Managing effective cash flow in every business serves as its lifeblood, irrespective of its size or industry. According to Charles Spinelli, businesses often face situations when they seek extra funds to carry on operations, meet unanticipated expenses, or pursue growth opportunities. Contextually, businesses have two common sources of funding: opting for a business line of credit and cash reserves.
Although both are productive in meeting their purposes, they differ in terms of usage, flexibility, and financial implications. Understanding when to use each can help businesses maintain stability and dodge financial strain.
Understanding a Business Line of Credit
Being a revolving type of funding, a line of credit allows businesses to borrow funds up to a pre-determined limit. Unlike a traditional business loan, in this instance, the borrower is charged interest only on the sum it has used, and not the entire limit. This unique flexibility makes it a perfect funding tool for meeting their temporary cash flow gaps, procuring raw materials, or covering seasonal expenses.
According to Spinelli, this makes the credit option ideally suited for temporary and unpredictable financial needs. Given that the businesses can draw and repay dues several times, a line of credit serves as a handy funding safety net, ensuring smooth operations without the necessity of breaking their emergency reserves.
Understanding Cash Reserves
According to Charles Spinelli, to effectively handle emergencies or financial downturns, the majority of businesses set aside certain funds every month in their cash reserves. To handle emergencies or financial downturns. The reserves work as a self-funded financial buffer cushion that can be used for expenses such as rent, employee salaries, or supplier payments during an unanticipated dip in revenues. Unlike borrowed funds, cash reserves do not require paying any interest or repayment compulsions, making them a low-risk and secure financial resource.
Importantly, exhausting cash reserves recurrently can be damaging for a company’s financial stability. If the available cash reserves are thus expended for daily expenses or investments, the business may have no option but to be left susceptible during genuine emergencies. So, it considers cash reserves as the best and last resort for unexpected crises, not for consistent operational needs.
When to Use a Business Line of Credit
Short-term cash flow fluctuation concerns and the need for quick access to operational funds should be considered when granting a business line of credit. It enables businesses to:
- Bridge demand seasonality:Cover costs during slow sales and repay them when revenues increase.
- Purchasing inventory:Paying suppliers at discounted rates without affecting interim cash balances.
- Bridge deposits:Handle expenses while waiting for client invoices to clear.
- Fund short-term projects:Invest in short-term opportunities.
Giving credit for these purposes preserves cash for emergencies and helps retain liquidity without draining internal funds.
When to Use Cash Reserves
Cash reserves are to be used in strategic situations that require immediate action or for which it is impractical to arrange for credit. Appropriate scenarios would be:
- Emergency expenses:Unforeseen repairs, machines breaking down, or sudden revenue losses.
- Avoiding debt:Paying off small, one-time expenses without paying interest.
- Economic downturns:Staying afloat when the credit gets tight.
It is recommended that a business keep at least three to six months’ worth of operating expenses in reserve so as to be able to survive an unexpected disruption.
A business line of credit is ideal in situations where the company expects short-term cash flow fluctuations or needs quick access to funds for operational flexibility.
Striking the Right Balance
Sound financial management lies in the ability to balance the use of cash reserves and the business line of credit. Cash reserves offer security and stability, while a line of credit offers flexibility and growth potential. Businesses need to build reserves and ensure access to credit for additional liquidity.
By employing them wisely, a business can ensure steady cash flow and overall financial health and stability.
