Line of Credit - AccountingTools

Home >> Financing Summary

The Line of Credit

A line of credit is a commitment from a lender to pay a company whenever it needs cash, up to a pre-set maximum level. It is generally secured by company assets, and for that reason bears an interest rate not far above the prime rate. The bank will typically charge an annual maintenance fee, irrespective of the amount of funds drawn down on the loan, on the grounds that it has invested in the completion of paperwork for the loan. The bank will also likely require an annual audit of key accounts and asset balances to verify that the company’s financial situation is in line with the bank’s assumptions. One problem with a line of credit is that the bank can cancel the line or refuse to allow extra funds to be drawn down from it if the bank feels that the company is no longer a good credit risk. Another issue is that the bank may require a company to maintain a compensating balance in an account at the bank; this increases the effective interest rate on the line of credit, since the company earns little or no interest on the funds stored at the bank.

The line of credit is most useful for situations where there may be only short-term cash shortfalls or seasonal needs that result in the line being drawn down to zero at some point during the year. If one’s cash requirements are expected to be longer-term, then a term note or bond is a more appropriate form of financing.