How does a line of credit work
Line of Credit Basics
How does a line of credit work?
A LOC works in much the same way as a credit card. A bank or lender grants you a line of credit, which you can tap into on an as-needed basis. You pay interest on the outstanding balance, usually on a monthly basis. When you pay back the principal, money is made available for future loans.
What are LOCs typically used for?
A LOC is considered a form of short-term credit. It is most commonly used to finance ongoing working capital when a business needs to shore up its short-term cash flow. For example, it may access a LOC when scheduled receivables are late and operating expenses (such as payroll or rent) come due. A LOC is also useful for financing short-term or seasonal expenses such as inventory purchases, or covering cyclical business fluctuations. Finally, some companies activate a LOC to pay bills early and receive the resulting discounts, which may be more than the interest due.
Why do companies use LOCs?
The most compelling benefit to a LOC is that money is available when your business needs it. This makes it ideal for handling short-term cash flow issues, seasonal purchases, or other last-minute financing needs. In addition, LOCs that carry no application fees, such as a Business Credit Line from American Express Small Business Services, do no accrue interest until you use the funds, so there is no immediate cost to taking one out. You only pay for it when you use it.
When should a business not use a LOC?
Small businesses should be careful to avoid using a LOC for longer-term financing. Companies that top out their credit line quickly and can only make minimum monthly payments may find that a LOC can be a drain on cash flow as they are unable to
reduce the LOC's principal. This can both stress the company's balance sheet, and potentially hurt its ability to acquire other types of credit.
What do lenders look for to grant a LOC?
The strength of a business' cash flow is often the key factor lenders look at before granting a LOC. They want to see that a company's cash situation is strong, and that it has contracts that ensure a reasonable flow of receivables. In addition, your credit history, your ability to secure the LOC, and other assets you have with the lender will likely play a role in your ability to receive a credit line.
How large a line should a business request?
Obviously, the amount of your LOC will depend on your business' specific financial needs and assets. Many financial experts suggest that a company plan to use 75-80 percent of its credit line to cover typical operating expenses, with the remainder available for contingency purposes. It is also important to be sure that your business has the cash flow available to pay down that debt to zero for at least one month during the year. Failing to do so may indicate to that you have borrowed too much, that you've underestimated receivables, or that sales are down.
When should a company apply for a LOC?
Conventional wisdom is that the best time to apply for a credit line is when you don't need it. Lenders are most likely to grant a LOC when your business' cash flow is strong and your balance sheet is clean. You can then tap into it should your cash flow experience any seasonal or temporary fluctuation. Companies with negative cash flow and startups typically do not qualify for a LOC because they are not able to demonstrate consistent receivables.
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