Many business owners reach for a line of credit when faced with a major obstacle, such as a recession or downturn. But sometimes the need comes at a less obvious moment — like right after distributing all the profits at year-end, only to have an unexpected expense or a big opportunity come through the door. Losing a major client, a delayed payment, or an unplanned investment can quickly drain cash reserve. And the truth is, many business owners don’t have a reserve at all, or they’ve already tapped it for another need. That’s when a line of credit can make all the difference. 

The problem is, if you wait until you need a line of credit to reach out to a lender, it might be too late — especially if you want to secure the most favorable terms. 

A Primer: Lines of Credit Versus Business Term Loans and Business Credit Cards  

Before we jump into the best time to get a line of credit, let’s first talk about business financing. Many business owners realize they need it, but don’t necessarily know which type is the right choice. While a line of credit is an option, there are also business loans and business credit cards.   

A business loan (including term loans and SBA loans) provides business owners with a lump sum of money up front with scheduled repayments. Each repayment includes interest. Often, small business loans are distributed only with a specific goal in mind, for example, purchasing a warehouse or investing in new technology for your office. Generally, you choose a business loan for one-time, expensive investments.   

A business line of credit works a bit differently. This funding option is a revolving form of credit that allows you to borrow money up to a specific amount. You borrow money up to the limit, pay it down, and use it once again rather than using it for a one-time scenario. For this reason, businesses often keep a line of credit open for times of short-term emergency when working capital is low, and business expenses are due. Lines of credit are obtained without a specific use-case, allowing the borrower to use funds as they need/see fit.   

Business credit cards are similar to lines of credit in that there is a borrowing limit. However, credit cards require a minimum monthly payment similar to a business loan. Credit cards usually carry smaller limits and are used for lower dollar amount purchases, such as a singular laptop for a team member.   

Regardless of which financing option you choose, you need to go through a process of credit approval to determine eligibility. A financial institution has an application process to determine the terms they are willing to extend. It’s best to have your business financials in order before approaching a bank or credit union.   

The Best Time to Get a Line of Credit  

The best time to get a line of credit is when business is great. Why? When a business owner’s financials are in order and they show consistent (or growing) revenue, a bank is more likely to extend a revolving line of credit on favorable terms.   

When an owner waits until revenue dips or inflation impacts their business, a lender may be reluctant to extend a line of credit, or the owner might not get great terms. That means higher interest rates or lower limits than you requested. Seeking a line of credit before a downturn secures a larger credit amount, lower annual fees, competitive repayment terms, and lower interest rates.   

Types of Business Lines of Credit  

There are two types of business lines of credit, and they are used for a variety of business needs.   

• Secured lines of credit are backed by business assets that serve as collateral. If payments are not made on the lines of credit as agreed, these assets are at risk.   

• Unsecured business lines of credit do not use collateral. Your assets are safe from being leveraged if you miss payments. Unsecured lines of credit often carry lower credit limits due to the riskiness of this type of business funding for a financial institution.   

Creditworthiness and credit history often dictate which line of credit you are eligible for, as well as the payment terms and interest rate you receive.   

How Much Should a Line of Credit Be?  

It’s generally recommended for a business line of credit to be equal to the cash reserve (which should range from 10-30% of annual revenue). Therefore, the line of credit a business owner should seek would also be within that 10-30% of annual revenue.   

Why Is a Line of Credit Necessary?  

Our virtual CFOs recommend lines of credit as a backup plan. Just like we all purchase auto, life, or home insurance for a “just in case” scenario, having a line of credit saves a business if the worst happens.   

Tapping a cash reserve is often better than using a small business line of credit or reaching for the company credit card, but there are times that reaching for a line of credit is a better safety net to prevent clearing out a cash reserve. Basically, a line of credit is a life raft for small business owners during times of downturns or unexpected expenses.   

A business owner should make sure their business financials are clean before seeking a line of credit, so they obtain ideal payment terms and larger line of credit offers.   

If you are a business owner looking to better understand cash flow management and hoping to put your best foot forward when speaking to lenders, reach out to one of our virtual CFOs for a free consultation.