Today we’re going to talk about setting up a small business line of credit. But first let’s discuss the differences between a line of credit vs small business loan. A credit line small business operates almost like a credit card. You have a limit of how much you’re able to use but the amount is not dictated by specific lump sum amounts. You don’t have to draw on all of the credit at one time. For instance, you could have a line of credit for your business of $100,000 but you may only need $10,000. The debt you then take on is only $10,000.
With a loan you get the full $100,000 in one lump sum and you can choose how you want to spend it. Typically a small business loan is used for a specific purpose, like buying a piece of machinery or truck. Small business loans can be used for operations and other working capital similar to a line of credit, but usually there’s a specific purpose to the loan.
Why Would a Business Need a Line of Credit?
A line of credit is available for you to use for whatever purpose. The best use for it is for short term borrowing. Maybe you’re a seasonal business, and you need to cover costs for a certain period of time when your cash flow is a little light. Or you may have a specific need where you need to have a lump sum amount of cash and you don’t want to draw on your reserves in your checking or savings account.
Consider the line of credit a short term borrowing. Come up with a plan as to how you’re going to pay it back in less than a year, maybe less than two years. We wouldn’t want to go further than that. Initially when you draw on it, you’ll get charged interest right away monthly. Try to come up with that principle in a short amount of time. Whether you turn it out over a number of months, or when your cash flow turns positive, you put a lump sum back into paying the credit off.
We always suggest that small businesses, especially ones that have payroll or cash flow issues, go out to the banks and get one of these lines of credit upfront. We say do that early instead of waiting until there’s a fire or emergency where you absolutely have to have it. Because in the event that you do need it, it’s quicker to draw on an existing line of credit than to go through the processes of getting one established.
Finding the Right Bank for Setting Up a Small Business Line of Credit
Once you come to the conclusion that you need to have a line of credit, we suggest figuring out what bank works best for you. Many times the bank that you use should follow where your business checking account is. The bank that you use when you first start your business should grow with you. Having that banking relationship is important to being able to get these loans in place and credits in place. This will help you get a quick turnaround for your business as well.
Keeping the admin paperwork to a minimum is really important. You want to be out there doing what you do in your industry or field making money instead of worrying about paperwork from the bank.
What Do Banks Need when Setting Up a Small Business Line of Credit?
What are the things that the banks are going to ask for when setting up this small business line of credit? They will want a current set of financials for your business: balance sheet, profit and loss. If you are a new business, then they’ll ask for projections as part of your business plan when you go to them to set up your accounts and apply for the line of credit.
If you run your books on a cash basis – which basically means you record income as you’ve earned it and collected it, and expenses as you paid them – the bank may also ask if you have any accounts receivable. This is anybody who owes you money. They want to know what the current financial situation for the company is. That’ll help them determine how much credit they’re going to extend to you.
After the bank gets an assessment of the business, they usually ask for some sort of personal financial statement outside of the business for both you and your spouse if you have one. These are the assets and the liabilities that you have personally: savings accounts, checking accounts, money markets, investment accounts, 401ks, IRAs, life insurance, real estate, mortgages, any debts, car payments, auto loans, and any credit card debt that you have. It’s basically the balance sheet for your personal life.
How to Get a Line of Credit for a Small Business
Usually you get one email or one discussion with them with a list of things that you need to provide to them. Most of the time the banks give you a form that you complete. It should be pretty self explanatory and easy to do on the computer. They may even have a client portal that you can upload or put this information in digitally.
If you’re using a bank that you haven’t been working with before, they’ll want documents for the business like incorporation documents, ein numbers or social security numbers, date of birth, and any other demographic information for both you and your business.
The bank then takes all this information and puts it together, and they come back to you with what level of credit they’re willing to extend to you. This initial number may be a little small if you’re a new business. But this is just the jumping off point. As your business grows each year, you will provide new financials, new personal financial statements, and, hopefully, they can extend you more credit.
How Does a Business Line of Credit Work?
If the bank extends you a credit that is too high, you can always lower the amount to something more reasonable. A larger amount of credit than you can handle can also affect your business credit score and may affect the ability for you to borrow in other ways. You really want to watch to make sure that it won’t cause other issues down the road, especially if you’re looking for larger capital improvement loans in the near future. Keep that in your mind as you’re doing the line of credit application and finding out what the banks are willing to give you. Look beyond just today. Your banker can help you identify where those issues are as well.
