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I know why you came to visit this article today. You are indecisive on whether a Business Line of Credit is a good option for you. Every situation is different, and it is impossible to give a blanket recommendation. All I can do is give you a firsthand look on why we decided to use it for our businesses and how it has benefited us.
To make your decision easier and to help explain our own decision, we also put some interesting information regarding the process. Whether it is for a university paper or to show the bank, having a detailed and thorough business plan is an important first step to getting that Business Line of Credit. It helps to show the bank that you, and your business are a solid and worthwhile investment.
How do you apply for a Business Line of Credit?
Determining where to get your Business Line of Credit can be different depending on your region. There are online and local options. They all have different terms and expectations. We decided to go with a local bank with whom we have both a personal and business relationship. This relationship with our bank allowed us to cut through some of the red tape we may have encountered if we went with a bank with whom we did not have a history. This, however, may not be an option for everyone, but if building a relationship with a local bank is a feasible option for you, we would recommend pursuing that relationship.
For further information of how to get a Business Line of Credit, check out this Forbes article.
What is a Business Line of Credit?
Before diving deeper into “why” we decided to use a Business Line of Credit to grow our two different businesses. We should define the differences and benefits of a Business Line of Credit versus other forms of credit or loans. The Business Line of Credit is a predetermined amount of funds to which you have access to advance your business when needing to “fulfill business purpose[s]”. This can be anything from payroll or construction projects or other business-related items. If you are a paid-upon-completion based business, you can also use this to cashflow day to day operations. There are typically no fees to start the line of credit. You do, however, have to pay interest on the amount of money that you have out on the line of credit. With most loans, your monthly payment amount is calculated based on repayment of the principal and the added interest. This is not the case with a line of credit. Your monthly payments for this type of loan consist solely of the interest. The principal is due upon the maturation of the loan. This makes sure you don’t have to dip into the fund to pay back the line.
Here is an example: you take out a $15,000 line of credit at 5 percent simple interest compounded monthly. To calculate your monthly interest payment, you would use the below formula…
Total Amount X Interest Percentage
12 Months
To make the math for this easier, let’s say that you decide to advance yourself 12,000 for easy math. Just because you are approved for a $15,000 line of credit does not mean that you need to max it out. So let’s plug our number into the above formula.
12,000 X 5%
12
If you are good at math or have a calculator then you might already have the answer, but just in case. The required monthly payment for the interest in this example is $50.
The great thing about this line of credit is that your minimum payment doesn’t require you to pay the balance back during the term of use. The line of credit is expected to be used for a project with an end date. After this end date, you will either negotiate a longer and bigger line of credit or be put on a typical loan repayment schedule. Typically in these loans, they are considered a secure line of credit which will require you to put up assets as collateral.
As mentioned above, you can renegotiate for a longer, bigger line of credit at the end of your term. If you have used your line of credit to expand your assets, you can then use those assets to in turn grow the line of credit. This is called a double dip. This is achieved by using the line of credit to purchase equipment that you are just going to use to up your line of credit.
Let’s use the numbers from our previous example. With your $15,000 line of credit, you buy $10,000 in assets. After gaining these assets, you can use them to negotiate a $25,000 line of credit at the end of its term. Sounds good, right? It definitely can be. This, however, is not a guarantee. If the bank does not extend your line of credit after you have used the fund to gain the assets, those assets can be seized. That is why it is important to not let the Business Line of Credit become an excuse to avoid supporting your business. While paying interest only, you should use this time to grow your business. By making your business stronger, you make your business a more tenable investment or just in general growing that net income line of the income statement.
Now that we have gone over the basic information of a Business Line of Credit, we will further explain why we determined it to be a good decision for our businesses.
What are the benefits of a Business Line of Credit?
One of the biggest benefits to the line of credit is you can use it to artificially increase your expenses. In other words, it can move your planned expenses into a tax year of high profitability. You will eventually pay taxes on that money, but you can push it off indefinitely if you are constantly growing and expanding. This is part of the tax code as it increases GDP and will allow for the creation of more jobs. You also can write off the interest accrued as a business expense. The interest is money leaving your pocket. At the end of the day, using the above example, if you are paying 50 dollars in interest a month, you want to generate at least 51 dollars more a month to consider your line of credit successful. You should shoot for a much higher rate of return, but if something makes a dollar, it is a success. Ensuring that the line of credit will increase revenue and net profit which is ultimately what makes this worth it. [Note: This is based on U.S. tax codes.]
For more information on the different benefits associated with different providers of a Business Line of Credit, check out this article on NerdWallet.
Increase Profitability & Number of Clients
The Business Line of Credit can be used to increase your profitability and the number of clients in your business which has the potential for greater profitability. Let’s look at some real world examples using both the massage therapy business and the granite business.
The Massage Therapy Business
When our business had grown to the point where a new location was needed, we were fortunate to find a great location with a lot of customizability. The initial expenses involved in this expansion only allowed us to cash flow an initial layout of four of seven potential rooms. We consulted our local bank, but it was determined that the business was too young for a Business Line of Credit at that time. Our age was a large factor in the decision, but our expenses had significantly increased during the expansion and remodel.
There is an old saying “build it and they will come”. We have definitely seen this within the past year at the massage business. In the past year, the business has grown rapidly. The amount we stood to gain from utilizing the space for three additional rooms convinced us that this was a great time to pursue this. We considered saving the money and using the subsequent cash flow to finance the expansion, but we saw an opportunity. The business had grown to the point that the benefits of the expansion outweighed the risks. To further help subsidize the improvements, we incorporated a room rental option through our website. This is something that is a really common need in our area. Freelance massage therapists are often searching for a space to use on a part-time basis for their own clients. This helped to maximize the profitability of each room. Any rooms not in use by our therapists and clients could be rented out or could be reserved ahead of time. We advertised this online and started to generate the same profit per hour as if we were servicing the clients ourselves. The amount we gained from the Business Line of Credit helped us to take advantage of an opportunity to maximize our profits.
The Granite Business
When considering the Business Line of Credit for the granite business, we approached it in a completely different way. Being adaptable to the changing and expanding needs of your businesses is crucial to growth. Granite installation is a business that can bring big returns on single item sales. The biggest issue with this model is that, unless you are part of the big hardware stores or stone conglomerates, most clients will not pay 100 percent up front, instead preferring a deposit. In some cases, the deposit is enough to complete the project at its projected cost. But as anyone in this industry will tell you, sometimes those projected costs do not end up matching your final costs. These are called cost overruns. Waiting on payments can significantly slow down job progress due to not having the funds required to acquire the next material and keep a crew at full capacity.
If you work within pre-described profit margins, you can also have problems where the cost of the materials is disproportionate to your profit line. So unlike the massage business’s utilization of the Business Line of Credit, we had to approach this method for the granite business in a different way: instead focusing on it as a financial opportunity to increase turnaround time and refine a cost saving and expense management structure. Having the line of credit has helped us fill in the gap between product orders and deposits and has allowed us to complete jobs faster while giving more leeway to wait on payments.
Stabilizing Cashflow & Payroll
As explained in the previous section, cash flow in this business can vary based on your client’s ability to pay on time. This can cause problems funding more than one job at a time. This could also encourage using other down-payments to fund multiple jobs rather than separating them into their own buckets. So if funds are running low, you could run into slowdowns as well as having to use credit cards to fund jobs. This becomes very expensive and often compounds the problem. That interest expense can really eat in the profit line. This is where the line of credit is a much cheaper option to keep the machine running. This industry has two distinct models: either you have salary individuals that get paid weekly or contractors that get paid based on the job. Typically larger and more well-funded businesses have salary employees while smaller businesses usually start with contractors. If you have a slow season, salary employees will get more pay for less work, but contractors will get less pay. This can make it difficult to retain contractors during slow seasons. Being able to push forward with payroll despite late payments from clients is another way to use the Business Line of Credit, and it can help you maintain your workforce.
What are some tips for avoiding common pitfalls when applying for and using a business line of credit?
We’ve talked a lot about the positives of the Business Line of Credit, but there are dangers to this approach. This line of credit is a collateral line of credit which means you must put up an asset. If you are unable to pay back the loan, you lose the asset. This could be devastating if you put up equipment needed to perform your work such as a granite cutting machine or your massage tables.
Forgetting you have to pay it back can be another pitfall. You can get used to having increased profits and decide to add expenses to improve the business but forget that you have to pay back this loan. This could cut into your take home pay if you are not diligent in setting a plan or course of action to increase your revenue. By doing this, you will cover the pay back and not affect your take home.
Another potential drawback is that you could be wrong. You thought you took the money out for an opportunity but that ship sails and doesn’t noticeably increase your profit margin. This could cut into your take home pay or even cause you to run at a loss. Understanding risks is important. But it is also important to not get stuck with analysis paralysis. Make a decision and stick to it. If it’s too risky to take the line of credit, save up and do it at your own pace with cash.
The biggest piece of advice I can give for using the line of credit is that you don’t need it to expand. You need to be able to cash flow the project over time. Using the line of credit to speed up that timeline can be a great option.
Do not take it out to help save your business. If you are using it to even out cash flow, put a really restrictive advance guideline as to not abuse it. Every situation and every business is different. It is important to talk to a financial advisor and your bank to decide whether it is right for you.
Are you looking for some additional ways to secure your financial future or that of your business? Check out this article!
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