How to Use a Business Line of Credit

Many businesses are fast-paced. You make a sale on Monday and manufacture on Tuesday because the customer wants their product by Thursday. There isn’t time to go looking for a new small business loan for each sale.

Luckily, business lines of credit were invented long ago. Lines of credit allow you to pull what cash you need when you need it and only make payments on the balance each month. Read on to learn how they work.

Overview: What is a business line of credit?

Business credit lines are a loan product used to help businesses with working capital needs. The business has free access to the line of credit as if it were a separate checking account and makes interest-only payments on the balance each month.

Lines of credit are usually collateralized by trading assets (i.e., accounts receivable and inventory) or may be unsecured.

Lines of credit are most often used by seasoned businesses with plenty of cash flow to make the payments. If your business is in distress or a startup, you may still qualify for a line of credit with an SBA loan.

Business line of credit vs. business credit cards: What's the difference?

Business credit cards are used to easily and quickly pay for operating expenses. They are effectively an unsecured line of credit (LOC) that comes with an easy-to-use pay mechanism. Imagine a non-accountant coming up with a definition that complicated for a credit card.

We will focus on revolving lines of credit here, which are used when there is a timing issue between collecting receipts from customers and the expenses needed to create the product.

The 3 requirements for obtaining a business line of credit

Be prepared with these items when you apply for a line of credit.

Borrowing base

A revolving business LOC is governed by a borrowing base. The borrowing base is a periodic reporting of the collateral in the loan along with adjustments. Most of the time, it includes the AR aging report along with deductions for concentrations, government accounts, and accounts that are canceled out by an account payable.

You’ll have to submit the borrowing base monthly or quarterly, and it determines the amount you can draw on the line until the next borrowing base is reported.

Guarantee

Trading assets are notoriously hard to collect when credit lines default. For added protection, the lender will likely require a personal guarantee of the line. This means, even if you have an LLC, you’ll still be held liable for the line balance if the business defaults.

Debt service coverage

The intent with revolving lines is for you to pay them off once you’re paid by your customer. In reality, very few businesses follow this exact process. To make sure you’ll be able to make interest-only payments each month, the bank will calculate what the payment would be if the line was fully drawn and make sure your cash flow is at least 125% of that payment.

How to use a business line of credit to support your business

Here is the typical revolving line of credit cycle. We’ll look at it through the lens of a fake company called Bryce’s $25k Closets.

1. Make sale and issue AR

The process starts when Bryce makes the sale to his client. That figure, $25,000, is a lot for a closet, so Bryce gives his clients 90-day terms to pay off the balance. Here’s what the journal entry would look like to book the sale as an account receivable (AR):

2. Report borrowing base to bank

Each month, Bryce reports his AR aging to the bank, and the bank adjusts it. Here are some of the common deductions the bank will make:

• Concentrations: When one customer takes up over 25% of your receivables, the bank will deduct that customer’s balance so that if it goes bad, it doesn’t tank the whole collateral balance.
• Government balances: The government is notorious for paying slowly and avoiding paying anyone but the business that provided the original service.
• Over 90 days late: It’s very likely that ARs over three months late will never be paid.
• Customers that have an AP: If the business owes money to a customer it cancels out the money the customer owes it.

The Bank then discounts the total value by 25% and that amount is provided on the line. Bryce’s Closets has a net AR balance of $450,000 so he should be able to draw up to $337,500 on the line.

3. Draw from line to complete product

Now Bryce has to make the product. He needs to buy materials and pay for the labor on the job. Part of the reason he’s able to charge so much for closets is his fast delivery, so he will draw on the line for the full amount.

Bryce can draw as much as $337,500 from the line, so he checks the balance, and when he sees it’s at $204,000 he makes the transfer for the deal into the operating account.

Here are the steps in journal entry form:

4. Collect AR

The closet is done and the client is very pleased, so it’s time to collect. The line has a 7% annual interest rate, so every month that the $18,000 sits unpaid costs 0.58% or $105. Even though he offers 90-day terms, it still makes sense for Bryce to attempt to collect as soon as possible. We’ll stick with the journal entry to illustrate the collection:

5. Pay off line

In a normal cycle, now would be the time to pay off the $18,000 taken from the line -- remember it’s costing $105/month -- but Bryce has a decision to make. He still has plenty of room available on the line, about $115,000, if he decides to reinvest the $25,000 back into his business he may be able to grow a little faster while making interest-only payments.

In the end, Bryce decides to pay the line down to keep his interest expense low. The client paid in 60 days, so he only ended up with $210 to tack onto the job:

Don’t go evergreen

Banks refer to lines that are never paid down as evergreen lines. Revolving credit lines are meant to be short-term loans for short-term purposes. If you let your line go evergreen, you’ll be making long-term payments on leverage that was used up long ago. That said, if you are going to go evergreen, make sure you do it on a line of credit and not business credit cards. Lines of credit will be far less expensive.