Working Capital Lines vs. Term Debt — When to Use Each
Bank debt comes in two primary forms for small businesses: revolving working capital lines and amortizing term loans. They look similar in early conversations and feel similar on first pricing. They are not similar in practice. The wrong choice creates years of friction.
What a working capital line is
A revolving credit facility (often called a line of credit or LOC) that you can draw on and pay down as needed, up to a defined limit. Interest charged on outstanding balance only. Typical structure: 1-3 year facility, revolving with annual renewal review, secured by AR and inventory.
Use case: funding short-term working capital needs — covering payroll between customer collections, building inventory for a sales spike, bridging the gap between billing and collection cycles.
What term debt is
A fixed-amount loan with a defined repayment schedule (typically monthly principal and interest payments) over a defined period (typically 3-10 years for small business). Funded once; cannot be re-drawn after repayment. Often secured by specific assets or the business as a whole.
Use case: funding specific long-term needs — equipment purchase, real estate acquisition, business acquisition, leasehold improvements, long-duration growth investments.
The mismatch that breaks businesses
Using a working capital line to fund long-term investments. The bank can reduce or eliminate the facility at annual renewal. Suddenly the equipment you bought is funded by a maturing facility you can’t replace. This pattern destroys businesses regularly.
Using term debt to fund working capital. You pay principal every month regardless of whether you need the capital. You end up with cash you can’t deploy because the loan was funded once. Cost is high; flexibility is low.
Match capital to need — the asset/liability matching principle
Short-term assets (AR, inventory) should be funded by short-term liabilities (working capital lines, AP).
Long-term assets (equipment, real estate, goodwill from acquisition) should be funded by long-term liabilities (term debt) or equity.
Violating this principle creates the kind of cash mismatches that take down otherwise healthy businesses during downturns.
What to negotiate on a working capital line
- Borrowing base (% of eligible AR + % of eligible inventory). Higher is better.
- Reserve requirements (what AR is excluded — usually old AR, foreign AR, government AR). Tighter exclusions are worse.
- Reporting cadence (weekly vs. monthly borrowing base certificates). Monthly is easier operationally.
- Covenants. Same as term debt.
- Annual renewal mechanics. Avoid facilities that require fresh underwriting every year.
What to negotiate on term debt
- Amortization period. Longer = lower monthly burden but more total interest.
- Interest rate. Fixed vs. variable.
- Prepayment penalties. Avoid if possible; cap if necessary.
- Covenants (DSCR, FCCR, leverage, capex limits).
- Personal guarantee terms.
The combined facility
Many small businesses benefit from both: a working capital line for operating cash needs plus term debt for longer-duration investments. Same bank often offers both; combining the relationship may improve pricing. Just don’t blend the use cases.