A business line of credit is a unique financing option for businesses of all sizes, but how does it compare against other, more traditional forms of financing? While an Accounts Receivable Line of Credit (LOC) provides flexibility and agility, term loans can also be suitable for certain expenses or financing provisions.
What is the Difference Between a Line of Credit and a Term Loan?
The main difference between an AR LOC and a term loan is the way that interest is accrued and the maturity of the debt. Term loans provide an instant capital injection which is great for large asset purchases, investments or other one-off expenses. An LOC has more built in flexibility as the business is approved for a certain credit amount that can be accessed over time and on a revolving basis. This also helps to minimize the interest repayments because as soon as repayments are made, that amount is added to the available capital.
How is a Term Loan Structured Differently from a Line of Credit?
Term loans are structured as a long term liability on the balance sheet of the business. The agreed amount is provided by the lender and becomes instantly available in full to the business. The interest rate is pre-determined and the term of the loan is also agreed upfront. The monthly repayments over the term of the loan eventually pay the loan off in full at the end of the agreed term. Monthly payments are split between reducing the amount of debt and paying toward the agreed interest.
If a term loan is being used to access finance to purchase an asset then a general rule is that the term of the loan must not be longer than the predicted lifespan of the asset. This avoids a situation where financing has been used to purchase a piece of machinery or equipment over a 5 year term but the depreciation of the asset means that it will be obsolete within 3 years.
When Should I Choose a Term Loan?
Term loans are most suitable for a fixed expense that is not expected to be required again and is a useful strategy for companies that have relatively fixed income and expenses. Common use cases:
- Asset Acquisition: When purchasing fixed assets such as buildings or machinery, the term loan is best used when the lifecycle of the asset outweighs the term of the loan. Businesses should also consider any anticipated maintenance costs or depreciation when calculating the cost of an asset purchase.
- Mergers and Acquisitions: Significant investments such as corporate buyouts, mergers or enterprise investment can take many years to see any significant Return on Investment (ROI). Funding these through a term loan is a good way to manage the outgoings on such a purchase while also ensuring that the ROI can materialize over an extended period of time.
- Commercial Real Estate: Real estate purchases either as an investment vehicle or as physical commercial assets in the form of warehouses, offices or facilities is another expense which can be managed effectively by a term loan. This ensures that the cost of the purchase can be managed over several years while the usefulness and value of the asset also increases over time.
When Should I Choose a Business Line of Credit?
- Short Term Asset Financing: When investing in inventory, raw materials or other short term operating costs, the ROI of these investments is often realized in a short space of time. Being able to repay the financing used for these as soon as possible reduces the overall interest obligation, therefore bringing down the overall cost of financing.
- Agile Cost Cover: Small and growing businesses can benefit from a buffer of available capital to help fill the gaps between the need for immediate expenses to fulfill orders versus extended payment terms from clients. Being able to access this buffer at any time of the month, for various levels of expense provides a continuity solution that helps remove the worry of a fluctuating balance sheet. This allows the business to maintain great supplier relationships while also covering all necessary expenses as they come up.
- Volume or Early Payment Discounts: Suppliers will often offer incentives for preferred clients who pay their bills on time. Depending on the level of purchase, this can provide a healthy addition to the balance sheet. To take advantage of these discounts and remain in good standing with your suppliers, it is essential to manage your cash flow in a way that means you are never late with payments. An AR LOC can provide this flexibility while also preserving your relationship with your customers as it takes the stress out of having to offer discounts on your products and services simply to get your clients to pay early. The amounts saved in vendor discounts can often far outweigh the interest paid for the time that the capital has been borrowed.
The Cost of Capital for Comparison
Term loans and AR LOCs provide unique benefits for B2B companies looking to access capital in a way that is specifically designed to fit their needs. When comparing the interest rates to calculate the cost of capital, it is important to remember that while LOCs may carry a slightly higher interest rate, this is only charged for the days that the capital is used and this can apply to small withdrawals instead of the full loan amount. Business owners should then take care to apply these figures along with the anticipated lifecycle of the assets to be purchased or the likelihood of continuing expenses, to establish a solution that works for you.
InterNex Capital has senior lenders available to tailor a tailored facility to fit your individual business needs.
Using both together
The two are not mutually exclusive. InterNex VelocityTerm loans run from 6 to 24 months and sit alongside a VelocityLOC or VelocityFlex facility, so a business can fund a one-off investment with a term loan while its line of credit covers day-to-day working capital.