Today’s SMB Manual explains when a business line of credit can be drawn, when the bank can restrict access, and what a personal guarantee means if the business cannot repay it.
A LINE OF CREDIT IS NOT FREE MONEY
Your business brings in $6 million a year. Two years back, the bank approved a $500,000 line of credit, and you drew on it to cover payroll while a large customer took 60 days to pay. Later, you used it for a new truck, a quarterly tax payment, and a shop manager’s salary. The balance has stayed near $450,000 for 18 months. The bank has raised no concerns, so you have come to rely on the line to fund day-to-day operations. Then the renewal letter arrives.
A line of credit, or revolver, is short-term financing for the gap between paying your costs and collecting from customers. You draw, repay as receivables come in, and draw again. Most small business lines carry a variable rate priced at prime plus a spread, and in the Kansas City Fed's latest bank survey, variable-rate lines accounted for about 91% of credit line usage. Prime moved to 7.00% after the Fed's September 16 increase, so a line at prime plus 1.5% now costs 8.5%, or about $38,000 a year on a $450,000 balance. Most lines also renew annually, meaning the bank decides each year whether to extend, reduce, or let the line expire.
Four terms in the agreement determine how much you can borrow and what happens if the business falls short. A borrowing base caps what you can draw at a percentage of your collateral, often around 80% of receivables less than 90 days old and a smaller share of inventory. If customers pay slowly, your available credit can shrink just as you need it. A clean-up provision requires you to bring the balance to zero for a set period each year, often 30 consecutive days. It shows the bank that customer payments can repay the line between borrowing cycles. Financial covenants require the business to meet measures set in the agreement. A debt service coverage ratio of 1.20x or 1.25x, for example, requires cash flow to cover scheduled debt payments by 120% or 125%. A personal guarantee makes you personally responsible for any amount the business cannot repay.
The mistake is using a line that renews each year to pay for a truck, equipment, or other costs the business will carry for years. The balance remains outstanding, and the business may fail to meet the required clean-up period. If revenue also falls and cash flow drops below the required coverage ratio, the bank may reduce the credit limit, raise the interest rate, propose a term loan, or decline to renew the line and require repayment at maturity.
Converting $450,000 into a three-year term loan at 8.5% increases the monthly obligation from about $3,200 in interest to roughly $14,200 in principal and interest. If the business cannot carry that, the guarantee comes into play. The Federal Reserve's latest credit survey found that 59% of small firms with debt had signed one.
The line also affects what you receive when you sell the business. Most lines are secured by a lien on business assets. At closing, the buyer’s lender will generally require the outstanding balance to be repaid and the lien released. If the line still has a balance, the repayment is deducted from your sale proceeds.
Start by sizing the line to the working capital cycle. If customers pay in 45 days and suppliers expect payment in 15 days, the need is roughly one month's worth of materials and payroll. Clear the line for at least 30 days a year even when the agreement does not require it, and finance vehicles, equipment, and buildouts with term loans.
Before signing, check whether a 20% drop in EBITDA would put you in breach of the covenants. If it would, ask the bank for more room. Negotiate a fixed dollar cap on the personal guarantee and its release after a set number of years of meeting the covenants. If jointly owned assets do not secure the loan, ask why the bank requires your spouse’s signature. Begin renewal discussions 90 days before the line matures, and maintain a relationship with another bank in case your current bank declines to renew.
WHAT WE’RE READING
JPMorganChase found that only 8% of owners have advanced succession plans, while 70% are still in the early stages. Over the next decade, roughly 12 million businesses holding nearly $10 trillion in assets are expected to change hands. The planning gap is especially consequential in industries the bank considers critical to national security, where more than half of firms have an owner aged 55 or older. Read →
The Conversation argues that the Fed’s rate hike is only part of the story. Long-term Treasury yields have been climbing for months on federal debt, energy prices, and heavy AI borrowing, and the 10-year crossed 5% on September 14 for the first time since 2023. With markets expecting further hikes, financing costs could stay high across short- and long-term debt, making projects with thin margins difficult to justify. Read →
