Small business loan vs line of credit

Small business owners are well accustomed to fuelling their business’s growth with their own hard work, but there are times when that’s not enough.

External funding can be make-or-break for businesses that need to ride out temporary cash flow squeezes that are out of your control – a situation the pandemic has made a reality for many. And funding can also be an essential ingredient for businesses looking to leap on an opportunity that could be your big break.

The array of finance options out there can be dizzying but the good news is that technology has transformed so many sectors, including business finance, making it more accessible than ever before.

Banks are far from the only option now, with fintech lenders, like Prospa, specialising in the specific needs of small businesses. This new breed of lenders also specialise in providing businesses funding much faster than traditional banks, making us more responsive to the unpredictability that COVID-19 has brought.

For most small businesses, two of the most common finance products that can serve their needs are a small business loan and/or line of credit.

So how do you decide which to use when?

A financial advisor explains the differences

Good debt has the potential to boost the health, net worth and income of your business, says Paul Cluff, Managing Director at MoneySmith Group.

“It can help you grow or start a business, especially when you’ve only got a certain amount of cash,” he says.

“The debt can enable you to retain the cash you have already, and then use the debt to increase your assets and potentially grow your income and business.”

Of course, different financial products suit different requirements.

With a small business loan, you receive all the funds in one go, and then pay those funds back on a set schedule.

Cluff says small business loans are usually considered for one-off expenses, such as new equipment or machinery, repairs or fixtures and fittings.

Where a line of credit differs is that instead of a single lump sum, it consists of an agreed credit limit. You can dip in and access funds when you need them, and only pay interest on what you use, while you use it.

“It’s generally used for working capital cash flow,” Cluff says.

“It gives you the ability to access cash flow as needed. For instance, you might have an opportunity to buy some inventory at a really good discount by paying now up front. You might then choose to sell that and push some of that cash flow back into the line of credit.”

Cluff says the balance of a line of credit is able to go up and down, reflecting the business’s cash flow.

“I’ve seen situations in small businesses where the balance is near the limit and it’s not going up and down,” he says.

“That means that the business then is carrying core debt, in which case [the line of credit] is not being effective.

“A line of credit should be used as a cash flow instrument – use it to pay for things and then pay the balance down when cash flows in.”

Want to understand how to better manage your level of financial commitment? This article might be helpful.

Pandemic pressures on cash flow

Due to COVID-19, there are a number of additional pressures on small businesses now.

“Take a gym owner,” Cluff says. “They now have to put wipes and hand-washing stations around the gym, spread out the machines and that will impact cash flow.”

He says cash flow should be a primary focus for small businesses right now, particularly as they consider future plans.

“If you were struggling with debt before COVID-19, now is not the time to borrow,” he says.

However, if a new investment – such as hygiene screens separating staff from customers, or an ecommerce site to allow you to keep trading as restrictions come and go – allows to trade more effectively in these times, then it can make sense to take on debt to ensure you don’t lose out on that opportunity, he says.

Can a small business loan and line of credit be combined?

Cluff says a lot of businesses will use both finance options together – loans and a line of credit. Victorian-based small business Muscle Dynamics shares how they do just that.

“You’re going to have cash flow highs and lows,” he says.

“A line of credit can really assist in that tough situation, which most businesses go through.

“Then some businesses will need access to a business loan to buy that piece of equipment that’s going to help them produce more income – so they can utilise both effectively.”