In Session 6 of Entrepreneurship for Transitioning Veterans our guest speaker discusses lines of credit as one of several capital sources for military entrepreneurs. Here Marco Terry, managing director of Commercial Capital LLC, shares part two of a two part article about lines of credit. Terry offers many tips business owners need to understand about this valuable sources of funding. Understanding the details will help you determine if a line of credit is right for you.
Terry writes--Last week, in the first of two parts looking at lines of credit, we covered some introductory points on the subject. That article described how lines of credit operate, the difference between secured and unsecured lines, and the role of the U.S. Small Business Administration in guaranteeing loans.
This article continues that discussion, looking at how you can make a business line of credit work for you.
Personal background and credit
Although you may be seeking a loan for your business, your personal background and credit are usually important factors in the lender’s decision. Lenders see how you manage your personal finances and credit and use it as a proxy of how you will operate the business’ finances.
The SBA can help owners with limited credit. It provides banking guarantees to incent banks to lend to individuals who would not otherwise qualify for a line of credit.
As part of the line of credit, you must agree to a set of covenants. Covenants are commitments — or rules — that you have to uphold in order to keep the facility in place.
Lenders may call back and cancel a line of credit if covenants are broken. In general, there are five types of covenants, and each lender has its own:
- Certification: Many lines of credit are tied directly to your assets. Funds availability depend on the total value of certain assets. The lender may require you to submit a monthly statement outlining accounts receivable, inventory and other assets. This valuation determines the amount of your funding.
- Worth: Your company is required to maintain a certain net worth and report this net worth to the institution regularly. This covenant ensures that your business has sufficient assets to cover a possible default.
- Ratio maintenance: Your company needs to maintain critical liquidity and debt ratios at a certain level.
- Confession of judgment: Some lenders use this covenant to get a blank judgment without having to go through a trial. It’s used in the event of default. Learn more here.
- Other changes: You are required to notify the lender of any material or adverse changes to the business. This can include taking distributions, obtaining other financing, etc.
For a more detailed description of the qualification requirements of a business line of credit, go here.
Advantages and disadvantages
The obvious benefit of a line of credit is that it can improve your cash flow and help you take advantage of new opportunities. The line is flexible and can be used for any business expense/investment as long as you remain below the credit limit. And, lastly, it is one of the most cost-effective ways to finance a business.
However, lines of credit also have disadvantages. They are harder to get than most people realize. Also, they are hard to maintain because you have to deal with ongoing covenants. And increasing the line, once you reach the limit, can be difficult. You will need to repeat part of the underwriting process.
These are among the points to consider if you are trying to decide if a line of credit is right for you and your business.