How to Get a Business Line of Credit & Pitfalls to Avoid

Businesses don’t run on elbow grease alone — they depend on cash flow to fund improvements, secure inventory, pay workers, and create new opportunities. Fortunately, there have never been more options for small business owners seeking financing. 

One of the more popular options is a business line of credit (LOC). It combines flexibility with affordable terms and doesn’t require the designation of a specific purchase to receive funding. An LOC may be the right solution to balance cash flow and fund growth. 

Today you’ll learn everything you need to know about opening and using a business line of credit:

• What is a business line of credit?
• Why do companies choose a business line of credit?
• What are the advantages of a business line of credit? 
• What are the drawbacks to a business line of credit?
• How do you apply for a business line of credit?
• What are the alternatives to a business line of credit?

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What is a business line of credit?

A business line of credit is an unsecured loan that enables businesses to borrow funds up to a predetermined limit. Withdrawals and repayments are made as needed, making them useful for short-term financing. The business owner only needs to pay interest on the amount borrowed according to the loan terms. A business line of credit (LOC) is usually secured through a credit check and examination of company assets such as inventory, accounts receivables, or other instruments owned by the business. This is also known as a revolving line of credit.

A line of credit (LOC) differs from a collateral loan for a specific, large-ticket item with a specific repayment schedule.

Why do companies use business lines of credit?

Businesses secure lines of credit for several reasons. In many cases, a line of credit offers businesses more flexibility than a traditional loan. Unlike traditional loans, businesses don't need to reapply whenever they need money — as long as the total amount doesn't exceed their credit limit. They can draw funds as they need them.

Additionally, lines of credit often come with lower interest rates and more lenient repayment terms than other loan products.

There are many reasons businesses turn to a business line of credit:

• To cover cash flow gaps during seasonal slowdowns or times of rapid growth
• To finance inventory purchases and extend terms as part of the cash conversion cycle (CCC)
• To purchase necessary equipment or materials quickly and without large working capital expenditures
• To cover accounts payable when there is a delay in associated accounts receivable 
• To take advantage of special deals and discounts offered to businesses with available credit

Businesses may also use an LOC as a way to remain independent. With a line of credit, you can forego investors and their influence on business decisions and direction. Many business owners use a line of credit as an early funding step while building the business and opt to seek outside funding from other sources later.

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Steps to securing a business line of credit

Applying for a business line of credit is an important step in ensuring financial stability and success. A line of credit can give businesses the funds they need to take advantage of special deals or discounts, purchase materials and equipment, or cover accounts payable. The process for applying for a business line of credit differs slightly from personal lines of credit. 

Follow these simple steps to ensure the best chance for success in your application:

1. Define your goal

Before applying for a business line of credit, it's important to have clear business needs in mind. Seeking a funding solution without a specific business goal may lead to overspending on non-revenue-generating items or underutilizing available cash. Define your goal and opportunity costs (figuring in factors like interest and annual fee as part of the cost equation). This will give you a clear picture of how much you should borrow and what financial impact it will have on the organization. 

2. Collect necessary finance documentation

Having all your financial documents in order before applying for a business line of credit helps ensure a smoother application process. This includes tax returns, credit history, profit and loss statements, accounts receivable balances, business expenses, bank statements, and any other related financial documents.

Being prepared with these records will help you fully understand your company’s financial position and project how much money you need to reach your goals. Having all the necessary finance documentation in advance will also inform credit approval and creditworthiness decisions on the part of your lender.

3. Explore potential lending partners

Many businesses create a shortlist of potential lending partners who can provide a line of credit. Research lenders that specialize in the type of loan you are looking for and any preferred lender relationships with your bank or other financial institutions. It’s important to compare several lenders before settling on one, so you know you’re making the most informed decision for your company's finances.

4. Conduct due diligence on lenders

Due diligence is important to ensure that the lender you are signing with is reliable and trustworthy. This process involves researching the lender's background and reviewing any customer feedback or reviews related to the lender and their services. Additionally, examine the specific terms of their loan offers, such as interest rates, repayment terms, fees, and other financial components. Gathering this information helps you make a well-informed decision that best suits your business's needs.

5. Select and negotiate with a lender

Once you have gathered all the necessary information, select a lender with the best reputation and product offering mix. Negotiating with lenders to get the best possible funding for your business with acceptable long-term costs and value is important. 

Negotiations may include lowering interest rates or extending repayment periods to make monthly payments more manageable for your company's budget. In essence, negotiating with lenders allows you to create mutually beneficial terms and ensures you feel comfortable with your chosen loan agreement.

6. Receive and record funding

Once you agree on the loan terms with your lender, it's time to close on the loan. After you sign a contract and make any required down payment or deposits, your lender will provide the requested line of credit funds so you can use them for your intended purpose. 

It’s important to set up tracking for this new funding source in your financial reporting software. This ensures you make the best use of the funding, track and automate repayment, and figure the funding source into your broader financial planning and forecasting.

7 Important benefits of a business line of credit

Flexibility is one of the primary reasons a company turns to an LOC for funding its operations. When utilized properly, it can help a business manage cash flow and expenses, avoid overdraft fees, and leverage vendor discounts. 

Additionally, lines of credit offer the following benefits:

Uncollateralized debt: No collateral is required to secure the loan, making the approval process much faster than traditional loans. It also opens up options for using the line of credit since traditional loans require the funds to be allocated for specific purposes (such as real estate or equipment purchases). 

More spending power: Credit limits are generally higher with lines of credit than with other forms of loans. This can give companies more opportunities to generate income. If your business is in growth mode, an influx of cash can boost production and fund increased marketing efforts to drive revenue.

Better terms: Because interest in a line of credit is tied to the prime lending rate, it’s often lower than other types of financing. This offers short-term growth benefits and long-term cost advantages over other funding options. 

Lower repayment: Interest is only paid on the amount used at any given time, not the entire limit. This extends your purchasing power for items and supplies that help you improve output and collect cash.

Fast turnaround: Unlike a traditional loan, LOC funds are available as soon as eligibility is approved. This lets you get started on new initiatives faster to get revenue flowing. 

More flexibility: Repayment terms are often more lenient than those associated with other forms of financing, providing more opportunities to stabilize your cash position and realize returns from your investments.

Better credit rating: As with personal finance, successfully managing loans is an important part of building your corporate credit rating. A line of credit may open the door to other types of funding further down the road.

Ebook

Financial Audit Preparation Checklist

Financial audits gives companies an objective read of their financial statements. Use this checklist to get started.

Download

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5 Disadvantages to consider before taking a business line of credit

Although a line of credit can positively impact your business outcomes, it’s not always the solution you need. Consider the potential drawbacks to a business credit line before you sign your promissory note.

They can get expensive

Although less expensive than other funding sources, LOCs may be less desirable during tough economic times. When the prime rate climbs, so does your LOC interest, with APR averages in the double digits. When evaluating a line of credit, check out the other loan requirements, such as origination fees, penalties, late charges, etc.

Not all lenders are reputable

When evaluating your options, do your homework on the lender. Work only with established traditional lenders, credit unions, and online banks with strong documentation of fair terms and good business ratings. Hard money or online lenders may give you funding when others won’t, but the rates and the risks are likely much higher. Once you sign an LOC agreement and spend the money, you may not have recourse to negotiation, so be sure to do your research beforehand.

Application prep takes time

Before beginning the loan process, get your necessary financial documents in order. Lenders want a full picture of your financial situation and repayment ability, so they ask for documentation to make their lending decisions. Lenders take on more risk from an uncollateralized loan, so they tend to do careful due diligence before underwriting a loan.

Lenders typically ask for various standard documents to qualify a business for a line of credit: 

• Banking statements
• Financial statements (income, balance sheet, and cash flow statements)
• Profit and loss (P&L) statements
• Personal banking information
• Tax return information
• Organizing documents (LLC formation or articles of incorporation)
• Leadership documentation, such as resumes

They require some discipline

Open-ended loans without specific requirements can be powerful for a business — but they can also be risky. Responsible use of an LOC can boost your revenue and empower your growth if  you use the credit conservatively and for its express purpose within your business. This isn’t the time or the funding source for making non-revenue-building purchases like office furniture or extras.

They might not be sufficient

Depending on your company’s current financial situation, the lender might not offer as much funding as you seek. If this is the case, evaluate whether a line of credit will produce the results you’re looking for. If not, consider other sources of funding that might offer you the full scope of support for your business.

What are the alternatives to a business line of credit?

A business line of credit isn’t the only possible source of funding for your business — individual circumstances will determine if it's the best option for you. Other financing options, such as venture capital or angel investments, can provide access to larger amounts of money with fewer strings attached. Although these might require more paperwork and reporting, they also provide the potential to invest in expansions or long-term projects that an LOC may not cover. 

Alternatives to a business line of credit include:

Small Business Administration (SBA) loans: SBA loans are backed by the U.S. Small Business Administration (SBA). The SBA guarantees part or all of the loan, which allows lenders to offer more favorable terms than they would otherwise. These loans help small businesses access capital when traditional financing options like a business line of credit may not be available. SBA loans can be used to purchase real estate, finance equipment purchases, fund working capital, and cover other business expenses.

Business term loans: Business term loans are a form of lending typically offered by traditional banks and credit unions. These loans provide capital to businesses, usually in the form of a lump sum payment with fixed repayment terms set at the time of approval. Interest is determined by business credit score, loan amount, and repayment period, which means loan terms are highly variable. Where an SBA loan may only cost 3 percent, others can run from 7 percent up to 25 percent. 

Merchant cash advances: A merchant cash advance is an alternative to a business line of credit where a lender provides a lump sum of money in exchange for a portion of future credit card or merchant account sales. These advances are much easier to obtain than traditional loans and do not require collateral or personal guarantee. However, they typically come with higher interest rates and shorter repayment terms than other forms of financing.

Corporate credit cards: Just like a personal credit card, corporate credit cards and procurement cards allow you to borrow money up to an approved limit as long as you make scheduled repayments. A corporate credit card typically comes with higher interest rates — 12 to 25 percent depending on credit rating. 

Crowdfunding campaigns: Depending on your business model, funding through Kickstarter or similar crowdfunding platforms allows founders to gain capital on a pre-order basis for their concepts while still in development. Typically, crowd-funders receive a price benefit by becoming early adopters and financing the development.

Angel investments and venture capital: Angel investment and venture capital are similar types of outside funding that can help businesses with early-stage investments. Angel investors are usually wealthy individuals willing to invest personal capital in exchange for equity or other benefits.

Venture capitalists, on the other hand, are firms offering large sums of money from a pool of investors' collective funds with the expectation of a return on investment within a certain period. Both angel investors and venture capitalists require detailed business plans and financial projections as part of the application process. 

Vendor credit: Vendors often extend flexible repayment terms and conditions to buyers. Terms may include the amount of credit a vendor is willing to offer and how quickly they expect payment. Vendors offer credit because it encourages buyers to purchase more goods, increasing the vendor's sales. Common net terms require buyers to pay within 30 days of receiving an invoice, although this can vary to 45, 60, or even 90 business days, depending on the negotiated agreement.

Order.co: Flexibility without a line of credit

For businesses of all sizes, flexibility is key to unlocking more opportunities and increasing revenue. Order.co gives users access to thousands of high-quality vendors within their supplier network. Even better, Order Capital gives every buyer the flexibility of extended net terms. 

• Flexible terms with access to net 30, net 60, and beyond
• Fast capital of up to $500k delivered right to your bank account with low interest rates
• Access to high-quality, reliable vendors to make your capital even more valuable to growth