Small Business Banking: Putting a Working Capital Line of Credit to Work for You
Putting a Working Capital Line of Credit to Work for You A credit line can provide funding for a wide range of expected or unexpected needs.
By Michael Morgan
A working capital line of credit can be a valuable loan product for your small business. It’s a common loan originated by commercial lenders, and when structured and used properly, it’s a great tool for small companies. Lines of credit for small businesses are effective loan products for daily operating purposes and can be a cost-effective alternative to factoring. Often times, business owners use their line of credit for inventory or equipment purchases; but, credit lines also can be used for unexpected expenses or seasonal purchases.
How Does a Line of Credit Work? A small business owner can establish a line of credit with a bank as a business loan to provide working capital. Most commercial lenders will work with a company to set up a credit line. Business owners should be prepared to provide financial information for the business, such as up to three years’ worth of income statements, balance sheets and tax returns. The bank likely will also request a personal financial statement on the principals of the business and the principals’ tax returns. Analysis of the financial statements will help the bank determine the repayment ability of the borrower and allow the bank to determine an appropriate amount of credit. Lines of credit typically have terms of one year (or are reviewed on an annual basis) and carry a variable interest rate. Monthly payments of interest only are standard with the outstanding principal due at maturity. A properly used line of credit will revolve, meaning the loan amount will advance up and the principal will be paid down to a zero balance. The line of credit should not be at the maximum balance for the entire term of the loan. A line that never gets paid down is commonly referred to as an evergreen line of credit. Evergreen lines of credit are not in the best interest of the borrower, and may ultimately need to be converted into a term note.
Collateral to Secure a Line of Credit As is the case with most business loans, the collateral for a line of credit can vary significantly from one business to the next. Some common types of collateral include:
Inventory and accounts receivable—These are frequently used to collateralize the working capital line of credit. It is common for the bank to require a monthly borrowing base certificate from the business when current assets, such as inventory and accounts receivable, are the main security for the loan. A borrowing base certificate is a signed statement attesting to the accuracy of the business’ accounts receivable aging. The borrowing base certificate will define how much the business will be allowed to borrow on the credit facility at any given time based on the margined collateral value.
Fixed assets—If a business does not have sufficient current assets (i.e., inventory and accounts receivable) to adequately secure the line of credit, fixed assets may be used. Real estate is an attractive collateral option for the line of credit, because it frequently holds its value for a long period of time. Other fixed assets, such as equipment, can be used as collateral as well. It is important, however, to understand the life span of the equipment pledged and how the value will change over the life of the loan. As the equipment is used, the value decreases. Therefore, the collateral value will need to be monitored closely in order to ensure acceptable collateral coverage.
Personal guarantees—In addition to collateral pledged by the business, all principals of the business may be asked to personally guarantee the loan. The principals’ guarantee may be either unsecured or secured. Collateral options for the principal’s secured guarantee can be a wide range of assets, but the most common is a mortgage on the principal’s primary residence. The principal may also use other real estate, such as commercial properties, second homes or vacant land. In addition to real estate, the guarantee may be secured by stocks, mutual funds or certificates of deposit.
When a line of credit is structured and used appropriately, it can be a great resource for your small business to provide working capital when funds are temporarily short. The line of credit also can be an effective tool when you need to purchase inventory or equipment.
Michael Morgan is a vice president at The Mission Bank. He is a commercial lender specializing in all aspects of small business financing. You can reach him at (913) 831-2400 or
