Whether it's for your business or your personal finance, having ready access to cash is never a bad idea and serves as an insurance policy. Many people are fearful of debt (and rightly so), but with a credit line, you only use it when you need it. Many credit lines expire after never being used.
For many business owners, a straightforward vanilla line of credit is the best and only choice. However, if you are a business-to-business company that has receivables and possibly inventory, you could also be eligible for an asset-based line of credit.
Running the numbers.
For example, let's say our company has $3 million in annual top-line sales, $500,000 in accounts receivable, and $300,000 in inventory.
As a general rule, a bank will lend about 10 percent of a company's top-line sales, or in this case, $300,000, with a straight line of credit.
But with an asset-based line of credit, a lender is generally willing to spring for 85 percent of accounts receivable ($425,000 in this case) and 50 percent of inventory ($150,000), for a total of $575,000.
And there's the added liquidity you might need.
Some other details.
Because an asset-based line of credit is secured by your accounts receivable, the lender will want to see you have sales to commercial clients that are creditworthy. Anything shady (or potentially shady) is going to make a lender think twice.
Your accounts receivable can't be tied up with any other kind of financing, such as another business loan, or the existing lender would have to agree to subordinate its position.
Also, your financial reports should be in sterling shape, with clear evidence you have an active and established process for collecting receivables.
On the positive side, the financial covenants involved with asset-based lines of credit often are more flexible than those with conventional credit lines; covenants for the latter might include maintaining a specific net worth, having a monthly certification, and maintaining financial ratios at predetermined levels.
Interest rates on asset-based loans are typically slightly higher than a straight line of credit. So you have to evaluate if extra liquidity is worth the additional cost. There will also be regular reporting into your lender to validate your assets.
So, how do you decide?
As with any loan or financial commitment, take your time when making the best decision for you. Build a forecast of your business going forward, and decide how much liquidity you will need to grow and meet your objectives. If an asset-based line gives you more flexibility, it might be worth the extra cost.