A business line of credit (LOC) is an agreement between a business and a bank (or other financial institution). It allows the business to utilize a bank facility (similar to a flexible loan or credit card) up to a maximum agreed value as and when they need it during a specified term. Consequently it is a flexible form of borrowing that can help businesses manage cash flow fluctuations, fund unexpected expenses, or take advantage of new opportunities.
A business line of credit typically has a lower interest rate than a business credit card. Furthermore they can be secured or unsecured. A secured LOC requires collateral, such as inventory, accounts receivable, or equipment. This security reduces the risk for the lender and may result in a lower interest rate for the borrower. An unsecured LOC does not require collateral but may have a higher interest rate as a result.
Using a Business Line of Credit
The business is only charged interest on the used portion of the line of credit, but has the certainty that the facility is available if needed. This is distinct from a loan agreement in which the business will pay interest on the full amount of the loan. The cost of a LOC is the interest charged on the drawn down balance and usually a commitment fee based on the entire facility. Repayments are to agreed terms, but there will normally be a minimum monthly amount to repay.
Lines of credit have many uses, for example, a business might use a working capital line of credit, secured on accounts receivable or inventory, to allow for fluctuating day to day cash flow for purchasing inventory and growing the business. A revolving line of credit is one which replenishes itself each time the business makes a repayment.
Line of Credit Accounting Entry
The agreement with a bank for a line of credit does not in itself require a bookkeeping entry. The use of the facility however will require a line of credit journal entry to record the liability to the bank.
To illustrate suppose a business agrees a LOC facility from a bank for 25,000. Until it uses the facility no bookkeeping entry is required.
Drawing of Funds
The business now draws down on the facility the amount of 8,000. The following line of credit journal entry is required.
| Account | Debit | Credit |
|---|---|---|
| Cash | 8,000 | |
| Line of Credit | 8,000 | |
| Total | 8,000 | 8,000 |
Debit
Firstly, cash has been received by the business and deposited into its bank account. Consequently the debit records the increase in the cash balance in the balance sheet of the business.
Credit
Secondly, the business now has a liability to repay the bank in accordance with the line of credit agreement. The credit records this liability in the balance sheet under the heading line of credit.
Interest Expense
Subsequently the business will pay interest on the drawn down facility. Assuming the interest expense is 500, then the following accounting entry is made.
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 500 | |
| Line of Credit | 500 | |
| Total | 500 | 500 |
Debit
Firstly, interest on the amount drawn down is 500. The debit records the interest expense in the income statement of the business.
Credit
Secondly, assuming the interest is added to the credit facility, the business now has a liability to repay the bank the interest due. The credit records this liability in the balance sheet under the heading line of credit. It is important to realize that the line of credit used now amounts to the original drawdown (8,000) together with the interest due (500) and therefore totals 8,500.
Benefits of a Business Line of Credit
- Flexibility
One of the primary benefits of a business LOC is its flexibility. Instead of receiving a lump sum of cash upfront, businesses can access funds as needed, up to a predetermined limit. This allows businesses to manage cash flow fluctuations and unexpected expenses without having to apply for a new loan each time.
- Lower Interest Rates
Compared to business credit cards and other short-term financing options, a business LOC typically has a lower interest rate. This can save businesses money on interest charges over time.
- Access to Capital
A business LOC provides businesses with access to capital that they can use to fund operations, purchase inventory, or take advantage of new opportunities. This can help businesses grow and expand their operations.
- Credit Building
Making timely payments on a business line of credit can help businesses build their credit score. This can make it easier to obtain future financing at better terms.
- No Prepayment Penalty
Most business lines of credit do not have a prepayment penalty. Consequently this means businesses can pay off the loan early without incurring any additional fees.
Downsides of a Business LOC
- High Interest Rates
While a business LOC typically has a lower interest rate than a business credit card, it may still have a higher interest rate than other types of financing, such as long-term loans or secured loans.
- Collateral Requirements
If a business chooses a secured LOC, they may need to provide collateral, such as inventory, accounts receivable, or equipment. This reduces the risk for the lender and
Summary
A business LOC is a type of loan that provides businesses with access to a predetermined amount of credit that they can draw on as needed, up to a specific limit. This type of financing can be a valuable tool for managing cash flow fluctuations and short-term expenses.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.