Small and medium sized business owners often will face this question when they have achieved a certain level of scale, and are considering options to finance their continued growth. As the business owner, you, and/or other owners, may have already invested a reasonable amount of your own capital, in the form of time and money equity. Now as the business they business is looking at additional funding sources, accessing forms of borrowing such as loans or credit will start to make sense as you look to achieve your next wave of growth. long as the business is not overburdened with debt.
To be clear, both a small business loan, and business line of credit are forms of debt financing. But which one is more suitable can vary greatly based on your business needs. Because of that, let us investigate the features of each of these product, and what kind of situations each is better suited for.
Even within the category of business loan, there are a range of variations. So we will only discuss the most popular form of this type of loan, and its common features. There are three defining characteristics
For a typical business loan, there is a defined amount that is agreed upon between your bank and your business. That amount is made available to your business bank account immediately once the loan documentations have been confirmed and signed. This also means the entire amount is “outstanding” and accruing interest.
Once the amount has been made available to your business, there is now an obligation to repay the business loan over a fixed period of time (known as the “term” of the loan), at predetermined intervals. This is important to keep in mind, because there can be serious penalties if this schedule is not followed accordingly. Missing payments repeatedly can constitute as default, which will hurt your business credit worthiness in the long run.
Because of the two characteristics above, the business loan will generally have a specified purpose. For example, you need to open a second store location across town, and require investment to set up the store, or you’re buying machinery or equipment. This is because with these type of investments with specified purposes, you can predict can have a prediction of how the investment will pay off during the term of the loan, and show the bank you have the ability to make the scheduled payments.
A business line of credit (LOC) is sometimes called an operating line of credit, because its purpose is to help finance ongoing operating expenses. Think of a line of credit as an insurance policy providing a cushion of cash when you need it. That’s why the best time to apply for a business line of credit as a borrower is before you need it. The general features are as follows.
An LOC offers the flexibility to borrow the amount of money you need at any time, regardless of how much or how little it is, provided, of course, it's within your credit limit. The amount needed is drawn down at the time of spend, and only the amount outstanding would accrue interest until the time at which it is repaid.
An LOC does not require you to make monthly payments on your outstanding balance; instead, you can make minimum payments each month, make bigger payments, or pay off your full balance, if you choose. This also provides a level of flexibility for business needs, given that sometimes the use of proceeds may not be easy to forecasts.
Based on some of the features of each, it’s very likely that you have already begun to figure out which form of financing would be more suitable for your business. Because of the more pre-negotiated and fixed nature of business loans, these type of borrowing are more suited for larger, fixed sum investments. You can forecast the amount invested, and its return over a period of time, usually more stable cash generating projects in nature so that the investment can cover the fixed payment schedules. These type of loans cover machinery and equipment leasing, and even mortgages on property can be viewed as a fixed term business loan.
For more everyday working capital, and buffers of operational cash flow shortfalls, a LOC would make more sense, because it offers flexibility to bridge short-term cash needs, and does not require repayment unless it’s being used. These type of borrowing products are useful for trading companies, retail, F&B businesses that require a lot of working capital, experience seasonalities and temporary lack of cash.
LOCs were traditionally considered a more flexible version of credit cards, where the same concept of using temporary capital to make payments. This used to be the case because credit cards were not always accepted, but cash from an LOC was. However, now that you can make payments of any kind using platforms like Reap, the line between LOCs and credit cards are quickly disappearing.
As a business owner, it’s definitely possible to have situations where at least one of the two products are needed, and also situations where both are needed. The key here is to understand the features of both, and what is the purpose of seeking out business financing.