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Entrepreneur Insight

How to Prepare for Volatility with Lines of Credit

May 14, 2018
Illustrated image of a girl standing under two umbrellas representing how lines of credit serve as umbrellas from a rainy day
Lines of credit give business owners flexible access to cash flow and serve as working capital. (Photo credit):

Opening a line of credit helps protect your business from delays and economic downturns.

When Kathy Pang sought out a line of credit in 2012 for her company, Pangtong Wellhead USA, she did not anticipate the global downturn in oil prices.

Pang, who serves as CEO of the Shanghai-based company, which distributes wellhead equipment to the U.S. petroleum industry and has a warehouse and sales office in Houston, refrained from taking on additional debt for years, but wanted to expand the business.

After working in Houston, dubbed the “energy capital of the world,” she knew that obtaining a line of credit would be a good backup in case the company needed to purchase additional equipment, especially if oil prices fell.

In 2014, oil prices plummeted, with Brent crude dipping to $62 per barrel from $112 per barrel, and Pang was able to tap into her line of credit to buy more equipment. Despite receiving a steady flow of orders in 2014 and 2015, Pangtong’s customers were producing less oil and faced their own financial hurdles. “The line of credit helped the company even through 2016, because our clients had cash flow problems,” she says.

Being able to draw down on her line of credit from East West Bank helped the company process its orders and remain successful during the downturn. Without access to capital, the company would have seen a decline in sales.

“It’s good to get a line of credit when your business is profitable, and you have the line of credit to rely on if you need to buy more equipment,” Pang shares. “We are always prepared for oil prices to go down.”

The bottom line? Business owners should obtain a line of credit even if they are generating a healthy profit with adequate cash flow.

Lines of credit provide cash flow

When small to medium-sized businesses are flourishing, getting approval for a line of credit from banks and other lenders is much easier.

A line of credit is when a lender makes credit available to a borrower for a defined period of time, says Stephen Sheinbaum, managing director of production at World Business Lenders, a Jersey City, N.J.-based small business loan provider. They are usually made available for one year at a time and can generally be used for any business purpose.

Lines of credit give business owners flexible access to cash flow in the amounts they need, especially during slower times, such as waiting for a payment from a customer, says Jim Brown, a New York-based CPA who previously provided auditing and consulting services to small and mid-sized businesses.

“It’s really all about cash flow, and they can help a lot of small business owners facilitate growth and avoid a lot of cash crunch headaches in the process,” he shares.

Since they are flexible and entrepreneurs can draw down on them when they need it, lines of credit can serve as an “ideal cushion or a safety net for unplanned cash emergencies that pop up at precisely the most inconvenient time for small business owners,” Brown explains. “If a bank grants a business owner a $100,000 line of credit, the owner may draw $10,000 from that line of credit to cover current cash flow needs.”

One of the advantages is that owners only pay interest on the $10,000 that is borrowed and not the entire $100,000 line.

Depending on the borrower’s financial performance and whether the business has assets to secure the line, the amount a business can obtain varies widely. A general rule is that a lender will want to see the ratio of EBITDA (earnings before interest, taxes, depreciation and amortization) to debt service to exceed two to one, he says.

“Unless a borrower is seeking an outsized amount, a line of credit should not be too difficult to obtain for a company that is making money and generating positive cash flow,” Sheinbaum says.

Profits from a business should be reinvested back into the business to spur further growth, while lines of credit can handle unplanned or urgent cash flow needs, according to Brown.

Lines of credit are another opportunity for entrepreneurs to develop a positive credit history, which can pave the way to additional types of financing in the future. “They can also enable entrepreneurs to retain control of their company as an alternative to bringing in investors in exchange for needed capital,” he says.

Without a line of credit, a business could miss out on an opportunity to attract a potentially lucrative customer, says Gerri Detweiler, education director for Nav, a San Mateo, Calif.-based company that helps business owners build their credit score and serves as a lending marketplace.

With a government contract or a significant deal, payments can take between 30 to 90 days. While waiting for payment, businesses are still required to pay salaries, insurances, surety bonds, or supplies that go toward the contract or deal. All of this demands upfront financial capital and not having it could potentially mean dropping the deal.

“That dream job will quickly become a nightmare,” Detweiler says. “A line of credit puts you in a better position to take advantage of opportunities that require you to lay out funds in order to complete the job.”

Being able to draw down on the line of credit also helps a company prepare for a crisis, such as if a supplier raises its prices significantly or a client closes its doors before paying the business.

“A line of credit gives you more leeway to deal with that crisis without falling behind on bills and hurting your business credit score,” Detweiler says.

Lining up business financing beforehand results in less stress for entrepreneurs because they can shop for the lowest interest rates and the terms that fit them the best.

How a line of credit becomes working capital

For the past decade, Andrew Schuman, CEO of Hammond's Candies in Denver, has had a line of credit that served as operating cash and working capital throughout the year. The company has 150 employees across Colorado and Virginia, producing candy, candy canes, caramel and marshmallow confections, along with brittle and peanut candy under the Old Dominion Peanut brand.

Since the company is a seasonal business, cash flow can be very unpredictable.

“A line of credit is helpful because it allows us to use our assets to borrow cash,” Schuman said.

During volatile periods, banks can put additional pressure on companies, especially ones that are seasonal and rely heavily on holidays. A line of credit protects the business during seasonal times and reduces the amount of risk.

“There are times when we lose or are very close to losing our ability to borrow against the line,” Schuman says. “Our business is seasonal, and we can run out of availability right before the busy season. In cases like that, having a solid relationship with your bank is key. You need to work closely with your banker to ensure you have the proper amount of working capital.”

Entrepreneurs need to always prepare themselves for uncertain conditions because the economy can “change on a dime,” Schuman says. “I think you always need to be looking ahead and never get complacent with what is or has happened. Technology is constantly changing, and that affects the landscape of retailers and manufacturers. Invariably, something will go wrong and just knowing that is important in preparing for uncertain times and conditions.”

No longer hesitant about having a line of credit, Pang shares that the company is striving to gain more oil and gas customers in the Middle East and South America.

“We feel confident about the economy, and many of our customers want to double their rig count since oil prices have stabilized,” she says.

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