Monday, March 17, 2014

One Accountant's Perspective: Line of Credit

Many businesses and owners have been talking to me recently about line of credit. In this article, I will address the major points of possessing a line of credit and also explain when it is necessary.  So, let's start with the basics.

What is a Line of Credit?
A line of credit or LOC, is n cash reserve extended to you by a bank or lender. It usually has a yearly fee depending on how much is extended to you. It is meant to work when your cash reserve dips into the negative -- instead of bouncing checks or defaulting on payments; the line kicks in and covers the additional charges to a set amount.

There is interest on the LOC, and it is charged according to how much is used, how long before you pay it back, and the type of interest rate (fixed or floating). For many, this may sound like "overdraft protection." It is exactly that -- just one term is used for home and individual, while the other exists for businesses.

What are the pros and cons of a Line of Credit?
Thankfully, this is one program that I have found to have more pros than cons -- when used correctly. Beyond acting as a reserve line of cash, a line of credit gives businesses the ability to have more flexibility in the event that a payment is late or unforeseen expenses occur.

It also acts as a way to establish a reputation with a bank or lender without the scare of applying for a credit card. Most banks will extend a line of credit to start-up businesses that simply open an account and have matching capital. That means  if you open an account with two thousand dollars, you can get a two thousand dollars LOC at the same time.

It is also something that does not expire,  so it acts as a great reserve cash source later down the road.

The con of this is the same as having a credit card. It has to be spent responsibly or it can quickly spiral into another interest heavy debt that you have to contend with. Also, if you default on a credit line, it is much worse than defaulting on a loan or credit card. Loans and credit cards are backed up on collateral, lines of credit are not. Defaulting on a credit line essentially means you destroyed any semblance of reputable conduct with that bank and all other. So be careful

Is a Line of Credit like a Loan?
Absolutely not.  A loan is a set amount given to you by a bank for the singular purpose of accomplishing whatever you asked the loan for, like for a house, expansion, cash flow, etc. The loan has to be paid back and once it is, it is gone. Another difference is that a loan starts with a low principal payment and slowly increases over time, which decreases the interest payment.  In technical term, this is called "amortizing.”

A line of credit is much more flexible and does not have the same amortizing affect as a loan. You can choose to pay back the entire amount at any given time and not deal with the interest at all. You also have the option to let it amortize and pay it off like a standard loan (not a preferable route in my professional opinion).

One distinctive feature of a line of credit is that  it is perpetual. Once it is paid off, it continues to exist in order to be used again. In short, it can be replenished and used over and over. This is the singular most important point of a line of credit.

Another distinguishing feature of a line of credit is its withdrawal pattern. Unlike a loan where you get lump sums, a line of credit can be used in bite size bits or on an as needed basis. This mean you can withdraw what is needed in the moment and leaving the rest in reserve.

When should I get a line of credit?
In my professional opinion, all businesses,  even successful ones, should have a line of credit. Many businesses make the mistake of looking for a loan when the time comes. A line of credit gives you the option to always be prepared for when the time comes (when you need capital). It is both operating and emergency funding rolled into one.

I often advise my clients to have a line of credit that is enough to cover three months of operation just in case time gets hard. Other larger companies have lines that will cover a year or so of operation. In short, it is better to have it and not need it, than need it and not have it.

Most small businesses can get a line of credit of at least three thousand to start, without collateral. However, this is an emergency lifeline not to be used as spending money.

How should I properly use my line of credit?
The best way I can say it is "Break in event of cash shortage"

As I have emphasized, a line of credit is a double edged sword. If used properly and carefully, it presents no danger to the wielder. While presenting a host of options and operational abilities to you and your business. However, if abused, it can cut both ways.

A line of credit is best used a supplement to your Account Receivable. If you have business or clients that takes a long time to pay off,  a line of credit is a great supplement to see you through to your pay day. Just be sure to have the discipline to pay it back for usage next time.

A line of credit is a great tool to have and I know from personal experience how helpful it can be. It is one of the few tools that I highly recommend to my clients, even those who are not cash struggling and have thriving businesses.

It's a great supplement and a great reserve resource to have. However, it requires discipline and planning. Be careful when using it and if possible, give it to your accountant to approve any usage of the funds.

I hope this has been enlightening and enjoyable to read , it was definitely fun to write. As always,  your comments and suggestions are welcome.

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