August 20, 2009

A bank line of credit can be hard to come by these days, especially for small companies. So what's it take to get one? Stellar credit and cash flow that can more than cover the fixed charges despite the downturn. That's a tall order for most small businesses in the current business environment. And nearly an impossible one for start-ups.

“Bankers want to take on virtually no risk whatsoever by making the loan,” says John Percival, Wharton adjunct professor of finance. 

A line of credit can be a convenient and flexible tool for a growing business. Similar to a credit card, it can help cover the gaps when you're waiting for customers to pay, but need to buy goods and services to fund expenses to continue to serve more customers.

A line of credit is different than a traditional bank loan in that:

• You draw only the amount you need, not necessarily the entire sum.
• You're charged interest on only the amount you borrow.
• You pay it back as you're able.
• You can go back and draw on the line repeatedly. 

A couple of years ago when credit was flowing more freely, such financing was a lot easier to get. Most small companies preferred banks and other cash-flow-based lenders to asset-based lenders that wanted to check their invoices and count their inventory on a regular basis. The credit crunch has largely reversed that.

"Bankers are acting totally different from how they did before. It's almost a 180-degree change," he says. 

The standards you have to meet to get bank financing today are tougher. Banks will look at the following:

• Collateral -- real estate collateral in particular -- and generally banks want more.
• Cash flow.
• Debt-service coverage ratios -- your net operating income divided by total debt service. 
• Your personal debt, in addition to your business debt. 
• The type of business -- bankers have grown more cautious about industries with greater volatility, such as retail and restaurants, and if you're a start-up, bankers are likely to be even more wary.

“They're all gun shy,” says Percival.

His advice for small-business owners now? 

“Do everything you can to reduce the need for a line of credit,” he says. If you're scrupulous about managing your working capital, you may find you don't need outside financing.