What is the difference between a line of credit and a working capital loan?

Line of credit vs. working capital loan

What is a line of credit?

A line of credit is type of short-term financing that works like an overdraft in a personal bank account. It is linked to a deposit account at a bank and lets a company withdraw funds above what they currently have in their bank account, up to a specified maximum. Whenever the business deposits funds into the account, they’re automatically first applied to repay amounts owing on the credit line.

“Every deposit you put in your account goes toward paying off any outstanding amount on your line of credit,” Chahim says. “When you have a positive account balance, you don’t need to draw on your line of credit. When you have no more money, then you draw on the line of credit.”

A line of credit (also known as a credit line or a bank operating loan) is sometimes referred to as a revolving loan because the business can repay some or all of the loan whenever it’s able, and then reborrow more—up to the original limit—with no need to reapply for funds. (BDC doesn’t offer lines of credit.)

How does a line of credit work?

A credit line is usually secured against a company’s accounts receivable and inventory. It is meant to help the business cover day-to-day operating expenses and bridge temporary cash flow shortages.

“Businesses often finance their account receivables because they have to deliver a product to their clients, but they don’t get the payments right away,” Chahim says. “The customer’s payments may be deferred for 30, 60 or 90 days depending on the industry, so a line of credit can help in the interim.”

Banks typically expect the line of credit to be repaid within a set period of time (usually 30 to 90 days depending on the business and industry).

How to calculate the amount available on a line of credit?

The bank calculates a company’s available line of credit (the maximum they can borrow) based on past accounts receivables and inventory levels. The specific amount depends on various factors, such as the company’s financial performance, debt level, industry, management experience and accounts receivable quality (the speed and reliability of customer payments).

For example, a line of credit may be set at 75% of the value of the company’s accounts receivable plus 50% of the inventory value.

Assuming the following:

Calculating the total amount available of the line of credit would be done as follows:

Banks closely monitor a company’s credit line use and may require the business to respect certain conditions (known as covenants) as part of the financing terms. These can include maintaining certain financial ratios, such as the fixed charge ratio or debt-to-equity ratio. (These ratios indicate the health of the company’s finances.)

Each month, the lender does what’s called a margin calculation to reevaluate the amount of the available credit line. If there is still an outstanding balance to be repaid from the prior month, this is deducted from the available credit line offered for the following month.

A line of credit is usually renewed on a yearly basis. It is also usually a demand loan, which means the lender can require it to be repaid at any time.

What is a working capital loan?

Working capital loans (sometimes known as cash flow loans) are term loans that are typically used to fund longer-term investments or purchases. They have a set interest rate and amortization period over which they have to be repaid. They’re usually not secured by any collateral, but are granted based on various factors, such as the company’s and its leadership’s:

• financial performance
• loan repayment record
• management experience
• business plan

“Lenders want to see detailed information to understand why you need the financing and what you’re going to do with the money,” Chahim says. “Have you looked at the risks? What is your past track record on this kind of project? Do you have the capacity to do it? Can you repay the loan based on your cash flows? What is the experience of the management and their track record of making profits and repaying debt?”

How does a working capital loan work?

Working capital loans are typically given for specific projects to improve growth or profitability (see examples below).

The repayment period is typically tied to the duration of the project or its results and can be two to eight years.

BDC offers working capital loans as well as specialized working capital financing solutions through BDC’s Growth & Transition Capital team.

When to use a line of credit?

A line of credit is appropriate for short-term financing needs, such as day-to-day operating expenses or covering temporary cash flow shortages. Appropriate uses may include:

• bridging the lag between sales and customer payments
• covering seasonal sales variations
• paying emergency or other unexpected expenses
• making inventory purchases to secure a discounted price
• managing exchange rate or commodity price fluctuations

Businesses should avoid using their line of credit for larger or longer-term investments. Using the credit line for such purposes can lead to cash shortages and affect lenders’ perception of your credit worthiness. When your credit line comes up for renewal, the lender could increase the interest rate, reduce the available credit line or decline to renew.

“A line of credit is meant to finance your accounts receivables and inventory,” Chahim says. “Misusing your line of credit may put you at risk of not having funds to pay employees, utility bills or other costs. Or you may not be able deliver on orders because you don’t have money to buy material. You have to leave room on your credit line for that.

“Some business owners just write cheques for all kinds of things, and they end up struggling because they have a shortage in their working capital. At the end of the month, they’re surprised to learn that they don’t have any availability in their credit line.”

It’s important to plan for your financial needs ahead of time and put in place the financing you’ll need. “Look at your spending plans for the year,” Chahim says. “What are your future projects? Talk with your lenders well in advance about the most appropriate financing for all your needs.”

When to use a working capital loan?

Working capital loans are generally used to finance growth projects, especially those involving assets that can't be used as collateral or have no lending value. Examples of such projects include:

• website redesign
• marketing campaign
• product development
• technology investment
• hiring a salesperson
• obtaining certification
• employee training
• small asset-light business acquisitions or financing the goodwill portion of an acquisition
• paying suppliers upfront to qualify for discounts
• protecting intellectual property
• market expansion

“The term, amortization period and payments of a working capital loan are fixed, which can help a business understand and plan for its cash flow requirements,” Chahim says.

A working capital loan should not be used to finance the purchase of a tangible asset, such as equipment or real estate, which can be used as collateral for the loan. These kinds of assets can be financed with equipment, real estate and other dedicated term loans that are secured with the purchased asset, resulting in a lower interest rate.

Is a line of credit more expensive than a working capital loan?

A line of credit usually involves a lower interest rate than a working capital loan. This is because lines of credit are typically secured by accounts receivable and inventory. A working capital loan, on the other hand, is usually an unsecured loan. This means it is riskier for the lender; the lender generally charges a higher interest rate to offset that risk.

Is a line of credit a demand loan?

A line of credit is generally a demand loan. This means the lender can require it to be repaid at any time. That could happen if a business doesn’t respect loan terms and conditions or if the bank calls in the loan for its own reasons, such as for risk management purposes or because it is exiting certain industries.

Next step

Looking to expand into new markets? Develop new products? Protect intellectual property? Launch a marketing campaign? A working capital loan may be right for you.