By Tom Kirchmann
If you are a business owner and you often find yourself needing a temporary source of capital, a line of credit, or LOC, may be the solution you are looking for. Business lines of credit are provided by banks to give businesses temporary capital and an instant source of cash to use as business needs arise.
When applying for your LOC, keep in mind that the bank will likely want to know on which occasions you intend on using it. While it is a relatively common practice for an LOC to be a part of the package of credit facilities offered to the average business, the bank will still need to know on which circumstances you are looking to require use of the line.
It is strongly recommended to be fully-prepared with sound documentation prior to meeting with your lender.
If you are preparing a financial analysis to present to your banker before applying for the line of credit, bear this important point in mind: In terms of analyzing your repayment capacity, the bank will not include the principal payments that you make on the line of credit in its total debt service calculation.
This means that the burden the line of credit will have on your debt ratios may not be as great as it may seem at first.
So, for example, on a $100,000 line of credit at a variable rate equal to the Wall Street Journal Prime Rate + 2.00%, the bank will only calculate the projected interest payments on that debt when looking at the debt side of your calculation. Let’s say that it is assumed, in the worst-case scenario, that the entire $100,000 will be loaned out for an entire year, with pay-downs from time-to-time. In this case, let’s also assume an average interest rate over that time of 10.00%. So, in terms of calculating the total debt service paid on this line of credit the bank will arrive at a figure of $100,000 * 10.00%, or $10,000. Just the interest expense is added to your total debt service payment projection, not any “principal” payments you make as you pay down the line of credit.
One word of caution: Do not let business lines of credit become crutches that are used to fund permanent expenses. These lines are best utilized as temporary financial instruments that cover short-term cash flow needs. Once your receivables are paid to you or cash comes in from another source, use this inflow to pay your line to $0.
It is strongly recommended to only use the line of credit for short-term capital needs and to pay it down in a timely fashion. This is the intent of the line of credit, and in many cases, a commercial bank will require that a business convert this short-term line of credit debt into a long-term loan if it is not utilized in a way that the bank sees proper. In general, a bank doesn’t want a business to use a line of credit as though it were a term loan, and if the business does this in many cases the bank will simply require that the line of credit be eliminated and fully converted into a term loan.
This means that the more you can pay your line to $0 after using it, the better you will look in the eyes of your banker, as it will prove that you are handling the line of credit in a responsible manner. Business lines of credit are excellent tools for business owners to manage their cash flow, but care needs to be taken in making sure the lines of credit are handled in a way that the financial institution sees as satisfactory.
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