Business Lines of Credit
Commercial banks deal with corporate customers. The needs of the corporate customers are quite different as compared to the needs of the retail customer. Hence, the lending products which are offered to corporate customers are also quite different compared to the ones which are offered to retail customers.
Lines of credit are one such banking product that is offered to corporate customers in a different manner as compared to retail clients. In this article, we will have a look at what lines of credit are and how they help businesses meet their financing needs.
What is a Business Line of Credit?
The working capital needs of a business can be quite erratic. For instance, it is possible that a business may bag a huge order and suddenly their working capital needs might increase drastically overnight. Now, businesses generally do not have much idle cash lying around. Hence, it is important for them to be able to raise the required financing at a short notice. This is where a business line of credit comes in handy.
A line of credit is a revolving credit facility. This facility can be utilized at any time by the borrower and the commercial bank will start charging interest from that day. The calculation of interest will stop on the day the borrower repays the loan. A line of credit is an open offer by the commercial bank wherein they offer a pre-approved loan that can be utilized at any time.
Difference Between a Term Loan and a Line of Credit
In order to understand what a business line of credit is, we need to compare it with a term loan. Understanding the differences helps in obtaining a better understanding of the overall process.
- A term loan is a specific loan agreement with a very specific repayment schedule. For instance, the commercial bank evaluates a commercial borrower now in order to make them a term loan immediately. However, when the same commercial bank evaluates a corporate customer for a line of credit, they have to take into account the fact that they are not making the loan right away.
It is possible that the loan could be utilized by the borrower at a later day and that the borrower’s credit profile may have changed in the due course of time. It is for this reason that commercial bank conducts more stringent credit checks before they extend a line of credit to any corporation. Also, the interest rates charges on the line of credit tend to be higher in order to make up for the additional risk.
- A line of credit can be significantly challenging for a commercial bank. This is because, unlike a term loan, it does not have a fixed or even a predictable cash flow. Lines of credit allow corporate customers to borrow and return the money at their own convenience. This has the potential to create cash flow problems for a commercial bank. It is for this reason that commercial banks only give out a limited amount of credit lines. They want the credit line to be a small part of their overall business.
Advantages of a Line of Credit
The advantages which are commonly associated with a line of credit are as follows:
- Lower Overall Cost: When a corporation considers the marginal cost of a line of credit, it may seem to be expensive as compared to other loans. However, when it is viewed in the context of overall financing, lines of credit may actually work out to be cheaper.
Lines of credit allow the customers to plan their working capital requirements based on their average expenses. However, if something extraordinary happens, the businesses have the flexibility to borrow money for the same albeit at a higher cost. Hence, under normal circumstances, corporations do not need to hold on to a very large buffer! This reduces their overall working capital requirements and the costs associated with it. If an unprecedented situation materializes, they can always borrow more money by utilizing a line of credit.
- Seasonal Businesses: A line of credit is considered to be a boon for seasonal businesses. This is because they have an abnormally high credit requirement during their peak seasons. A lot of the time, this requirement is also very unpredictable. Once again lines of credit provide seasonal businesses with the flexibility to borrow the exact amount of money that they need.
Disadvantages of a Line of Credit
There are certain disadvantages associated with a line of credit. They are as follows:
- Higher Rate of Interest: If considered in isolation, a line of credit can be quite expensive as compared to other loans. This is because a higher interest rate is charged and also there are a lot of fees and charges associated with this loan. Hence, a line of credit should be considered as being emergency finance. If a business is having to use it often, then it is a symptom that there is an issue with their cash flow planning.
- Difficult to Qualify: Commercial banks are very selective when it comes to giving out lines of credit. As a result, they offer this only to corporations that have a very stable cash flow. Since a vast majority of corporations are not able to utilize this facility, they do not consider it to be very useful.
The bottom line is that a line of credit is a very useful financial product that is provided by commercial banks to eligible corporations. Even though some corporations may find it expensive, it is a very useful product that helps companies save money, if properly utilized.
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