Business Lines of Credit 101
It’s that time of the month again. You have payroll coming out of your account tomorrow and you had to buy materials yesterday. You check your business checking account and realize that there isn’t enough in your business checking account to cover payroll. Uh oh. Your stomach drops. You make the frantic call to the branch manager or business banker to transfer money from your personal savings account into your business checking. Did you make the call in time? How late is the bank open? Can you make the deposit in time? You’ll tell your accountant later, you have to get this done. You just figure this is part of the territory. This scenario is just another fire that you have to put out because you are the business owner.
What if I told you that this does not have to be your monthly routine anymore? What if there was a way for you to make sure all your bills are paid so you can focus on gaining more customers and growing your business? Well there is, it is called a line of credit.
What is a line of credit?
A line of credit is a loan agreement that gives the borrower a maximum amount they are allowed to borrow. The borrower can lend up to that limit. This is known as revolving credit. So let’s say a business, we will call it Brick Construction, LLC, receives a line of credit of $800,000, Brick Construction can borrow up to $800,000. So let’s say the business borrows $75,000 from the line that means they would have $725,000 left that they can borrow. If the Brick Construction pays off $50,000 of the balance it means that they have $25,000 that they still owe the bank and have $775,000 available to borrow. Now remember, you will need to pay interest on the amount that is borrowed but I want to keep the math simple for our examples.
How to use a line of credit
A line of credit is used to bridge cash flow gaps a business may have. Let’s say you have a construction business. You just received a contract for $1,000,000 but you will not receive your first payment until the project is 50% complete. This means that you will need to buy your material and pay your employees before you receive any payment. Sounds like a problem, right? Well this where your line of credit would come in.
Let’s use Brick Construction, LLC from our example before. Brick Construction figures it will cost them $300,000 to begin the contract work. Brick Construction uses $300,000 of their $800,000 line of credit. This means they now owe the bank $300,000 with $500,000 still available for them to borrow.
Brick Construction begins work on the contract and is able to complete 50% of the project after 3 months. Brick Construction is then paid $500,000(50% of the $1,000,000). Brick pays off the $300,000 balance on their line of credit plus any interest and pockets the rest as profit. This means they will have the entire $1,000,000 available to them to begin the second half of the project or start a new project. While this is rough math, this the basic way a line of credit works.
A line of credit can be used for retail shops or distributors who need to buy inventory as well. A line of credit is meant to bridge the gap between purchasing material and inventory and getting paid by your customers.
Benefits of Lines of Credit
Lines of Credit are a great tool to help you manage cash flow. They allow you pay the bills without having to dip into your personal savings to bridge the gap between starting work and getting paid for that work. A line of credit can help you rest easy that you have the cash to cover payroll or any other bills that may come due before you get paid by your customer. Like the example above, without the line of credit it would have been very difficult for Brick Construction to begin on their project for the customer.
Another benefit is that a line of credit will help you take on more work. Let’s say Brick Construction, during the current project, they had been asked to begin on a second smaller project. Because of the line of credit and them budgeting properly, they could use the line of credit to begin the second project as well. This means more revenue for Brick Construction.
Lines of Credit are also beneficial to businesses that may be seasonal. The business can use the line of credit during slow times of the year and pay off the line of credit during their busy time. In this scenario, you will be paying more in interest, but it is better then having to close your doors because you do not have the cash coming in to keep the lights on during the slow parts of the year.
How large of a line of credit should I ask for
Here is a quick guide to figuring out how large of line you should ask for:
- Calculate Cash Conversion Cycle: Days of Accounts Receivable + Days of Inventory on Hand – Days of Accounts Payable
- Find Cash Need per Day: Annual Sales ÷ 365
- Take Cash Need per Day × Cash Conversion Cycle
- Round Up
Note: Banks will give you 70%-80% of your current receivables. So you should ask for whichever is the smaller of the two.
Lines of credit are a great way to help you manage your cash flow. Managed properly, it can help you grow your business and reduce the number of fires you need to put out.
If you want to learn more about how a line of credit can help your business please send me a message or leave a comment! Or call me at 513-304-5576
Micah Dickson is a Community Business Lender at Fifth Third Bank. He is focused on helping small businesses in Dayton/Cincinnati get access to capital, small business loans, and solving their financial needs.
This post originally appeared on Micah’s LinkedIn Page: https://www.linkedin.com/pulse/business-lines-credit-101-micah-dickson/