Understanding How Business Credit Works: A Comprehensive Guide

Credit Cards in Hand

Whether you are a new business or one that is struggling with cash flow, it is important to understand how your business credit can help your business no matter what industry you are in.  Maintaining good business credit can help you gain access to capital, manage cash flow, and facilitate growth. 

Business credit is distinct from personal credit and operates on the same, yet very different set of principles.  Payment history is important, but with business credit, there are more factors that go into whether your business is credit worthy.  In this article, we will try to dive into nuances of how business credit works, why it is important, how to establish and maintain a strong credit profile for your company.  Ultimately, your business credit report is going to be the determining factor of whether you are able to get access to the funds you need, and if you are granted funds, the terms of the financing that is offered.

What is Business Credit?

Business credit is used by lending institutions to determine not just the likelihood of repayment, but also the success or failure of the business, and what the terms of the contract should be for your financial needs.  There are 3 main companies that generate business credit scores, all of which will calculate several numbers trying to predict several factors for lenders. Dun & Bradstreet and Equifax generate different scores on the likelihood of the business going under, the likelihood of repayment, and also the likelihood of paying too slowly.  Experian gives a couple of scores to lenders to determine how slowly a company will pay off their debt and the stability of the company in general.

Whether it is a credit card or a loan, a low credit score can mean getting denied or having unfavorable terms, such as quick repayment or higher interest rates. Higher credit scores can open up the doors to save money for your business, or create opportunities for growth and expansion without using all of your capital. 

Importance of Business Credit

  • Separation of Personal and Business Finances:   Having business credit allows you to keep your personal finances and business finances totally independent from one another.  This can have a huge impact on how much you will pay in taxes every year.  It is important to always separate your personal capital from your business capital. By keeping these separate, you can take advantage of many of the tax laws that allow you to write off your business expenses, but only if you file taxes for the business separately. Keeping everything separate ensures not only accurate accounting but also protect your personal assets and capital in the event of insolvency, bankruptcy, or lawsuits.  If you do not have an established business and things go south, you could be held personally responsible for the debts of the business. This could include liens on property or even wage garnishment.
  • Access to Capital:    Having access to capital can be a lifeline for some businesses.  This could potentially allow you to expand, cover payroll, buy inventory, or even make repairs to equipment.  There could be many different reasons a business needs access to capital.  You may have a seasonal business that has more cash flow during a certain season, but have expenses for your business all year long.  A company may have an opportunity to expand but does not have the capital for the purchase. Maintaining a solid business credit score can give you piece of mind that if any need arises, you will be able to contact a lender and secure funding.
  • Supplier Relationships:    Depending on the business that you are in, having and maintaining a good supplier relationship with timely payments could be key to continued revenue.  Having a good supplier relationship can be the difference of having to front money for inventory before it sells, or being able to order inventory and sell it, before you even pay for it.  Many suppliers will extend lines of credit based upon your business credit report.  If you score is low, you may need to pay up front or put a deposit down.
  • Business Growth:  Access to credit can help companies achieve growth in many ways.  Whether it is upgrading equipment to be more efficient, or buying out a competitor of your business, having access to funding will allow your business grow, diversify, and experience more revenue. 
  • Credibility and Trustworthiness: A strong credit rating can enhance your business’s credibility with not just lenders, but also can build confidence from customers or even investors.  People buy from companies that have a good reputation, as it instills confidence that they will not lose their money, or the product is as described. 
  • Better Interest Rates and Terms: As we all know, borrowing money is not free, but it can cost you less with a better credit rating for your business. A better credit score can add up to cheaper interest rates on the money you need, a larger credit line, or even a longer repayment term.

How to Establish Business Credit

  • Establish a Legal Entity – Before you establish business credit, you need to make sure you have established a business.  Depending on your industry, this might be a partnership, or corporation.  Most small businesses initially start out as a Limited Liabiity Company, more commonly known as an LLC, and can be done for a small cost through your state.
  • Get Assigned an EIN through the IRS – After you establish your business, you can then go to the IRS website or call them to get assigned an EIN (Employer Identification Number).  Make sure to keep the document provided as you will need it over and over again. 
  • Open a Business Bank Account – With your new EIN, you will now be able to open up a true Business bank account.  Some banks will allow you to open this type of account as a DBA (doing business as), however, it is only backed by your social security number and therefore you can be held personally accountable. 
  • Open Lines of Credit with your EIN – If you have never had business credit before, there are still credit card companies that are willing to extend you credit in the beginning.  The lines of credit might be small, and there may be annual fees.  Though, with the right management of your finances, this is sure to change. 

Factors Affecting Business Credit

  1. Payment History: Timely payment of bills, loans, and credit accounts is a key factor in establishing positive credit. Late payments can have a negative impact on credit scores.
  2. Credit Utilization: This refers to the ratio of credit used compared to the total available credit. Keeping credit utilization low demonstrates responsible financial management.
  3. Credit History: The length of time a business has been using credit and the age of its credit accounts contribute to its credit score.
  4. Public Records: Bankruptcies, liens, and judgments against a business can significantly damage its credit profile.
  5. Industry Risk: The industry in which a business operates can affect its creditworthiness. Some industries are considered riskier than others.
  6. Company History: The industry is not the only important factor. The age of the business and number of employees you maintain will also be a factor used in your credit score.

Building and Maintaining Business Credit

Once you start to build your credit and get it to where it benefits your business daily, you want to make sure you maintain it properly. Do this by requesting your scores and reports on a regular basis, ask your lenders if they will report to your credit, and of course, make timely payments. Remember, credit is hard to build and easy to lose.

Ahead of the Game with Solid Business Credit

Finance companies, banks, suppliers, and even leasing companies are all going to check your business credentials, including your credit score before giving you a line of credit or loan.  Some might go even further and request financial documents of your company or projections that you expect.  Getting ahead of the game and knowing in advance that the companies you are requesting capital from are going to look at all of these items, will put you in a better position to get the credit your business needs, and the terms you can easily repay.