Business Revolving Line of Credit: Increased Flexibility At A Lower Cost

There are many different types of business loan products on the market. They are designed to fit the needs of the borrower, while minimizing risk to the lender. One type of loan product often used by companies to manage cash flow shortages is a revolving line of credit. Companies like this type of loan because it provides access to credit without ownership, which translates into increased business flexibility at a lower rate than a typical term loan or business credit card.

What Is a Business Revolving Line of Credit and How Does It Work?

Also referred to as a commercial revolving line of credit or a revolver, a business revolving line of credit works like a cash advance on a credit card. You gain immediate access to a certain amount of cash, for a certain amount of time. The word 'revolver' is used to describe a line of credit that allows the borrower to access the funds repeatedly after repaying the loan. The business has the ability to repeatedly withdraw and repay the loan until the end of the term. The result is ready access to funds on an as-needed basis for a lower cost than a regular term loan or a cash advance on a business credit card. 

Example Business Line of Credit Terms and Features

Revolving business lines of credit are either secured or unsecured. Secured means the loan is backed by collateral. Unsecured means the loan is not backed by collateral. Secured loans provide lower rates since the collateral lowers the bank’s risk. 

Whether secured or unsecured, business lines of credit come with several features. Here’s a typical profile of a revolving line of credit:

Loan Type: Secured Revolving Loan or Secured Revolving Credit

Collateral type: Accounts Receivable

Loan Amount: Up to $100,000

Loan Term: 5 years

Repayment Period: 9 months after each withdrawal

Rates: Variable (Interest Rate on Excess Reserves + Flat Rate); higher flat rate w/ no collateral

Maintenance and Availability Fees: $600 annually

What Are Revolving Lines of Credit Used For

The academic answer to this question is working capital and cash flow problems. The real-life answer is that it depends.

The Great Recession dried up the credit markets, especially for small business owners. In 2009, the Federal Reserve surveyed a host of small businesses. It's no surprise that the primary concern at the time was credit availability. "Small businesses reported that existing lines of credit had been reduced, hampering their ability to offset lower cash flows," the report said. It went on to say that businesses "had to scramble to meet intermediate financing needs and change their business models to adapt to less credit availability."  Banks also found that revolving lines of credit were being used for major purchases and salaries more so than working capital needs. It was at this time that banks began converting revolving lines of credit to term loans.

Fast-forward to 2015 -- the economy is in better shape. The Federal Reserve conducted the same study on small business credit.

Top challenges of a revolving line of credit

Now, managing 'cash flow' is the "top business challenge", beating out all  other facets of business including business costs, credit availability,  sales, hiring, taxes and government regulations. Indeed, of the companies surveyed in the study, 63% held debt; the same percentage pledged personal assets to secure that debt. While 79% of firms that applied for a loan or line of credit were approved for some financing, 50% of applicants had a financing shortfall, meaning they received less financing than the amount asked for. It is important to note that the main reason for the financing shortfall is lack of collateral, not lack of strong cash flows.

Primary Reason Companies Don’t Get The Loan: Collateral

Reasons to deny revolving line of creditWhile the strength of a business' cash flow is often the key factor lenders consider for a loan, it is the lack of collateral that is the primary reason that small business owners don’t get the full ask. To be clear, collateral is an asset which the bank can sell for money in case you can’t repay the loan. Typical types of collateral used for business revolving lines of credit are equipment, buildings, accounts receivable and inventory. It is also important to understand that not all loans require collateral, however, it can greatly reduce the rate of interest. Also note that different types of collateral are valued differently than they may be on the market. For example, real estate is generally worth more than inventory. (Chart Source: 2015 Small Business Credit Survey, Federal Reserve Bank)

Summary: The Pros and Cons of A Revolving-Line of Credit

There are three main reasons why businesses use a revolving line of credit as opposed to a term loan or business credit cards. They are as follows:  

Pros

  • Flexibility - Unlike a term loan, a revolving line of credit can be used for a number of different purchases including inventory, payroll and rent. It also allows for flexible repayment terms, whereas a term loan requires a set monthly amount.
  • Access - Unlike a traditional term loan, a revolving loan gives borrowers access to cash or credit. Access is not the same as ownership; banks only charge interest on the funds you've accessed, not the funds you have access to.
  • Costs - Revolving loans generally have a lower cost of financing than term loans. Additionally, while revolving lines of credit operate much like business credit cards, credit cards are generally for a smaller loan amount and at a higher rate. This is especially the case for cash advances. In many ways, revolving lines of credit are akin to getting a cash advance on your business credit card, but at a considerably lower rate.

There are also three reasons why a business might not want to use a revolving line of credit as opposed to a term loan or a business credit cards. They are as follows:  

Cons

  • Variable Interest Rate - The primary disadvantage to a revolving line of credit is that the interest rate is generally variable. This variability increases the risk associated with lending, especially in difficult economic times. 
  • Reduction in Loan Amount - In difficult economic times, the bank may reduce the limit on all lines of credit, regardless of performance. This is not an issue for closed loan products as the cash has already been fully distributed.
  • Insufficient Collateral - It is not unusual for the bank to require collateral regardless of the loan type. According to the Federal Reserve, insufficient collateral is the top barrier to obtaining financing.

Takeaway

The best time to apply for a loan is when you don’t need it. Whether in good or bad times, revolving lines of credit are a low cost solution to short-term cash flow needs. If you never use the capital, you never pay for the cost to use funds, but the cash is there if you need it.

Posted in Finance, Credit, Management