Business Line of Credit vs Term Debt

Owner-managed companies routinely borrow the wrong way. A business buys a $400,000 piece of equipment on its operating line, then spends the next two years wondering why cash always feels tight. Another negotiates a five-year term loan to fund a seasonal inventory build, then pays interest on money it does not need for eight months of the year. The instruments are not interchangeable, and matching the facility to the purpose is one of the least glamorous and highest-value decisions a business owner makes.

What each one is actually for

A business line of credit, sometimes called an operating line or revolver, funds the gap between paying suppliers and collecting from customers. You draw when you need it, repay when cash comes in, and pay interest only on the balance outstanding. It is designed to fluctuate and, in a healthy business, should return to zero or near zero at some point in the annual cycle.

Term debt funds assets that will generate returns over years: equipment, vehicles, a building, a leasehold buildout, or an acquisition. It is drawn once, amortized over a fixed schedule, and repaid from operating cash flow. The matching principle is simple. Short-term assets should be funded with short-term facilities. Long-term assets should be funded with long-term facilities.

How a line of credit works in practice

Most Canadian operating lines above a modest size are margined, meaning your available limit is not a fixed number but a formula against your current assets. A common structure allows seventy-five percent of accounts receivable under ninety days, plus fifty percent of eligible inventory, subject to an overall cap.

This has a consequence owners often discover at the worst moment. Availability falls exactly when the business is under stress. If receivables age past ninety days or a large customer goes on hold, the borrowing base shrinks and the facility tightens at the point you most need it. Reporting is typically monthly, through a borrowing base certificate with an aged receivable listing attached, and lenders take that reporting seriously.

How term debt is structured

Term loans in this market usually run three to seven years, amortized either over the term or over a longer period with a balloon at maturity. Equipment loans amortize over the useful life of the asset. Commercial real estate typically amortizes over fifteen to twenty-five years with a five-year term and a renewal.

Prepayment terms matter more than owners expect. Fixed-rate term debt often carries a penalty of three months of interest or an interest rate differential, whichever is greater, and the differential can be a large number if rates have fallen since you borrowed. Read the prepayment clause before you sign, particularly if a sale of the business is plausible within the term, because that penalty becomes a closing cost.

Sizing the operating line correctly

Most owners size the line by asking the bank what they can get. The better approach is to work out what the business actually needs from its cash conversion cycle: days of inventory, plus days of receivables, less days of payables, multiplied by daily cost of sales. A company holding sixty days of inventory, collecting in forty-five days, and paying suppliers in thirty runs a seventy-five-day cycle, and that is the working capital the business has to fund somehow.

Then add headroom for seasonality and for growth. Growing businesses consume cash even when they are profitable, because receivables and inventory expand ahead of the collections that fund them. A line sized to last year’s peak will be too small next year. Sizing to the projected peak plus roughly twenty-five percent avoids the awkward mid-year request for an increase, which lenders read as poor planning even when it is simply growth.

This is the same arithmetic that shows up as a working capital peg when a business is sold, which is why the discipline pays twice. Our note on working capital adjustments in M&A covers that side of it.

What each one costs

Operating lines are almost always floating rate, priced at prime plus a spread that typically runs from half a point to three points depending on the strength of the credit. Expect a standby or unused-portion fee on the undrawn amount, and an annual review fee. Term debt is priced fixed or floating, generally at a wider spread than the operating line because the lender is exposed for longer.

The headline rate is not the whole cost. Setup fees, appraisal and environmental reports on real estate, legal costs, ongoing monitoring fees, and the cost of preparing the required reporting all add up. On smaller facilities those fixed costs can add a meaningful amount to the effective rate, which is a reason not to fragment your borrowing across too many small facilities.

Covenants and reporting differ

Operating lines lean on borrowing base compliance and often a minimum working capital or current ratio test. Term debt leans on cash flow coverage: a fixed charge coverage ratio, a funded debt to EBITDA ratio, and frequently a limit on capital expenditure or distributions without consent.

Both sets of covenants are negotiable, and the time to negotiate them is before the commitment letter is signed. Our note on loan covenants and what business owners should negotiate sets out which terms are worth pushing on. The practical rule is that you want headroom of at least twenty percent against every ratio at the time you sign, because covenants get tested in bad quarters, not good ones.

Security, guarantees, and where they overlap

An operating line is normally secured by a general security agreement over accounts receivable and inventory, with priority in those assets. Term debt is secured by the specific asset it funded, plus a GSA that ranks behind the operating lender on current assets. Where two lenders are involved, an intercreditor or priority agreement sets out who ranks where.

Personal guarantees are common on both, particularly below roughly $5 million of facilities. They are more negotiable than most owners assume. Limiting a guarantee to a dollar amount rather than leaving it unlimited, or agreeing a release once a coverage ratio has been met for four consecutive quarters, are both reasonable asks that lenders do accept.

The mistake that causes the most damage

Funding long-term assets on the operating line is the single most common financing error in owner-managed businesses. It looks efficient at the time because the line is already in place and the draw is quick. What it does is permanently consume working capital availability, so the business runs with a chronically high line balance and no capacity for a seasonal swing or an opportunity.

The fix is a term-out: refinancing the hard core of the operating line into a term facility amortized over the life of the assets it funded, which restores availability. Lenders are generally receptive because it improves their position too, and the conversation is much easier when you initiate it than when the lender raises it during an annual review.

Most businesses need both

A typical structure for a growing owner-managed company is an operating line sized to the working capital cycle, a term facility for equipment and leasehold improvements, and where there is real estate, a separate commercial mortgage. Add-on acquisitions get their own facility, often with a different lender or structure. Our note on how to finance a business acquisition in Canada covers that layer, and the acquisition financing calculator gives a sense of what a deal will support.

Where cash flow will not support all of it from senior debt alone, subordinated or mezzanine capital sits between the bank and equity. We cover the hierarchy in senior debt versus subordinated debt, and our debt and capital team structures these facilities for privately held companies across British Columbia and Alberta.

What lenders look at

Three years of financial statements, interim results, an aged receivable and payable listing, a fixed asset schedule, and personal net worth statements from the guarantors. Beyond the documents, lenders assess the quality of the receivable book, customer concentration, the credibility of the reporting, and whether management can explain variances without going back to the accountant.

Presentation matters more than most owners believe. Two businesses with identical numbers get different pricing depending on how coherently the request is packaged. Our note on what lenders look for in a mid-market business sets out what the credit committee actually reads. Small to mid-market companies that present well typically close faster and on better terms.

Frequently asked questions

Should I use my line of credit to buy equipment?
No, other than as short-term bridging until term financing is in place. Equipment funded on the operating line permanently reduces your working capital availability. Term it out over the useful life of the asset instead.

What interest rate should I expect on a business line of credit?
Most operating lines are floating at prime plus a spread. Strong credits with clean reporting and low leverage sit near the bottom of that range; higher-leverage or concentrated businesses sit well above it. Expect a standby fee on the undrawn portion as well.

Does my line of credit have to be repaid every year?
Formally it is repayable on demand and reviewed annually. Many lenders expect it to be cleaned down to zero for a period each year to demonstrate it is funding a cycle rather than a permanent shortfall. If yours never comes down, expect that to be raised at review.

Will I have to sign a personal guarantee?
Below roughly $5 million of facilities, usually yes. The terms are negotiable. Capping the amount, excluding the principal residence, or agreeing a release once coverage ratios are met for several consecutive quarters are all achievable in the right circumstances.

Can I have facilities with two different lenders?
Yes, and it is common where an operating line sits with a chartered bank and equipment or acquisition debt sits elsewhere. The lenders will require a priority agreement setting out who ranks where, which adds legal cost and time but is routine.

Next steps

If your operating line is chronically drawn, a covenant is tight, or you are financing growth and want the structure right before you commit, an independent review is worth the time. Review our business loan services, see how our debt and capital advisory team works, or contact us directly for a confidential, no-obligation conversation.