How to get the most out of a line of credit

(By Carolyn Rourke, Finance and Strategy Specialist with the Michigan Small Business and Technology Development Center. From SBAM’s member-only Focus on Small Business magazine)

Businesses often are short on cash and looking for ways to manage cash shortfalls. The shortfalls can happen due to good circumstances like sales growth – or from poor reasons such as lack of inventory management. Many factors impact managing cash flow on a short term and long term basis. A financial review of multiple areas is important, but often short-term financing is the best option.

One option for short-term financing is a line of credit. A line of credit (LOC) provides a business with a source of funds (credit) from a financial institution – bank or credit union typically. This type of account is used by a business to fund short term operations and is an important tool for managing cash flow. Depending on the customer billing cycle, a LOC is useful to support working capital. For example, if a customer pays their bill in 60 days and the business needs inventory to fill the order, a LOC may fund inventory purchases until customer payment is received.

Supporting Working Capital Through Line of Credit

Working capital is the difference between current assets and current liabilities. It is a measure of the company’s ability to fund short-term operations. Negative working capital means a company is currently unable to meet short-term liabilities (accounts payable & payroll) with current assets (cash, accounts receivable, and inventory). In the event of a cash shortfall, the LOC is used to support working capital. Positive working capital illustrates a company is able to meet short term obligations with short term assets. Companies with positive working capital may use a LOC to extend working capital resources – essentially putting more cash to work for the company. For example: rapidly growing sales or a new product launch require an inventory build-up which can be funded using short term credit.

A business with declining working capital over the long term must evaluate why the business model is not working and determine whether it is a symptom of operational inefficiency. For example, decreasing sales volumes result in a lower accounts receivable balance, diminishing the assets of the company. If the company continues to produce at a high rate, an excessive level of inventory thus limits the cash available to reduce debt obligations. Inefficient collections for accounts receivable will show up as an increase in the working capital (assets), but by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company’s operations. This is also illustrated when a company becomes dependent on a LOC for the majority of its working capital. Establishing metrics for inventory turns, accounts receivables days and monitoring those on a weekly/monthly basis, will help a business utilize its LOC more effectively.

Effective Use of LOC

The most common LOC establishes a maximum loan balance the financial institution will allow the company to borrow. The company can draw on the LOC as needed, provided the balance does not exceed the maximum level set in the agreement. This flexibility gives the company the discretion to manage short term cash. Interest is paid only on money actually withdrawn, an advantage over a regular term loan, and the borrower can draw on the line of credit at any time. Depending on the agreement, the LOC may be a demand loan, meaning any outstanding balance must be paid at the request of the financial institution. Another reason to use the LOC for short term cash needs only! LOC should not be used to purchase equipment or other capital expenditures. 

A LOC can be secured by collateral or unsecured. Collateral is an asset the company or its owner pledges toward the loan. The lender has the legal right to the asset for the term of the loan and is able to sell the asset in the event of default. In the event collateral is not required, the LOC is considered unsecured. The company’s financial ratios as well as borrower credit ratings are decision factors for collateral requirements.

Business owners should proactively manage cash, short term debt and long term debt. A common challenge is balancing short and long term financing needs. Because a LOC is readily available and may be more easily obtained than a long term loan for equipment, the owner may be tempted to use the LOC to purchase equipment. This can be a critical cash management mistake due to the requirement to pay down the LOC in the short term. When the long term asset (equipment) does not generate cash or delays in implementation occur, working capital for normal operations may not be available. The key to effectively managing working capital using a LOC is to use this short-term debt exclusively for short term activities that will generate the funds to repay the loan within the defined lending terms. A LOC is an important financial tool that can bridge the timing gap between short term purchases and account receivable collections.