Infographic: Line of credit vs small business loan

Small business owners are used to investing in their business’s growth with their own hard work, but there are times when that’s not enough.

Having access to external funding can make or break businesses that need to cover cash flow gaps that are out of their control. Funding can also be an essential ingredient for business owners looking to take on a new growth opportunity.

The array of finance options can be dizzying, but the good news is that technology has made it more accessible than ever before.

Banks aren’t the only option available, with lenders like Prospa specialising in the specific needs of small businesses and providing funding more quickly and with as much flexibility as possible.

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

So how do you decide which facility to use?

A financial adviser explains the differences

A line of credit and a small business loan have separate but complementary functions, according to Andrew Armstrong, Mortgage Director at Lighthouse Financial Services.

With a line of credit, you can dip in and access an agreed amount of funding when you need it, and only pay interest on the funds you use.

“A business line of credit allows you to improve liquidity, have funds on hand to smooth income fluctuations, reduce your interest costs when your account is in credit, and recycle cashflow easily,” he says.

A line of credit can help to match income to expenses, especially when expenses increase and income has not yet caught up.

“Our clients use a line of credit to finance operational expenditure such as rent or wages,” says Andrew.

On the other hand, a small business loan is, in Andrew’s view ,more of a one-off finance solution. Funding is provided as a lump sum amount and repayments follow a set schedule.

“Once funds have been spent, a small business loan leaves you with a regular debt repayment,” he says. “Our clients use this to finance capital expenditure such as tools and equipment.

“Discipline is required to ensure the line of credit is not used to fund owner drawings or capital expenditure items.”

Regardless of the structure of a loan or line of credit, Andrew is keen to stress the importance of making repayments on time.

“As a business owner, you are financially responsible to meet your business’s expense obligations when they fall due,” he says. “Being consistently late on payments can quietly erode your name and reputation, which can lead to missed opportunities and reduced profits.”

Managing financial instability with flexible funding options

Given the instability of recent years, Andrew advises planning for a potentially uncertain future.

“Post-pandemic jitters have meant you might get paid later than expected, or your regular costs suddenly increase without warning,” he says. “It is best to be organised and arrange to have a small line of credit or overdraft in place before it’s desperately needed.”

He also notes how some of Lighthouse’s clients have combined a small business loan with a line of credit.

“We’ve seen clients use a business term loan to acquire a new staff member where there are large initial one-off set up costs – such as new laptop, phone, desk and often a recruiter fee – and where increased revenue may not occur until months later,” he says.

“A line of credit allows you to make regular repayments (i.e. additional term loan repayments or increased wages) until additional income makes up the shortfall.”