Types of Debt - Line of Credit

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One way to think of debt types is by the relative maturity – short or longer term.

Someone once described a balance sheet to me this way: The company has assets (cash, accounts receivable, computers, furniture, intangible assets), which have been paid for (financed) with liabilities (accounts payable, accrued liabilities, deferred revenue, debt) and equity.

Ideally, short-term assets will be financed by short term debt and longer-term assets will be financed by longer term debt and equity.

Let’s start at the top with short-term assets and debt.

Most companies extend credit to their customers. “Buy a software license from us today and you can pay for it next month. Or two months from now. Please not three months from now.”

The money owed by customers is called Accounts Receivable (A/R for short).

As a company’s revenues grow the volume of Accounts Receivable also grows. If customers pay their bills, on average, in sixty days a company with £1mm per month of revenue will have £2mm of A/R. That £2mm of A/R is £2mm of cash the company doesn’t have on hand to pay its own bills.

Like salaries.

The “like salaries” part is important for tech firms because payroll is typically their largest cost and employees can’t really wait two months for their paycheques while customers process invoices.

When a company grows the assets (receivables in this case) grow. Those assets have to be paid for either by a liability (such as a loan which we discuss below) or by equity. For startup companies this can be a problem because getting a loan is difficult and equity, especially early equity, is expensive.

If you really want to dig into this topic here’s a link to a classic first year corporate finance case: Clarkson Lumber Co.  

One way to solve this problem is to ask your customers to pay up front. Netflix does this, for example. They charge my credit card every month in advance, meaning that they have my cash before I’ve seen a single movie. Nice. My Amazon Prime membership is paid a full year in advance. Even nicer.

Now this pay in advance idea is great if it works but it reminds me of a finance professor whose answer to (almost) any cash problem was “raise prices.” Looks great on the spreadsheet but won’t always fly.

Another answer is to finance the receivables. This is typically done with a working capital line of credit. The lender (often a bank) will advance a short-term loan tied to the level of accounts receivable knowing that the company will collect the A/R within 30 to 60 days and can repay the loan from those collections. 

Take the company with £2mm of receivables for example. A bank might lend them 75% of eligible receivables or up to £1.5mm in this case.

Why not 100%? The bank has to build in some cushion in case customers pay late, dispute an invoice or in a worst case don’t pay. The other spot where the bank builds in a bit of safety is its definition of eligible receivables. Banks will often exclude/discount receivables where customer concentration is high, payments are delayed or the customer is in a foreign country. These are generalizations but you get the idea. We can cover exclusions in a later post. They are important to consider when modeling line of credit availability.

In its simplest form this type of loan is called factoring. A lender will factor (purchase, really) each invoice at a small discount to face value. All payments will go to the lender to repay the factoring loan. New invoices generate new loans and the whole cycle revolves for as long as the arrangement is in place.

The difference between the discount and full value of the invoice is the profit margin for the factor. A 2% discount factor applied to invoices that pay in 30 days gives the lender 2% x (365 days in a year / 30 day collection period) = about 24% annualized return.

Since the lender is relying more on the credit worthiness of each customer than the company it buys the invoices from, some startups have used factoring until they build their credit profiles. Factoring can be flexible and may come with few financial covenants. It can be expensive but is still cheaper than using that early equity to fund working capital. 

I’m of the view that this option is best suited to companies with high gross margins. If every £100 invoice nets you £20 of gross margin then that 2-3% discount on the £100 invoice means that 10-15% of your gross margin dollars goes to funding working capital. Ouch.

Bank revolving lines of credit are generally a less expensive form of working capital financing. With a standard line of credit the bank will work with accounts receivable as a group rather than individually as a factor does. The bank applies a loan margin formula (75% in the example above) and advances that to the company. These loans are often on a 364-day term (to keep them as short term assets on the bank’s balance sheet) and are due or renewed at maturity. 

But the idea is that the company could repay the loan at any time because banks want their clients to fund working capital with the line of credit, not operating losses.


  • Assets are funded by liabilities and owners’ equity. Ideally, short-term assets should be funded with short-term liabilities.

  • Growing business (like startups) often have a growing base of short terms assets (receivables) but their short term liabilities (ie, payroll) can’t be used to fund those assets.

  • By arranging a revolving line of credit, the company goes a long way to funding its working capital needs at a lower cost than equity.