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 one 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--Business lines of credit are one of the most misunderstood business financing products.
In principle, they sound great. The reality is that they are often hard to get, difficult to maintain, and aren’t always as flexible as business owners think. In this article, the first of two pieces, we offer a short primer about this financing product.
How do lines of credit work?
A line of credit allows your company to draw funds from the finance company up to a certain amount. To get funds, you simply request a draw. As your cash position improves, you can pay down the line, which diminishes your debt and increases availability of funds.
Secured vs. unsecured
A line of credit is considered secured if it has assets backing it. In case of default, the lender gets to foreclose on the assets. A line of credit is unsecured if it has no direct assets backing it.
However, if you default on an unsecured loan, the lender can sue you and/or your company. If they win, the judgement can be used to secure specific assets to repay it. Most business lines of credit are secured.
How to qualify for a line of credit
Qualifying for a conventional line of credit is difficult, especially for small and new businesses ( learn more).
The role of the Small Business Administration (SBA)
Contrary to popular belief, the SBA does not make loans. Instead, it guarantees loans from qualifying financing institutions. This guarantee allows companies to get loans when they wouldn’t have initially qualified for one.
The SBA acts as a secondary guarantor. This means that the bank must make every effort to collect from the debtor before it collects the SBA’s guarantee. You can find more information about SBA programs here.
Company assets and cash flows
Most loans and lines of credit are provided with the assumption that they will be paid back from company cash flows. If that fails, the bank will consider foreclosing assets to recover losses. As a result, most startups won’t qualify because they often lack substantial cash flow, assets and track records.
Even if your company is profitable and has a track record, most lending institutions evaluate its performance by reviewing certain financial ratios. Evaluation methods vary, but lenders commonly review the Debt Service Coverage Ratio, Fixed Charge Coverage Ratio and the Current Ratio, among others.
Meeting a lender’s requirements with regards to financial ratios is important for both getting and keeping a line of credit. Lenders review these metrics often.
At a minimum, your company needs to guaranty the line of credit with its assets. Lenders usually secure their position by filing a lien against your accounts receivable and other assets. Many lenders also ask for a personal guarantee from all the majority owners of the company. This measure allows the lender to foreclose on their personal assets if there is insufficient corporate collateral.
Next time, we’ll address common line of credit covenants, benefits, drawbacks and product alternatives.