Your business credit line—it's all about the cash flow. There are some general rules of thumb you can use to determine the size of the credit line your business can reasonably maintain.
Cash flow: A simple idea (on paper)
Cash flow is one of the most fundamental business concepts: Your business has expenses, so it needs to bring in enough cash each month to meet those expenses. Ideally, in order for the business to grow, it brings in more. But while your expenses may stay relatively stable from month to month, your cash flow may vary from month to month.
Cash flow: Not so simple (in practice)
When your business isn't taking in enough money to meet your bills, you have 2 main options: pay those bills with any cash reserve the business has on hand or use credit. Because variable cash flow is a very common business issue (and a leading cause of new business failures), a general rule of thumb for any business is to have a cash reserve to cover 6-12 months of expenses.
A line of credit can help smooth out your cash flow
Many businesses use a line of credit to help address cyclical cash flow issues. With a line of credit, your bank provides a maximum amount that you can borrow. Draw against that amount at any time, as long as you don't go over the maximum; you only pay interest on the amount you borrow, not the entire line amount.
But how big should the line be?
This is where you get to play Goldilocks: You don't want a credit line that's too large or too small—you want it to be just right. What "just right" means varies with each business, of course, but as we noted in our article about the 5 C's of credit, a business typically needs to have $1.25 of income to support every $1 of debt service. You need to be confident that when you draw on that line of credit, your business will be able to readily absorb the resulting debt.
Collateral may affect line size, too
Think about the collateral your business can use to secure the line: real estate holdings, receivables and inventory. Remember that the type of collateral helps determine the size of the line of credit: You may be able to secure a line of up to 40% of inventory value, but up to 100% of CD or savings value.
Bottom line: Be smart
Nobody knows your business better than you. Once you secure your line of credit, be thoughtful about how and when you draw against that line.