For any company trying to maintain consistent growth, finding a way to pay off short-term costs without breaking the bank is a crucial element of success. One of the easiest and most flexible ways to do this is to apply for a business line of credit — also known as a working capital line of credit.
Working capital is a metric used to determine the financial health of a business by evaluating its current assets minus its current liabilities. In other words, take your liquid assets that can be converted to cash within a year (e.g. accounts receivable and inventory) and subtract them from your financial obligations (e.g. accounts payable and accrued expenses) that are repaid within a year. The result is a measurement of short-term liquidity known as net working capital.
This metric is important to creditors because it gives them a good idea of a company’s ability to pay off its debts. For a business, this number offers a reliable estimate of how much money it spends regularly and how quickly it can grow without incurring short-term debt that it cannot pay back.
Once you understand net working capital, the next step is knowing how to turn that understanding into action. Unless your typical asset conversion cycle is more than 30 days, paying off monthly expenses can be difficult. This is where a business line of credit comes in.
A business line of credit is different from a typical business loan for a couple of key reasons. A loan acts as a one-time influx of cash, usually paid off over a set schedule. Once paid off, you would apply for another loan, with no guarantee of the same terms. These types of loans are often more narrow in scope and tied to specific use cases rather than applying to any need.
A business line of credit, however, has flexibility similar to that of a credit card. Although typically tied to working capital assets, there are fewer limits to how you can use it, and your revolving line of credit remains available when it is paid off, meaning it can be used and reused regularly. In addition, you only pay off what you use. This can help you pay fixed overhead costs, as well as fluctuating day-to-day costs such as financing new accounts receivable and shifting inventory level purchases.
While the benefits of a business line of credit are clear, the advantages do not mean a business line of credit is the solution to every financial need. When using a line of credit, it is important to understand how it is best used and when it might become risky.
A business line of credit is generally best-suited for managing short-term liabilities. If you attempt to use it as a cash advance or to pay for long-term or fixed assets (e.g. equipment, rolling stock, or real estate), you invite unnecessary risk. Transactions like these take away from the true borrower’s ordinary course of business and do not align with the intended use of funds.
“In the case of fixed asset purchases, these are long-term assets that should be financed separately under a term loan structure,” says Albert Perez, First Vice President, Underwriting Manager for Corporate Commercial Lending at Cathay Bank. “Similar to financing short-term assets with a short-term line of credit, long-term assets should be financed by long-term debt. Otherwise, the company will compromise its required liquidity to support ongoing operating needs.”
Likewise, using the business line of credit for advance payments to employees and affiliated parties may become problematic because these advances are unrelated to the primary borrower’s operating financing needs. Employee advances should either require outside financing to the individual directly or flow through payroll. Advances to affiliates and related parties should also require separate facilities in order to better track the asset conversion cycles of these parties.
Another risk associated with these lines of credit is the deterioration of working capital assets. If accounts receivable become discounted or uncollectible or inventory does not sell as well or as fast as expected, then the calculations for your net working capital will change for the worse. This risk of deterioration can compromise a company’s asset conversion cycle, which, in turn, compromises its ability to repay its line of credit. For this reason, it is important to reevaluate how much of a credit line you are using and determine whether you can still reliably pay back the amount.
Now that you understand the benefits and possible risks, the next step is figuring out what the business line of credit requirements are.
To obtain a business line of credit, you need to meet minimum requirements for financial reporting and financial metrics. For financial reporting, lenders generally ask for the following information:
In addition, here are some typical minimum financial metrics you may have to meet:
The above minimums are not all-encompassing. As with any line of credit, there is a significant amount of dialogue involved between the lender and the borrower during the assessment. However, if you meet these requirements, your chances of getting approved will be notably better.
Learn how a business line of credit can be an excellent financial tool to help you grow consistently and pay off your current liabilities in a timely manner. Contact Cathay Bank today!
This article does not constitute legal, accounting or other professional advice. Although the information contained herein is intended to be accurate, Cathay Bank does not assume liability for loss or damage due to reliance on such information.