More and more small businesses are seeking credit to improve cash flow and fund growth. While the lending environment is still tough, total funding from bank and non-bank lenders is on the rise. The finance industry as a whole is becoming friendlier to small firms seeking credit.
With financing being offered to firms today that were unable to obtain credit in the past, many firms are facing the decision on whether a credit line would be beneficial for their business. As with most decisions, there are pros and cons on each side. Leverage certainly has many benefits, but carries risk as well.
Benefits of Credit Lines for Small Businesses
There are two reasons that small businesses seek financing – cash flow and growth. Few small businesses have the resources required to grow at an accelerated rate. In order to produce additional output, you have to increase your input. Depending on your industry, those inputs may be marketing, raw materials, employees, or any combination thereof.
A business without any outside source of funding can only rely on the cash that the business generates to fund additional inputs. Growth is then limited to the current profitability of the business.
With a line of credit, the business is able to accelerate growth by increasing production, marketing and overall output without the immediate need to collect on outstanding receivables from recent sales. Without funding, you have to manage the “cash flow gap“, which is the time period from when funds are used to purchase inputs to when funds are received from sales.
Depending on the terms you have with vendors, customers and your overall business model, that cash flow gap can be upwards of 120 to 180 days. That means you have a lot of cash tied up in your business that can’t be used for growth. Credit solves this issue.
Potential Issues Leverage Creates
Leverage doesn’t come without risk. Another way to look at a line of credit or other form of financing is that it magnifies your decisions. When business is good, leverage accelerates that; however, when business is bad, leverage can turn a slow period into a bankruptcy event.
Credit increases the overall load on your business. Additional man hours will need to be spent providing the required reporting to your lender. There will be calls and meetings from time to time to answer questions or alleviate concerns that the lender may have. There is also the financial burden that the monthly payments bring. During a slow period, the additional fixed costs that a line of credit brings makes a difficult time even tougher.
This isn’t to say that financing is detrimental to your business. It’s not unlike fire. When contained and treated properly, fire is a fantastic tool; however, when caution isn’t exercised, fire is an incredibly destructive force.
What to be Aware of When Applying for a Loan
When you apply for a small business loan, there will be an underwriting process. The actual process will vary depending on the lender and the type of financing, but there are some common threads that you should be aware of.
Your personal credit will be taken into account. Practically every lender requires small business owners to sign a personal guaranty. This means that if the business defaults on the loan, you as the business owner will be personally liable. Since the personal guaranty is part of how a lender gets comfortable, they will check your personal credit to ensure that the personal guaranty is actually worth something.
You don’t have to have perfect credit; however, serious credit issues will indicate to the lender that it’s unlikely that a personal guaranty will increase their chances of recovering any outstanding loan balance. If you have had credit issues in the past, hiring a professional credit repair service can be beneficial.
Credit repair services check for questionable negative payment experiences on your credit report. They then follow-up with the creditors to ensure that they are reporting information accurately. If inconsistencies are found, the credit repair service will work to have the issue corrected.
Be weary of credit repair agencies for which you are unable to find a significant amount of reviews or third party mentions. There are a lot of companies that charge high fees, but rarely get results. Reputable companies will have numerous third party mentions and will be rated well on review sites and by the Better Business Bureau.
Lenders aren’t only looking at your personal credit. They are looking at credit information on your business as well. Just as you have a personal credit score, there are agencies that provide a credit score on your business as well. The score takes into account payment experiences reported by your vendors as well as your performance on any loans or credit cards in the name of the business.
If your business is fairly new or is in an industry where vendors rarely report trade experiences, you can build your business credit by running some expenses through a business credit card. If you don’t typically spend much on supplies and goods for your business, look for other opportunities such as paying your taxes with a credit card or setting up recurring expenses on auto-pay.
Does Leverage Help or Hurt Your Chances for Success?
If your personal and business credit history is strong enough to qualify for a business loan, consider the implications before committing to a long term financing agreement. Don’t take the decision lightly.
Leverage, like many tools, will increase your productivity when used properly. Businesses that are structured well, have adequate measures in place to guard against slow periods, and understand the risks they are undertaking likely benefit greatly from credit. Businesses that treat a line of credit like and irresponsible teenager will quickly find themselves in trouble.
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