Working capital line of credit: definition, advantages and how to access
Financing 101
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If you're looking for flexible cash flow to cover one-off needs, a credit line is a great place to start. Unlike other forms of funding with rigorous rules and restrictions, you can tap into a line of credit as and when you need it.
If you need the whole credit at once, you get it. If you only need a portion for a few weeks, you can use that too. It’s a fair and malleable solution, which makes it particularly suitable to small and fast-growing businesses.
In this article, we'll take a look at how credit lines are defined, how they work, their features and costs, and the different forms they can take. You'll also find out how to open a line of credit quickly, regardless of whether you choose a bank or an online fintech platform.
1. What is a line of credit for business?
In essence, a business credit line is similar to a bank overdraft. You are pre-approved by a lending institution to borrow up to a set amount, whenever you need it. As long as you stay within the rules, you don’t need to re-apply or talk with a bank manager.
With this cash cushion available at any time, you can make any current expenditure you need, generally for operating purposes. You do not have to justify the use of the funds on an invoice-by-invoice basis.
Despite the similarities, a credit line should not be confused with an unauthorized overdraft or a short-term loan. An overdraft facility is simply a one-off tolerance that puts you in short-term debt to the bank.
1.2 - What’s the difference between a line of credit and a bank loan?
A conventional loan has an amortization schedule with repayments of capital and interest up to the due date. This is highly predictable: you know what’s due, when. And you may even be penalized for early repayments.
A line of credit works differently. The lender doesn’t hand over the cash when the credit line is created, unlike a loan contract. You activate the use of the credit line according to your company’s actual needs. For this reason, the cost of the credit line depends on the sums used and not on the ceiling set.
1.3 - Different types of credit lines
The kind of credit line you take really depends on how you plan to use it. There are two main forms to be aware of:
Working capital line of credit
This is the classic case of a credit line. Companies are looking to finance day-to-day requirements such as the purchase of stocks or a sales campaign — commonly known as working capital requirements (WCR). You’ll mainly use this line of credit to pay supplier invoices.
A credit line is also a great option for seasonal financing. Particularly where you don’t know exactly how much additional capital you’ll need to cover the busy season — or if you’ll need any at all — a line of credit provides extra flexibility.
Credit lines for investment or and longer-term financing
This is a solution offered by banks, within certain limits, to buy equipment, for example. It’s a pre-arranged loan that banks reserve for well-known corporate customers. This financing facility avoids the need to apply for a conventional loan for each new investment.
This type of package generally has a limited duration of one year. However, the sums borrowed in this way are repaid over several years. The aim is to acquire fixed assets, including durable goods for the business.
Sometimes, the bank will then set up an earmarked loan contract, on presentation of proof of purchase. In this case, the traditional financing automatically reimburses the credit line in question.
2. How does a short-term credit line work?
The principle behind a credit line is that the borrower has the right to draw on funds made available by the lender at any time. It is both flexible, but with some strict conditions to ensure the line is used as agreed.
2.1 - The amount of the credit line
The maximum amount that the customer can obtain with a credit line is called the “ceiling.” It is negotiated and set out in the contract between the borrower and the bank or financial institution.
The ceiling depends on factors like your credit history, current assets, and monthly turnover. If you can prove a good track record and show that money flows into the business regularly, you’re likely to receive a higher ceiling.
2.2 - Term of financing
For a line of credit used for operating cash flow and working capital requirements, the term usually will not exceed a few months. But in many cases, the term can reset provided you repay credit as agreed.
In other words, you may have a credit line for two months. But those two months may start again once the initial funds have been repaid, without any new meetings or paperwork.
If the financing takes the form of an authorized overdraft, the term is generally one year. But the customer is often obliged to periodically return to a balance greater than or equal to zero.
And for an investment credit line, the term is often 12 months, but repayments are made over several years.
2.3 - Interest rates and fees
Interest is calculated against the amount of credit actually borrowed. The lender advances the funds at the company's request. Interest is therefore calculated on the basis of the funds advanced and the repayments made.
Sometimes, a commitment fee calculated on the credit line ceiling is also added.
2.4 - Repayment of the credit line
The contract specifies the conditions under which cash advances are repaid. Repayments are generally made quarterly or annually.
In some cases, the capital is repaid only at the end of the contract. This is often the case for short-term loans such as campaign loans. The sooner you repay the advance, the lower the cost of the credit line.
2.5 - Revolving aspect of the credit line
This type of advance is often renewable. The line is a drawing right for the company to make various payments of its choice. If you repay the funds advanced, you can borrow again for the duration of the contract.
What's more, the authorisation can be renewed after the scheduled expiry date. The terms of this renewal are governed by regulations and the contract.
3. Advantages and disadvantages of a line of credit
Why opt for this type of short-term financing and in what situation? Here are the advantages and disadvantages of credit lines as part of cash management.
3.1 - Cost proportional to the actual use of the credit line
A company that borrows the traditional way receives the full funds after the loan agreement is signed. As a result, you have to pay interest on the total amount borrowed, whether or not you use the money.
With a credit line, you only pay interest on what you actually borrow. The faster you repay, the less the line of credit costs you. So you have more control over the interest and the total cost of the financing.
3.2 - A non-dilutive solution for cash flow
This method of financing cash flow requirements, or even investment needs, provides the liquidity to develop your business without diluting your capital — unlike fundraising.
This means you retain more control over how the funds themselves are used, but also over the business itself. You’re not handing over any kind of state to a third party.
There's no non-dilutive financing that's more flexible than this.
3.3 - More flexibility can mean more fees
As well as applying an interest rate to the advances used, traditional credit institutions also charge commission on credit lines. So it's up to you to carefully study each offer you receive and assess the full cost of the transaction.
Some more modern options like Defacto charge nothing other than the day-to-day credit fees, which are already very low.
4. How and where to apply for short-term financing
Do you need cash to finance your working capital requirements? Here's how to open a line of credit.
4.1 - Find a working capital credit line
You have two main options. One is through traditional banks. The second is online financing institutions, which offer even more flexible solutions for immediate cash flow.
Traditional banks
Most banks offer lines of credit among their portfolios of services. These are in addition to overdraft facilities.
Here are some of the disadvantages of bank credit lines:
- The business needs to have been in existence for several years and be known to the bank;
- The application is complicated to prepare:
- Long lead times (in particular, the time needed to analyze the financing application);
- The full cost is difficult to understand, with added interest and various fees;
- You may need to provide additional guarantees to the bank, such as collateral.
Conditions for approval by a bank
Bank credit lines are not granted automatically. The application must prove solvency the borrower's ability to repay the advances. You must therefore produce supporting documents detailing your company’s equity capital, debt levels, revenues, and more.
You must also set out your plans, including a projected budget. Show how future income and resources will cover the loan repayments requested.
The bank then examines the application to assign a credit score and assess the risk. And it may require collateral. Then it's time to sign the contract and set up the line of credit.
Online credit organizations (like Defacto)
Fintechs with financing platforms also offer cash lines of this type. There are alternatives to traditional bank loans.
Compared with this traditional approach, which takes an average of one month, Defacto offers immediate financing.
Here are the key differences:
- You don't need to submit any supporting documents or a traditional application. We connect directly to your financial tools with your agreement (bank, accounting tools, CRM, etc.).
- On average, it only takes 27 seconds to assess your eligibility and decide to finance you, thanks to automated credit scoring.
- Get instant access to funds up to the approved ceiling.
- Pay a single, transparent cost of 0.05% per day of credit used.
Adopt a credit line for maximum flexibility and transparency
It's a shame to be constrained in your sales development because you're short of cash. Financing solutions such as lines of credit solve these exact stumbling blocks.
Rather than waiting until you have the money in the bank, think about financing your trade receivables, buying extra stock or increasing your marketing expenditure with a cash buffer.
Then use it only when you need it. You choose the repayment dates and have full control over the financial cost of the operation.
Want to get started? Discover our platform for SMEs.
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