists. Those small community businesses do not whet the appetite of the big banks who are driven by large profits.
Other conditions affect the small business’s inability to borrow money from the banks. That is that the small business owner has not set up their business for viability and credibility, which means that they will not meet the standards for prime financing. Many of these small business owners also run their business at a loss or a minimal gain to minimize their tax liability, thus trying to maximize their cash availability. But this hurts them. How can a business pay monthly payments if they are operating at a loss, which means that there are no available funds for more debt. Yet when you talk to the business they say we can afford it, and yes that is probably true. They can cut a little here and a little there but banks and lenders don’t look at that. They need to see the money available, otherwise, they will decline the file. Many other factors are involved in the prime lending process which will be discussed further in this article.
SBA (Small Business Administration)
If the small business has established itself as a viable entity for funding then they may have the ability to walk into their bank and possibly obtain funding, and yes I said possibly. Again depending on the size of the small business and how valuable the bank regards that small business, the process may drag on for months and in the end, it still may be declined. Many banks use board members to make the final decision on all financing transactions, and if they find that the small business is not worth the risk and that the profit that will be earned will not meet their minimum standards, they will decline the file.
Although the banks rely mostly on SBA for their business financing options, and even though SBA will insure that loan up 90%, the bank still has the final decision. SBA does not make the loan, which is a common misconception. What SBA does is act as an insurance policy to protect the approved lender from the consequences of loan default. As an insurer, SBA does utilize very strict guidelines that the lender must follow, and one of these guidelines may ask the borrower to pledge assets to protect SBA and the lender. It must only be understood that if the business does not have positive tax returns it is not getting approved
Like we discussed earlier if the business is not up to par on their financials and other points that go into qualifying for prime financing, the business will have to alter course and try alternative lenders. Alternative lenders will still base it on personal credit score and the activity in the business bank account, but they provide the additional options some small businesses need.
Every business owner must strive to focus on the development of the business, and that means all areas. The back end will complement the front end and allow for faster growth. Only 30% of all small businesses utilize an accounting service and this is most likely the biggest contributor to 60% of all new ventures failing within the first 5 years. A small business owner may save a few tax dollars but will spend more on financing charges, suffer credit restrictions and stunt the growth of their business without the right back-office support.. A proper accounting system that is focused on growth will increase profits and increase the income of all owners.
Now let’s look at some of what underwriters for prime financing look at…..
Background and Credit Check
In the first part of the process, the underwriter will review personal and business credit checks. The weight of which report that they rely on is based on the lender and the size of the company and its assets. So both must be maintained, specifically for small community businesses that don’t have a lot of business assets. The personal credit report will show the stability of the principal and their assets. Personal assets like homeownership play an important role in the approval process. It shows that the borrower has stability, and helps for higher approval amounts even in Personal Lines of Credit. The business credit report will show the credibility of the business. Most declines by prime lenders are that the small business has not established any business credit. (Vendors and creditors may place negative items on a business credit report which will lead to an automatic decline, and the business owner may never know why).
A background check will also be performed. Many lenders have different views on how far they will go on the decision-making on this, but unanimously it is understood that any white-collar crime is an automatic decline. They also want to understand the professional backgrounds of all owners and key individuals.
Another review will be an internet search of the business. It starts with the company website, customer reviews, how easy it is to locate, and can everyone understand the type of business that is being executed. Is the phone number published? They also look to see that your identity is viable and that you are not trying to do business under alternative names.
Please review the module on the 5C’s of credit to understand how credit is reviewed. It is not only based on a credit score. Most lenders utilizing SBA financing require a 680 FICO score, and that is further reviewed for depth and the capacity that the borrower exhibits. Business credit should be reviewed before submission to assure that no derogatory items have been placed on the reports. You can contact us for information on getting that report. Proper structuring will prevent poor results.
- The Financials
Lenders will review the financials to see the company’s income and assets. The real key here is that they want to see a positive cash flow that will determine what the business has available in the form of payback. Showing a loss on the bottom line shows that the business cannot afford any additional debt. Lenders want to see 2-3 years of financials to see the track of the business. They also will want to review your accounts receivables, and a detailed view of your assets (machinery, real estate, inventory, etc).
When structuring a deal for submission always include 3 years of business tax returns, cash flow statements, balance sheets, and year-to-date P&L. Other items should include accounts receivable print out, and a list of assets, personal financial statements, and 3 years of personal tax returns.
- Formulas, Ratios….it’s all in the numbers
The lender will perform calculations based on their underwriting guidelines to determine affordability and the maximum amount that can be funded. These calculations are ratio based and it determines that after all your expense (profit) what the business can afford. It is important to understand that if you9 show a profit of $12,000 for the year, $1,000 per month, that the lender will use only a portion (varies by lender, rule of thumb is 50%) of that amount. They want to see that the owner is still realizing a gain or a profit.
It is important to understand that the lenders can only take into consideration what is shown on your financials and the other factors that are in print in front of them. The borrower can promise to repay the loan but the lender is not interested in future changes only about proven history.
Guarantees are required, but the type of guarantee depends on the small business. I always state that Bill Gates does not personally sign a guarantee to repay when Microsoft wants to borrow money. Because their financials ate in order, they have plenty of assets, it is guaranteed by the company ( where an executive who has signing power will endorse the guarantee for the company). This may allow the lender to file a lien on the company’s assets in case of default, and to protect the lender’s assets. This also means that no person is personally liable for the repercussions of loan default.
For most small community businesses, the lenders will require a personal guarantee. That means that in case of default the lender can pursue the owners of the business and their assets and requires a guarantee from the company as well.
Congratulations! You have met all the conditions of the underwriting process and you have been approved for funding. The last step in the process is to understand the closing documents and any restrictions or covenants that they include. This is where you will understand how to maintain the line of credit in good standing and the reasons they may restrict or cease the use of the line.
Access to cash flow is important to a small business. It keeps the business whole and keeps it growing. But obtaining the right funding at the right terms, and the right funding amounts is the secret to a long and viable business life. We have discussed that there are many factors in running a business. It takes a uniform cohesion between the back end and the front end of that business to be sustainable. Yes, sales are important, but knowing how that cash flow is working for you is just important. Think of those history lessons that showed kings with massive stashes of gold and jewels just to lose it all. It was because they had a bad accounting system! The most famous was Caligula.
There are various routes for business financing, and you must understand the benefits of the options available to small businesses. Contact Ebizmore Accountants and Advisors (firstname.lastname@example.org) to learn financing options and why it is important to have a functional back end that enhances the work and focus of the front end.
Business Lines of Credit
You’ve got a business to run.
A Line of Credit makes financing accessible whenever you need it
Flexible financing that allows you to draw what you need when you need it.
Only pay interest for money while it is working for you.
Ultimate Capital Access
As draws are repaid those funds are available to draw again, giving you ultimate flexibility in capital access.
Helpful commercial financing specialists dedicated to make sure the loan works for your business.
What you need to get started
Time in business (6 months)
Personal credit (Above 500)
Monthly sales (Above $10,000)
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