Entrepreneurs frequently encounter difficulties managing their cash flow as a result of seasonal credit demands and time gaps between capital needs and revenue realization. This is especially true of business start-ups during their early stages of development when they have not diversified enough to generate a constant positive cash flow. Once inventory has been purchased, it is necessary to ride out the cycle until accounts receivable have been collected. Without sufficient working capital, a serious cash flow problem could develop. These types of cash flow problems have forced many entrepreneurs to close down businesses that were making money on paper but just ran out of cash.
Lines of credit accommodate the seasonal credit demands of your business along with ups and downs in your cash flow. They also enable you to purchase inventory in anticipation of future sales. Discuss establishing a line of credit with your bank at the beginning of your relationship. If you are just starting your business, the bank will probably not grant a credit line immediately.
A line of credit is a standard service provided by many banks that serve small businesses. Getting the loan approved depends on the business's ability to repay and/or the personal assets of the owner, for example, a second mortgage on a home, assignment of stocks and bonds, or assignment of the cash value of life insurance policies.
Banks will extend a secured line of credit to most start-up ventures. The line may be unsecured if the business can demonstrate consistent earnings, an excellent capital position, and multiple sources of repayment. Traditionally, banks will commit a specified maximum amount of funds from which you are permitted to draw on as needed. You have the right to repay and re-borrow during the agreed-on time, which usually will not exceed a year. You pay interest only on the outstanding principal.
In addition, the bank needs to know how you will repay the line when your first source of repayment does not come through. Bankers look for enough elasticity in your operations to accommodate temporary reversals in adverse situations. What happens when you discover that your inventory is not selling as projected? What secondary sources of repayment are available?
Banks may also require you to pay down your line of credit when you have not followed your payment schedule, even though the total amount of money that you borrowed is not due for several more months. Banks do not like to approve lines of credit for use in managing cash flow. Instead, lines of credit are intended for cyclical borrowing needs at identified pay-down intervals. A failure to pay back the money on schedule indicates a potential problem in your ability to manage cash.
Smart Tips for Establishing a Line of Credit
- Most likely a bank will not issue a line of credit to a new venture without the owner's personal guarantee of repayment.
- If your business is relatively new and the bank is not satisfied with the primary and secondary sources of repayment, it may ask for personal collateral to secure the loan.
- If the venture is a partnership or corporation with more than one principal, the bank will most likely collateralize the loan from all the principals involved to obtain a line of credit.
- You must present reasonable financial documents that follow standard accounting practices to obtain a line of credit.
- Unless you are a well-established business, you must provide pro forma, i.e., forward-looking, cash flow documents that demonstrate your ability to pay back the money. Pro forma balance sheets and income statements will also be required.