The basics of small business lines of credit

Many times small business owners will experience cash flow shortages during the year.  This can come from many different reasons, including their cash being tied up in inventory or Accounts Receivable.  When cash is tied up in inventory it means that you have simply used all your available cash to purchase inventory. Perhaps because it was because there was a minimum amount or because he needed to take advantage of a steep discount by purchasing a large amount inventory upfront.  Or it could have been because you have shipped the products and are now waiting to be paid by your customers.

This is the reason why most companies will need a small business line of credit.  At some point, a small business line of credit allows the company to borrow in order to bridge the gap from the time that they expend money to buy the raw materials or to carry their receivables to the time that they actually get paid.  An example would be a small business borrowing $100,000 to purchase raw materials and when sell off finished goods they will then repay the hundred thousand dollar that they borrowed off the line of credit. The rest is their profit, which will go toward paying overhead or perhaps investment in other assets that will benefit the company.

Banks typically will secure small business lines of credit with inventory or Accounts Receivable. If the dollar amount small enough they will not require any monitoring on your line of credit.  If the dollar amount is larger then the bank will likely require you to submit something called a borrowing base certificate.  The borrowing base certificate is a form that the bank would require you to complete on a monthly basis.  Quite simply, it is a formula that the bank has come up with, which states how much you will be able to borrow on your line of credit.  So for example, the bank might say that they will lend you up to $500,000 or business line of credit.  Then, whenever you were about to borrow they would require you to complete a borrowing base certificate.  The borrowing base would have the formulas that you and the bank agreed to.  So, for example, they might lend you 80% of your outstanding receivables and 50% on your inventory.  If you had $200,000 in A/R and $100,000 in inventory, you would be eligible to borrower $210,000 on your business line of credit. 

Lines of credit are a great tool to help grow your business, but they should be used with caution.  Many small business owners get into the habit of using their small business lines of credit to fund long-term purchases.  Small business lines of credit should only be used for funding short-term purchases that will be converted into cash within one year. If you leave balances on your line of credit then your bank will likely require you to make monthly pricipal and interest payments on it to reduce the balance.  So it's in your best interest to make sure that you are using the business line correctly for both the bank and for your own good.

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