Lines of credit are a popular option for acquiring working capital. But the risks are often overlooked or underestimated. If you plan to apply for a business line of credit, make sure you know exactly what you’re signing up for.

 

Business debt is a fact of life for most small businesses. In 2023, nearly three-quarters of firms with fewer than 500 employees had debt outstanding, and 39% had more than $100K in outstanding debt. 

Much of that debt takes the form of loans and lines of credit (LOCs). More than half of small businesses hold bank loans (53%), while 34% hold LOCs. And while a LOC is healthier than potentially predatory forms of lending, such as merchant cash advances or online loans, they still carry risks. With default rates for U.S. businesses predicted to reach 1.8% this year, business owners need to be aware of these risks and factor them into their financial decisions.

Top risks and downsides

Here are the top issues that business owners should evaluate carefully before applying for LOCs.

Defaults

Defaulting on a LOC can have devastating financial, legal, reputational, and operational consequences for a business. While no business expects to default, according to Equifax data, nearly 3% did in 2023. A more recent report from Fed Small Business found that 34% of firms found making payments on debt a financial challenge. And in a high-interest environment, the risks of delinquency and default are that much greater, especially for LOCs that have open rates. 

TIP: Consider minimizing your debt burden by supplementing LOCs with debt-free financing options, especially if you are a new business owner or have limited experience in financial management. 

Broken covenants 

LOCs often come with strict covenants that prevent business managers from making financial and managerial choices that are best for the company and its owners. For example, you may be prevented from securing additional credit, selling business assets, or issuing shareholder dividends. 

TIP: Read the fine print, and don’t accept the first first offer. Lenders often have room to adjust the terms of the LOC, so think about the areas where your business might need more flexibility.  

Time-consuming paperwork 

Between the initial application and the ongoing compliance and reporting, business owners can spend up to two weeks (80 hours) per year on paperwork. This includes submitting financial statements, such as quarterly or annual reports, balance sheets, income statements, and cash flow statements. While this is a small price to pay for access to working capital, it’s something to think about, especially for busy owner-operators who can’t delegate the task to others. 

TIP: Try negotiating for less frequent reporting intervals (quarterly instead of monthly, for example) and standardized instead of customized reporting. Some lenders may be open to this, especially if your financials are strong.

Collateral restrictions 

For LOCs that are leveraged against business assets such as equipment or vehicles, you must maintain their condition and value to the bank’s satisfaction and are prohibited from selling them. You are also restricted from selling these assets, and may be forced to forfeit them if you miss loan payments. 

TIP: To minimize the impact on your business, try to offer non-essential or depreciating assets to be used as collateral.

Lower credit rating 

Business LOCs can have a net positive effect on your business credit rating by demonstrating that the business can handle credit responsibly. However, the opposite can happen if you make late payments or default. A higher debt-to-income ratio can also lower your credit rating and make it harder and more expensive to borrow in the future.

This is an issue for LOCs in particular because they don’t require regular payments. As a result, business owners can forget they need to calculate that debt as a business cost that counts against revenue. The issue is compounded for LOCs that offer interest-only payments. If the revenue dries up (because of seasonal business, supply chain issues, poor sales, etc.), that debt can quickly become an outsized problem. 

TIP: Take steps to improve your business credit score and ensure it’s as healthy as possible to strengthen your overall business resiliency.

Poor cash flow 

The goal of a business LOC is to increase your company’s cash flow, but in some cases, they can have the opposite effect. Large monthly payments, a variable interest rate, and penalties and fees can all negatively impact cash flow. If they start to drag your company’s DSCR (debt service coverage ratio) below 1, it will immediately affect your ability to operate, let alone thrive and grow.  

TIP: Know your current DSCR before taking on additional debt. To calculate it, divide your net operating income by the cost of your debt, including interest, principal payments, and fees. 

Overleverage 

LOCs are an attractive option because they are structured flexibly, allowing a business to borrow more or less as required and avoid paying interest on funds they don’t need. But that flexibility can also encourage overleverage (excessive debt) by business owners who aren’t disciplined about spending. Because many LOCs charge variable interest, this type of loan product can be particularly dangerous during an interest spike. LOCs can be particularly risky for startups that don’t have much experience managing credit responsibly.  

TIP: Consider using this loan product for short-term needs only, such as managing seasonal fluctuations or covering unexpected expenses.

Factoring to mitigate line of credit risks

LOCs are a valuable tool in a business’s financial toolkit, providing access to relatively low-interest working capital that can help the business weather a setback or explore a new opportunity. But every type of debt carries some risk, and the risks posed by LOCs are often underestimated. 

One way to mitigate this risk is to consider using invoice factoring. Factoring can accelerate cash flow for a business without involving covenants, high debt loads, or restrictions on collateral. And because factoring does not add to the business’s debt profile and the credit requirements are calculated differently for factoring,  this form of financing can be used to complement any LOCs the business may already have in place. 

Learn more about using factoring to reduce your reliance on LOCs. Talk to a factoring expert.