Which Types Of Credit Are
Right For Your Business?

Most people don’t have the personal funds to bootstrap a business. It costs money to set it up and make it successful. Therefore, they need to find investors or look to borrow money in the form of credit.

Credit makes the business world go round. If everyone had to save up cash and pay upfront for every expense, businesses would quickly grind to a halt. Whether it’s managing your cash flow, buying resources on credit, or a one-off lump sum to get things started or expand operations, every business needs credit in some form or another to operate.

Given its importance, businesses should take the time to learn about various types of credit and determine the right types to match their needs. How you use credit, especially how you pay it back, will affect your business’s credit score, determining whether lenders and other companies are willing to offer you credit in the future.

The Federal Reserve Bank 2020 Small Business Credit Survey gathered responses from over 5,500 small firms (classified as less than 500 full or part-time employees) across the United States. Securing credit (33%) was the second most prevalent issue cited by respondents that faced financial challenges in the past 12 months.

Whatever credit you end up using, relying on it long-term and maintaining access to it requires a good credit score and proving you can make the payments. Whether that means new cash flow processes to keep up with bills or new payment options to streamline the way you get paid, falling behind on repayments creates serious consequences.

Who’s Giving You Credit?

The two most important distinctions to make when it comes to types of credit are who’s giving you the money and how they expect to be paid back.

Bank Credit

As the name suggests, bank credit is funds borrowed from a financial institution such as a bank. Bank credit entails entering into an agreement with a financial institution to repay the original amount at a later date; this may include interest. Lenders determine how much money they are willing to offer your business based on your ability to meet repayments. This requires them to analyze the business’s finances, including its credit rating and income, and determining whether the funds offered are secured.

Bank credit can either be secured or unsecured. Secured means you, the borrower, must provide assets as collateral in the event of failing to meet the payments. Unsecured means the credit provided does not require providing collateral. Borrowers with a poor credit history are typically only offered bank credit with unfavorable terms, such as lower limits and higher interest rates.

Credit cards are the most common form of bank credit. They allow you to make purchases and repay the balance later, generally at the end of each month. Credit cards come with a credit limit and interest for late payments quoted as an annual percentage rate (APR).

Other forms of bank credit include mortgages and car loans. These types of credit must be secured with collateral. When accessing these types of credit, you will agree upon a payment plan with either fixed or variable interest rates. Another common type of bank credit offered to businesses is a line of credit (LOC). This acts as a revolving loan offered to companies demonstrating the capacity to meet repayments.

Trade Credit

Commonly used in business-to-business (B2B) transactions, trade credit is an agreement where you pay suppliers at a later date instead of with cash up front. Trade credit typically gives purchasers 30, 60, or 90 days to pay the invoice, referred to as net 30, net 60, and net 90, respectively. Generally, no interest is charged as long as the purchaser meets the payment date.

You can think of trade credit as a way of deferring payment for specific goods and increasing the value of company assets. For example, many companies buy resources through trade credit, then pay for them after making a profit off them.

It’s an excellent tool for managing business cash flow and can help generate short-term growth. However, to access trade credit, you may have to prove your business’s financial capabilities or develop business relationships with your suppliers.

How Are You Repaying The Credit?

How credit is repaid can be separated into two forms, open or closed. Open-ended credit is a continuous source of funds that remains available, up to a specified limit, as long as you continue to make payments. Closed-end credit is a fixed amount of funds that are paid back in fixed installments.

Important types of open and closed credit to consider are revolving credit and installment credit.

• Revolving credit: An open-ended credit where you repeatedly borrow and repay funds from a single source. The borrower spends as much money as they choose up to a set limit and then pays the credit after a fixed period, typically at the end of each month. Interest is only charged on the unpaid balance at the end of the agreed-upon period. The line of credit remains open indefinitely. The most common form of revolving credit is a credit card.
• Installment credit: Close-ended credit in the form of a loan that is received in a one-off lump sum and repaid on an agreed-upon plan. Once the total amount (original loan plus interest) is repaid, the account is considered closed. Examples include a mortgage or car loan.

Finding Suitable Credit For Your Business

When running a business, there is always more you could do if only you had the funds available. By finding the right sources of credit for your business, you can borrow money and expand operations in a sensible manner without getting yourself into a precarious financial position.

Always remember the mix of credit you have, and your payment history defines the business’s credit score. Missed payments lead to paying extra interest while also affecting your credit score and access to future sources of credit.