Is a Line of Credit Right for Your Business Recession Plan?
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More than 90% of small-business owners are worried about experiencing an economic recession over the next 12 months, according to a June 2022 Goldman Sachs survey.
Because lenders tend to tighten their lending standards during recessions, small-business owners may be looking for ways to secure funds before access to credit is possibly reduced.
One option to consider is to apply for a business line of credit — even if you don’t need it right now. Unlike a business loan, a line of credit lets you decide when to withdraw funds and how much to take out, up to a set limit.
Would your business benefit from a line of credit?
Since it’s common for access to financing to decrease during a recession, getting a line of credit before you need it can be a smart move, especially if you see the potential for cash flow issues in the future.
For example, if you plan to make large investments in inventory and materials or take on projects that require substantial outlays of cash before you receive payment from your customers, a line of credit can help ensure you have funds available in the future to do it.
In addition, a line of credit can be used to cover operating expenses such as rent, wages, insurance and maintenance when your business experiences a short-term reduction in revenue.
Generally, lines of credit are a good option for businesses that are concerned about fluctuating needs for funds, according to Carolyn Katz, a mentor at the New York City chapter of SCORE, a nonprofit organization offering education and mentorship to small businesses.
When you decide to apply for a credit line, “you should try to get whatever line is available to you,” says Katz, “because even if it doesn’t fully cover your costs, drawing it down and repaying it regularly will help you earn your way to a larger line.“
Are there drawbacks to having a credit line?
If fluctuating cash flow isn’t a concern, your decision to apply for a line of credit is more complicated. While a line of credit could be used as a reserve or emergency fund during challenging economic times, there are drawbacks to consider when getting one that may not be used.
It takes time to apply and complete the necessary paperwork, the lender may charge a maintenance fee if you don’t use the line and your limit may be lower than you want. Also, because lenders look at credit lines, even unused ones, when evaluating a borrower, a line of credit could negatively affect your ability to get other types of financing.
What do you need to get a line of credit?
If the benefits of a line of credit are stronger than the drawbacks for your business, and you decide to apply for one, lenders will typically review your business profitability, credit score and accounts receivable. Accounts receivable, the money owed by customers for goods or services, represents future revenue that can be used to pay off your line of credit.
“Receivables are important for any kind of a loan product, but in lines of credit, your accounts receivables are really the No. 1 criteria,” Katz says.
Also, keep in mind that older accounts receivable can be considered at risk of nonpayment. Katz says, “if a line of credit is something that you’re going to be looking at, try to keep your receivables below 60 days.”
When should you apply for a line of credit?
Shauna Huntington, from the NAWBO Institute of Entrepreneurial Development, the non-profit education foundation of the National Association of Women Business Owners, says that business owners who want a line of credit should consider getting it before they actually need it.
“If they wait until they get that large order and they need the line of credit to produce it, it’s going to be harder to go to the bank and ask for that money at that time and get it turned around quickly,” Huntington says.
With the option to draw down money as needed, a business line of credit can be the right move for businesses that are concerned about cash flow issues in the future. However, a line of credit, used solely as a way to hedge your bets on an uncertain economy, may be an unnecessary expense that offers few, if any, benefits.
This article was written by NerdWallet and was originally published by The Associated Press.