Are Small Lines of Credit Needed for a Business?
Small businesses often establish small lines of credit, but you do not have to establish a line of credit if you have the financial resources to operate the company without borrowing money. However, if you have minimal cash reserves, you may need to establish some kind of credit to keep your business running.
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Lines Of Credit
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Business lines of credit are revolving credit instruments that work the same way as credit cards. You have access to a pool of money, and you can use those funds at any time. You must make monthly interest-only payments, and you can pay off the entire balance at any time. The credit line remains in place if you pay it off, so you can borrow up to the available amount again in the future. Generally, lines of credit have a certain lifespan, such as 10 or 15 years, or the lines are annually renewable, in which case you can keep using the line as long as your business remains financially healthy enough to requalify each year for the renewal.
Business Cycle
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Businesses typically use lines of credit to buy inventory. Interest-only payments keep the businesses costs to a minimum while supplies are being bought. When sales are made, the business uses the sale proceeds to pay down the line of credit. This cycle of buying inventory on credit and paying it down with cash revenues normally occurs on an annual basis, although companies that sell products year round may go through this cycle repeatedly throughout the year.
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Alternatives
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If you have sufficient cash to cover your inventory purchases, you have no need for a line of credit. However, depending on interest rates, sometimes it makes sense to borrow money rather than use your cash. If the rate of return you can earn by investing your cash exceeds the rate you have to pay for borrowing money, you may be better served saving your cash and putting your expenses on a line of credit. However, lines of credit are tied to the variable U.S. prime rate, so your low interest rate can rise over time.
Other Considerations
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Aside from needing either cash or credit to cover inventory purchases and other basic expenses, insurance companies also require businesses to have funds on hand to cover insurance deductibles. In most states, businesses have to buy a variety of types of insurance policies ranging from liability insurance to commercial property insurance. Deductibles on commercial insurance are high, and you usually cannot buy insurance unless you can prove you have funds to cover the deductible. If you lack the cash, the insurer may require you to set up a line of credit before you can take out an insurance policy.
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