Understanding Credit Lines and Term Loans
Every business owner eventually faces the same question:
“Should I ask my bank for a line of credit or a term loan?”
It sounds simple, but it’s not. The answer depends less on what you want and more on what your business needs.
Banks underwrite these two products very differently because they serve different financial rhythms: one keeps your business breathing, the other helps it grow muscle.
The Credit Line: Your Financial Lungs
A line of credit is designed for short-term liquidity, not long-term investment. Think of it as the oxygen that helps you make it through each working-capital cycle — buying inventory, paying vendors, waiting for receivables to come in.
Underwriting focuses on how quickly money moves through your business, not how much profit you make. The lender studies:
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How fast customers pay (Days Sales Outstanding)
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How long inventory sits (Days Inventory Outstanding)
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How you manage payables (Days Payables Outstanding)
The cleaner and faster that cycle, the more comfortable the bank feels about giving you flexibility.
The Term Loan: Your Business Skeleton
A term loan, by contrast, funds long-term needs, such as equipment, expansion, or acquisitions. This helps build structure, rather than covering short-term gaps. The lender focuses on sustained cash flow and debt service coverage (DSCR), meaning:
“Can you generate enough operating income to pay this back with room to spare?”
The repayment comes from future profits, not from the next customer check.
Let’s Look at a Real Example
A manufacturing company requests $2,000,000 to expand operations and stabilize cash flow.
Here’s their current picture:
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Annual Sales: $10,000,000
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Gross Margin: 30%
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Net Income: $600,000
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Accounts Receivable: $1,500,000
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Inventory: $1,000,000
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Accounts Payable: $800,000
They ask: “Should we get a $2MM line of credit or a $2MM loan?”
If It’s a Line of Credit
The bank will build a borrowing base around current assets:
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Accounts Receivable ($1.5MM) – 80% = $1,200,000
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Inventory ($1.0MM) – 50% = $500,000
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Total Availability = $1,700,000
Even though they asked for $2MM, the lender might approve a $1.7MM line based on their working capital.
As receivables turn into cash, the line pays down. As new sales create new receivables, availability replenishes.
The lender isn’t betting on long-term success; they’re lending against short-term collateral quality.
If It’s a Term Loan
Now suppose the $2MM is used to purchase new CNC machines and expand capacity. The bank looks at cash flow instead of collateral turnover.
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Net Income: $600,000
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Add back Depreciation: $200,000
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Add back Interest: $50,000
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EBITDA: $850,000
For a 5-year term loan at 8%, annual payments are about $500,000.
Debt Service Coverage Ratio (DSCR) = EBITDA ÷ Debt Service = $850,000 ÷ $500,000 = 1.7x
That’s strong.
Most lenders want 1.25x or better. Here, the company shows they can comfortably handle the payments — even if profits dip.
The Difference in Risk and Responsibility
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The line breathes with your business: constantly expanding and contracting.
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The loan gives your business a backbone: stable, structured, and predictable.
Which Do You Want vs. Need?
You want a line of credit when you feel cash-tight.
You need a line of credit only if your working-capital cycle supports it, with reliable receivables and fast turns.
You want a term loan when you’re growing.
You need a term loan when your earnings can comfortably support fixed payments.
Sometimes, the right answer is both: a line of credit for working capital and a term loan for growth.
The trick is matching debt duration to asset duration.
Don’t use a short-term credit line to buy long-term equipment. That’s how liquidity problems start.
What to Remember
If you’re preparing to talk to your lender, start with your own math:
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How long does it take you to collect from customers?
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How much cash do you tie up in inventory?
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How predictable is your monthly EBITDA?
Your answers will tell you what kind of capital you truly need. Because in business finance, just like in life, the smartest move isn’t always what you want.
It’s what you need to keep breathing, building, and growing.
At Shōkunin, we help business owners think strategically about how to structure their capital, not just what to borrow, but why.
Whether you’re evaluating a working capital line, a term loan, or a full recapitalization strategy, our advisory approach integrates finance, strategy, and long-term business design.
We help you match the right capital to your company’s growth rhythm so you can focus on what matters: running the business, not chasing liquidity.
Connect with us at https://cbc.marcelobermudezinc.com/ to start a conversation about your capital strategy.
