By Trace Reddick, MBA,
Sometimes securing funding from outside sources is how you keep your business going. You’ve double-checked your books, and the money you need to cover your essentials is just not there. Or to stay competitive, you have to purchase new equipment or open a new location.
There are numerous scenarios where you may be faced with having to borrow money, and many business owners have gone through this.
In 2017, the Small Business Administration (SBA) found that businesses borrow about $600 billion annually with the average loan being $663,000.
Why do businesses end up needing to borrow so much money?
Common Contributors to Cash Flow Issues:
- Losses: Unexpected expenses like repairs, litigation, etc. are all situations that could throw everything off if a business doesn’t have cash on hand to offset the loss.
- Low profits: Sometimes reality doesn’t match up with a forecast. Promotions may not perform as well as they did before. A new competitor or bad publicity may take away some of your market share. Lean times are brought on by seasonal demand ebbs and flows.
- Capacity overinvestment: Overspending on production with but not generating profits.
- Too much stock: When the business holds too much stock, this ties up cash.
- Overtrading: Operations grow faster than profits.
- Extending too much credit: Allowing customers to purchase on credit can encourage more sales, but when they are slow to pay, this causes cash flow problems. (Dorado Finance can help with this).
When you borrow money, you don’t want to create more problems for your business. So it’s important to do your homework about what options are available before you take out a loan or line of credit.
We’ll go over important information about your options, including invoice factoring as perhaps the better solution.
Business Line of Credit vs. Business Loans: At-A-Glance Comparison
|Loan||Revolving Line of Credit|
|Interest Rates||Higher||Lower (may be raised based on late or missed payments, over-limit spending)|
|Repayment Terms||Fixed and due immediately (6-10 years)||No payment due until funds have been used. Typically revolves so repaid funds can be used again (6-10 years)|
|Personal Guarantee||Typically required||Typically not required|
|Fund availability||48-72 hours||24 hours|
|Age of the business||6 months in operation||1 year in operation|
|Range of fund amounts||$10,000 – $5Mil||$10,000 – $5Mil|
|Use||Short term needs||Specific investments|
Common Uses for a Business Line of Credit
To gain a better practical understanding of a business line of credit, let’s go over some scenarios where it’s typically used.
- Working capital: Covers temporary operating needs like payroll, inventory or rent while a business awaits payments on accounts receivable. This type is usually based on one-year terms that may be eligible for renewal at the end of the term.
- Asset purchase: Covers a one-time purchase (for example, a large order of industrial equipment. Unlike other lines of credit, this is not revolving.
- Construction: Covers covers a single project. For example, a small business makes a leasehold improvement or fit-out on a property they do not own. As with an asset purchase, this is also not revolving.
- Guidance: Pre-approved financing for property acquisition. For example, a real estate developer can buy multiple properties up to the credit limit without having to borrow for each property individually.
Does My Business Qualify for a Line of Credit?
A business should be at least 6 months old and make at least $50,000 in annual revenue. Even with lower personal credit score, you may still qualify.
A secured line of credit requires putting up a valuable personal asset to be used as collateral if a default occurs. Examples of collateral: homes (or other properties), cars, boats, and bank accounts.
Borrowers who are determined to be “low risk” aren’t required to secure the line of credit with personal property collateral.
Common Uses for Business Bank Loans
Here are some examples of when a business would apply for a loan.
Real estate or operation expansion: If a business is turning a profit, they may decide the time is right to expand by opening new offices.
Moving expenses: It costs money to relocate. You may be moving to a cheaper place to save money, but you still need the money to move there.
Pay off tax debt: Some business owners may find bank loan terms more palatable than IRS debt over their head along with mounting penalties.
Equipment purchases: Like a line of credit, business loans can also be used to purchase needed equipment.
Hiring employees: Sometimes more employees are needed to maintain operations and grow profits. A loan covers the expense of a new hire.
Inventory purchases: Being able to buy in bulk can save a lot of money and lead to bigger profits. If it’s a sizable discount, it may be a smart move to use borrowed funds.
Does My Business Qualify for a Business Bank Loan?
A business typically needs to be at least a year old to qualify for a loan, though some banks may extend a start-up business loan to younger ones.
You’ll need a credit score of at least 650 and a qualifying business credit score as well. Some creditors will also evaluate your personal debt-to-credit ratio.
The business will need to have a healthy annual revenue stream of at least $50,000 and a net operating income 1.25 times greater than the total expenses.
The bank may also require that you disclose what the money is needed for and have you agree that it will be spent for only that purpose.
Is Factoring a Good Alternative for My Business?
Let’s summarize the downsides to business loans and business line of credit.
- Risking the loss of personal assets.
- Long waits for funds while a loan process completes and finalizes.
- Cumbersome interest rates (which could go up on a line of credit).
- Large fees and maintenance schedules for line of credit.
- It can be difficult to determine the borrowing base.
- Creditors and lenders may limit what you can spend the funds on.
So before you start the application process for a loan or line of credit answer this one question.
For your business, if accounts receivable paid their outstanding balances today, would you have the money you need to cover all or most of what you need to do?
If you said yes, then factoring may be right for you. In this scenario, you get the cash you need without going through the pitfalls of other financing options.
How Does Factoring Work?
Just four steps can get you the cash you need now.
- Assess your client’s risk: Instead of running a credit check on you, we determine the creditworthiness of your customer(s). If they turn out to be low risk, we’ll buy the invoice.
- Prepare the documents: You prepare the invoice to your customers. This documentation should also be accompanied by back-ups, purchase orders, approvals, etc. For invoice sums that are larger than usual, we may contact your customer for verification.
- Mail invoice + payment: We mail the invoice to the debtor and you get a check for the value of the invoice less our reasonable fees.
- Factoring company gets paid back: Dorado Finance gets paid back and everyone wins!