A line of credit is an agreement between a lender and a borrower to issue cash to the borrower as needed, not to exceed a certain predetermined amount. A line of credit is commonly secured by selected assets of a business, such as its accounts receivable. Since the line is secured, the lender typically allows a relatively low interest rate that does not greatly exceed the prime rate.
A line of credit is intended for the funding of short-term cash shortfalls caused by periodic (possibly seasonal) changes in a company's ongoing cash flows. Thus, it should be paid off at some point each year. If not, the line of credit is being used to fund long-term operations, and so should be supplemented by an equity issuance or long-term debt.
Several aspects of a line of credit are:
- Audit. The lender will likely require the borrower to undergo an audit of certain asset balances, which the lender needs to assure itself that the borrower has correctly represented its financial position and financial results.
- Balance pay down. The lender may require that the outstanding balance for a line of credit be completely paid off at some point during each year, or else it can cancel the the line.
- Compensating balance. If the lender is a bank, it may require the borrower to maintain a certain minimum cash balance in accounts at the bank. By doing so, the lender increases the effective interest rate paid by the borrower, since the borrower earns little or no return on cash kept in a checking account.
- Maintenance fee. The lender charges the borrower an annual maintenance fee in exchange for keeping the line of credit open. This fee is payable even if the borrower never uses the line of credit. The reason given for this fee is that the lender must still invest a certain amount of administrative time in loan-related paperwork, and must have funds available if required by the borrower.
In short, the line of credit is a necessary part of the financing structure of a business, but is only intended to fund short-term cash shortfalls that are not expected to continue over the long term.