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Reduce Risk by Separating Personal and Business Credit

By Tim Devaney

Most small businesses begin as a sole proprietorship where the owners use their personal assets to get their business off the ground. Eventually, many of these companies will grow and transform into corporations or some other legal entities with their own unique capital structure. Until that happens, business owners are taking business risks with their personal property and the business takes on risk from the owners' personal credit. The only way to protect the company and to reduce some of the business risk is to separate personal and business credit.

The most common way that small business owners comingle their personal and business lives is by mixing personal and business credit.  Often, the only source of financing available is the owner’s personal credit card.  It is used to purchase inventory, supplies, equipment or anything else that is needed to start a business. At this point, there is no difference between the owner’s personal credit rating and the company’s business credit, since the credit card is the only form of credit available.

At this point, and until there is a legal separation, the company’s assets are at risk because of the owner’s personal credit and liabilities.  For example, if the owner gets into a bad traffic accident and the other driver gets a judgment for $1 million, the driver can lay claim to $1 million of company assets without argument or restraint.  Conversely, if the company was to default on a $1 million business loan, the bank could garnish the owner’s savings or other income until the balance of the loan is paid.  Comingling any type of personal and business account is dangerous and usually creates more risk than it is worth.

The first step in separating personal credit from business credit is to incorporate the business.  Most legal structures, such as a corporation or limited liability company (LLC), create a separate legal entity with its own assets and liabilities.  By incorporating the business, you shield it from any personal liabilities and, unless legally provided for (in the case of personal guarantees on a bank loan), you shield your personal assets from the activities of the business. Once incorporated, you can start building business credit that will be used to determine the credit quality of the company that is separate and distinct from that of any individual’s personal credit.

Establishing and maintaining superior business credit is necessary for business growth, since it is required for obtaining any type of external financing and to build trusting relationships with vendors and suppliers.   By obtaining a high business credit score, owners increase the probability of receiving bank loans and credit lines, and saving money by obtaining an interest rate and loan terms that are commensurate with the firm’s perceived credit quality

As far as trade credit is concerned, most vendors will review a credit report and other business credit analysis before negotiating terms with customers.  A strong business credit score coupled with a solid transaction history will help company’s attract the very best suppliers and obtain the best possible trade terms. Gaining superior trade terms, especially the grace period on credit purchases, can be as important and effective a form of financing as a traditional bank loan or line of credit.  Trade terms allow business owners to maximize the use of internally generated cash before it must be sent to vendors as payment.

Not establishing good business credit can have a disastrous affect on business operations and economic growth.  Having to rely on personal credit or cash to buy inventory and equipment means operating with minimal working capital reserves and minimal retained earnings to be reinvested in the business.  Receiving trade credit, equivalent to 30 to 60 day no interest loans helps owners, to stabilize cash flows, and ensure that vendors and suppliers are paid on time and without issue.  Trade terms also allow owners to extend credit to customers.  Extending credit to customers increases the amount of credit sales and total operating revenues.  Having to pay everything in cash puts greater strain on the collection activities and reduces the amount of credit that can be extended to customers.  In fact good business credit is the key to obtaining internal and external financing which in turn helps maximize revenues and operating cash flow.  Since operating cash flow determines company value, the greater the company’s business credit the greater the potential market value of the firm.

Once business credit has been established owners should refrain from offering personal guarantees in order to obtain financing.  The purpose of establishing business credit is to separate the business from the owner’s personal credit.  Many business owners fail to realize that they have given personal guarantees as a requirement for obtaining credit cards or business lines of credit.  To ensure that this doesn’t happen articulate to potential financiers that you will not provide any personal guarantees to shore up any debt financing.  Provide access to your business credit file or require potential lenders to review your company’s business credit before negotiating credit terms.  One way to avoid providing personal credit or guarantees is to abstain from providing your social security number on any loan applications and instead provide only the company’s federal tax identification number or your employer ID number.

In periods where available debt capital is tight and vendors are reluctant to give flexible trade terms, owners are compelled to establish and maintain very high business credit ratings.  To do this, owners must make maintaining a high credit rating as part of their firm’s strategic vision and to implement the tactics necessary to achieve it.


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