A Business Line of Credit (‘LOC’) is a great debt finance product for businesses that need to level their cash outflows with cash inflows. Many businesses require covering significant costs up front continuously before they are compensated (i.e. real estate developers, contractors, software developers, etc.); however, they also need to finance their day-to-day operations as well (i.e. administrative and office costs). Therefore, a LOC could provide a business with funds to finance their operations ongoing until compensation is received.
Businesses can manage the amount they can withdraw and pay back, but there may be restrictions depending on the nature of the banking agreement. Such flexibility can be beneficial for businesses who are very disciplined with their cash resources, but it could be dangerous for businesses that are not organized or knowledgeable of their spending habits.
What’s the worst that can happen?
If a business is bad at cash management, they can easily max out their line of credit within a blink of an eye. Although the intentions of the business owner were probably good (paying overdue bills, acquiring capital assets, purchasing inventory, etc.), the company’s ability to pay down the outstanding balance may not be as easy as management forecasted. Now, the company is operating with a fully loaded LOC that charges interest payments that can be a burden to the company’s monthly cash flow. Also, depending on the contract set by the lending facility, the business could be at risk of assets being liquidated to cover the balance.
If a company’s LOC is not on margin, and they are able to afford the monthly interest payments, another risk could be the opportunity cost of financing the LOC interest instead of investing in revenue generating activities. A business may also become reliant on the LOC to make their recurring fixed and variable monthly expenses and could also be at risk of increasing their LOC to remedy short-term cash flow requirements. A vicious cycle that could set a company back several months if not years to improve their debt to equity ratios.
How does a company avoid financial turbulence while maintaining an LOC?
As previously stated, a company that is disciplined with their cash flow management could reap the benefits of having a LOC; however, most small business owners have too much on their plate to micro manage every dollar spent. Therefore, the following is a list of strategies to avoid maxing out the LOC and maintain lucrative financial ratios:
- Do not have the LOC attached to the business checking account
- Never refer to the balance available on the LOC as ‘cash available’, an LOC is debt and it should never be considered cash available
- Do not make the LOC easily accessible (avoid online transfers capabilities, applying for debit/ credit cards that are attached to the business LOC, etc.)
- Plan the funds carefully that will be used from the LOC
- Do not apply or accept an increase to the credit limit of the LOC unless it is actually needed for specific strategic purposes (i.e. capital acquisitions, debt consolidation, etc.)
Be aware of the risks of owning a business line of credit and plan your spending carefully. Businesses that are over leveraged are doomed for failure; therefore, business owners should only apply for a LOC that meets the needs of their company today. Unless a company is capable of managing their cash flow consistently, a LOC may not be a wise decision. Otherwise, a business owner should consult an accounting professional to streamline cash flow practices before they integrate a LOC into their financials.