Follow these tips to qualify for a line of credit that will help with pressing financial challenges or allow you to buy equipment to grow your business.
You have good cash flow, minimal debt and no upcoming major purchases in the works.
But you know just how unpredictable the future can be. “Chance favors the prepared,” the old saying goes, but how do you realistically prepare for every eventuality? You can’t, of course. But anything you can do to provide more flexibility when fortune changes, for better or worse, can put you on the right side of those wise words.
One way to prepare is to establish a line of credit even when you don’t need it. Strengthening your position now to borrow in the future can pay off handsomely. And along the way, it lets you forge a stronger relationship with your bank.
Mills Snell owns Pendleton Street Advisors in Columbia, South Carolina, a business financial planner. He says setting up a line of credit when you don’t need it helps in three ways: timing, sentiment, cash flow.
Timing. Getting a line of credit takes several weeks if not longer, Snell points out — even if you have already organized all the information your banker needs. When opportunity knocks, why risk losing out to a better-prepared rival ready to open the door immediately?
Sentiment. If the emergency that sends you to the bank puts your company in a fiscal bind, “lenders will either avoid perceived risks or make the borrower pay more in order to make it worth their exposure,” he notes. A credit line already in place helps avoid that.
Cash flow. Even present-day good times and a healthy savings account might not insulate you from future business ups and downs. “The ability to be flexible and tap into a line of credit could be a make-or-break moment for a business owner,” Snell says.
“Cash flow is different than cash,” he continues. It can be shortsighted to evaluate a decision simply by looking at whether you have enough money now.
Suppose you see an opportunity to add another service truck and hire two more people. You crunch the numbers and find that it will take two years to break even on the added cost — but once you get there, your profits can take off.
Still, short-term strains on your immediate savings and on your cash flow could reasonably scare you off. A credit line gives you freedom to look at the idea’s long-term sustainability, Snell explains: “It also creates a margin of safety where things have time to play themselves out rather than something having to work out perfectly right away.”
OK, so you’re sold on the concept. Now what? Analyst Ian Atkins, at Fit Small Business (FitSmallBusiness.com), offers this prescription:
- Always have an accurate, current profit-and-loss statement and balance sheet.
- Always have an accurate, current personal asset/liability list.
- Keep your personal and business credit scores as high as possible.
- Make sure taxes are filed on time, with no tax debts.
“Small-business owners should also ask themselves on a regular basis, ‘Will I need financing six months from now?’” Atkins counsels.
“Getting the best terms on financing means impressing your lender. If there are any blemishes on your credit, you have time to improve them. If your books are disorderly, you have time to straighten things up. It’s all about accurately presenting yourself in the best possible light.”
It gives a whole new twist on the adage time is money: “If you don’t give yourself plenty of time to get spruced up, you can’t address issues before working with a lender,” Atkins explains, because suddenly, you’re looking like a riskier borrower. That could cost you in a smaller line, shorter payback terms or higher fees.
Once you have the credit line in place, Snell suggests that before drawing on it you ask yourself, “Is this an expense for consumption or investment?”
You might need to tap the line once in a while to make payroll or buy supplies in tight times — “but you will certainly get in trouble if you make it a habit.”
Instead, Snell suggests, use your credit line to build long-term income. “Buying a new piece of equipment could expand your business’ service offerings and generate revenue that you would not have access to otherwise,” he says. “By financing the purchase with a line of credit, you allow the investment to begin paying for itself before you have to part with your hard-earned cash.”
Traditional vs. guidance
There’s more than one approach, however. Dominic Karaba, executive vice president for business banking with UMB Bank, points out that some businesses routinely use a traditional credit line to cover “working capital needs like paying salaries or expenses while you are waiting for receivables to be paid or collected.”
For bigger capital expenses, though, Karaba suggests a different animal: a “guidance line of credit.”
A guidance line is “primarily for equipment needs this year, but the needs might not be known yet,” he explains. You don’t actually draw on it until you give the bank an invoice for the new equipment. At that point, the borrowed amount is converted into a term loan, typically with a three- to five-year payback schedule.
For a guidance line, your banker will want a clear picture of your expected needs for capital expenditures and equipment in the coming year. (Of course, you also need the other usual documents — tax returns, balance sheets, P & Ls and so on.)
Banks apply different standards to guidance lines and conventional credit lines, Karaba notes. The traditional line will rise and fall over the annual expense and revenue collection cycle, and it typically must have a yearly “resting period” when the line has a zero balance owed.
What you don’t want to do, cautions Snell, is treat it as an infinite safety net. Better to suffer the short-term pain of watching cash go out the door than the long-term disaster of your balance owed creeping up month after month with no end in sight.
Meanwhile, the guidance line is specifically designed for major expenses, as is the term loan that takes its place once the purchase is made.
“Always think about how long it will take to pay off the loan through operating profits,” says Karaba. “If you can pay it off in less than a year, then a line of credit could be OK. If it will take more than a year to fully repay the amount borrowed, then a term loan or a guidance line with a term-out feature is more appropriate.”
Setting up a line of credit also means a closer relationship with your bank — and that demands better communication. That will help when things get sticky. Atkins, of Fit Small Business, notes that a bank line of credit “can be slowed or reduced at the lender’s discretion.” Keeping in touch — and alerting your bankers to sudden changes, like a ding on your credit report or a shift in your normal borrowing pattern — means they won’t be caught off guard, he adds: “Lenders hate surprises.”
UMB’s Karaba agrees. Meet every three months or even every month with your banker “to talk about needs and plans for the next six to 12 months,” Karaba says. “The business owner should not wait until the last minute to tell the banker any new business needs. Instead, be open and honest with your banker so you both can plan.”
A strong banker relationship is good in every respect, and failing to forge one is “the first mistake,” he adds. Don’t hold back information about how you’re doing or your potential future needs. “Being proactive makes the entire business a lot easier.”
ABOUT THE AUTHOR
Erik Gunn is a magazine writer and editor in Racine, Wisconsin.