Do you really need a line of credit?
Over the past decade the number one financing request I receive from entrepreneurs and small business owners is for a line of credit. I probably get asked this question at least 3 times a week. My response is why do you need a line of credit? The answer, you probably guessed, is working capital. Working capital is everyone’s favorite response when asked why they need to borrow money. Let’s break this situation down to determine if a line of credit is the appropriate financing tool for you with a few simple questions.
Question 1 – Is there a delay between the sale and when you receive payment?
If you answered yes, you may need a line of credit. Understanding how long the delay from completing a job/sale to when you actually receive payment can help you determine if a line of credit is right for you. If you purchase materials to make an item or complete a job and you are not paid immediately at the time of the sale, not having enough cash handy could abruptly end or delay your businesses growth. The key here is payment was delayed at the sale creating an account receivable.
Some examples of businesses that may need a line for this reason are doctors who receive payment from insurance, manufacturing and distribution companies that sell on terms. Most cash based businesses that received payment at the time of sale do not need a line of credit. These types of businesses include restaurants and many retailers.
Question 2 – Is your business cycle seasonal?
If you answered yes, you may need a line of credit. Having a seasonal sales cycle means you work all year but the majority of your sales happen during a few specific months. An example of this would be a contractor or toy manufacturing company. The manufacturing company receives orders early in the sales cycle. They must hire employees, purchase materials and build toys all year to gear up for their prime sales season during the winter months. Not having a line of credit could prevent the business from having the appropriate cash flow to meet its needs during the months prior to completing the sale during the winter months, if there is no cash paid up front.
Question 3 – Will you used the line to purchase fixed assets or equipment?
If you answered yes, you probably don’t need a line of credit. This was a trick question. A line of credit should be used to purchase assets that will be used within one operating cycle (12 months). Most often fixed assets and equipment should be purchased with a term loan as the assets will generally be used over several years. Many borrowers make the mistake of purchasing equipment on a line of credit only to later need the line to meet a true gap in collecting cash from a sale only to not have it available when necessary.
If you answered no to question 1 or 2 odds are you do not need a line of credit. You may need a working capital term loan or an injection of equity into the business. A term loan or equity injection would be used to help the business meet long term growth. A term loan is also the appropriate choice if you are experiencing annual sales growth greater than 10% as a line of credit will not be able to keep pace with your growth.
Many bankers are very busy, so having the appropriate request when you make your first approach may help lead to a more successful request. Hopefully these questions will help you determine if a line of credit is the right option for you.
Please continue to use the contact link on my webpage to submit your topic requests.