Small business credit may seem like a good idea, but it is always possible to get too much of a good thing.
Cash Flow Should Limit Credit Limits
Small business success is largely determined by cash flow. In order to succeed, a business needs to have enough cash coming in each month to meet its monthly expenses.
In order to grow, the business should have an amount of cash coming in each month that exceeds the amount going out. While these are simple ideas, they are difficult to execute in the business world.
Because of this, one of the leading causes of business failure is a lack of sufficient cash flow.
Many small business owners have financial statements that they can use to see exactly what their cash flow has been in the past. They can also easily create projections of what their cash flow will be in the future.
Because there are so many reasons that projections will prove to be inaccurate, cautious business owners should limit their credit to an amount they could afford to make payments on, based on actual past results, rather than projections.
Total debt payments, including interest and principal reduction, should usually be less than 40 percent of the monthly cash flow, according to some experts. That payment amount can be used to calculate how much credit a small business owner should have.
Have Credit Ready for a Rainy Day
One of the most important points to consider when starting a business is that an insufficient cash reserve is among the leading causes of failure for business startups. Most experts recommend starting with a cash reserve that will cover at least six months of operating expenses.
Many businesses start with an amount that is less than that, and even those that start with large cash reserves often use the cash to grow, rather than as a savings account.
To maximize sales and potential profits, business owners do need to invest. That makes a large cash reserve a factor that limits growth in the eyes of many business owners. Instead of holding cash to meet unexpected expenses, they may carry a line of credit.
When determining how much credit you should have, the rainy day credit account should be considered. Assuming the rainy day credit line is used, ideally, the payments would still require less than 40 percent of the cash flow.