Entrepreneurs frequently encounter difficulties managing their cash flow as a result of seasonal credit demands and time gaps between capital needs and revenue realization. This is especially true of business start-ups during their early stages of development when they have not diversified enough to generate a constant positive cash flow. Once inventory has been purchased, it is necessary to ride out the cycle until accounts receivable have been collected. Without sufficient working capital, a serious cash flow problem could develop. These types of cash flow problems have forced many entrepreneurs to close down businesses that were making money on paper, but just ran out of cash.
Lines of credit accommodate the seasonal credit demands of your business along with ups and downs in your cash flow. They also enable you to purchase inventory in anticipation of future sales. Discuss establishing a line of credit with your bank at the beginning of your relationship. If you are just starting your business, the bank will probably not grant a credit line immediately. A line of credit is a standard service provided by many banks that serve small businesses. Getting the loan approved depends on the business's ability to repay and/or the personal assets of the owner, for example, a second mortgage on a home, assignment of stocks and bonds, or assignment of the cash value of life insurance policies. Banks will extend a secured line of credit to most start-up ventures. The line may be unsecured if the business can demonstrate consistent earnings, an excellent capital position, and multiple
sources of repayment. Traditionally, banks will commit a specified maximum amount of funds from which you are permitted to draw on as needed. You have the right to repay and re-borrow during the agreed-on time, which usually will not exceed a year. You pay interest only on the outstanding principal.
Business Loan vs. Business Line of Credit When you own a small business, finding the right kind of financing can be key to growth. While there are several options available, business loans and business lines of credit are two of the most common. But before you decide to choose one over the other, you should understand the differences between the two as well as the advantages and disadvantages of each. 1. Renewals. Business loans don’t renew at the end of the terms. You use your business loan once, while a line of credit is revolving. You can use it multiple times. 2. Timing. “When” you apply for a loan and a line of credit are different. A loan is something you get when you need it, and for one specific purpose. In contrast, a line of credit is usually set up before you need it and, unlike a loan, it can serve multiple purposes. 3. Monthly payments. With a loan, your monthly payment begins immediately and doesn’t change from month to month, whether you’re using all the money or not. With a line of credit, your payments only reflect the amount of money you’ve borrowed. If you carry a zero balance, you won’t have a payment. 4. Closing costs. These are often lower for a line of credit than a loan. While there are exceptions, the closing costs for most loans (may include processing, credit and appraisal fees) range anywhere from 2% to 7%. The closing costs for lines of credit (may include processing and transaction or withdrawal fees) are generally minimal, if any. 5. Terms or repayment periods. These are fixed on a loan. Because the terms are fixed, the monthly payments are usually higher when compared to lines of credit. As an example, the monthly payment on a $50,000 loan can be $400–700 per month, more than on a $50,000 line or lines of credit. 6. Long-term vs. short-term. Loans are usually paid off in 2 to 6 years. Lines of credit, on the other hand, solve short-term needs. Lines of credit help finance account receivables as well as marketing and payroll needs. They’re also useful for unexpected cash-flow shortages. 7. Interest rates. With a business loan, you’re likely to have higher interest rates that are fixed, whereas a line of credit may offer lower variable rates. Keep in mind, with a line of credit, if you’re late on a payment or exceed your credit line, your interest rates will increase. Conversely, when you manage your line of credit more wisely, you may be able to actually lower your rate. With different financing options available, it can be difficult to choose the right one for your business. But knowing the difference between two of the most common small business financing
solutions can help paint a bigger picture of what your business might need in both the short- and long-term and ultimately empower you to make the money work to grow your business.
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