How does a line of credit work?

Definition

A line of credit is a revolving loan you can draw on and repay as cash needs change. On the books, the amount drawn is a current liability, not the unused limit and not an expense.

You record the drawn balance so the Balance Sheet shows what you actually owe the lender today. The unused remainder is only capacity, not a liability.

Cash-basis books still show the cash that arrived when you drew. Accrual books also keep the owe until you pay that draw back.

This line is the revolving balance, not a one-time note. You can pay it down and draw again without signing a new loan each time.

Where it shows up

Balance Sheet: Located in the current liabilities section.

P&L: Related to interest on the amount drawn.

Cash flow: Increases in this account, reported cash from financing activities increases.

See also: Borrowing Base · Interest Expense · Working Capital

When you look at your Balance Sheet, this line sits in current liabilities with other near-term amounts owed. The total is what you have drawn, not the full limit the bank approved.

When the balance is high, you have used more of the line to cover short-term cash needs. When the balance is low, you have repaid draws, or you have not needed the line.

The profit and loss statement does not list this account as a line. Interest on the amount drawn hits the Income Statement; the unused limit does not.

On the Statement of Cash Flows, drawing on the line is a financing inflow. This account rises, and reported cash from financing activities rises with it.

A Debt Schedule is the worksheet that tracks the limit, the drawn balance, the rate, and the maturity. This statement line is only the amount currently owed.

How it works

The owe gets onto the books when you draw. You debit cash and credit this account.

That entry does not wait for a year-end recap. Each draw raises the liability the day the funds hit the bank.

The unused limit stays off the Balance Sheet. Capacity is useful for planning; it is not an amount you owe.

Interest is charged on the drawn amount, not on the full limit. If you repay part of the draw, interest from then on follows the lower balance.

When you repay, you debit this account and credit cash. The line is open again for a later draw, which is what makes it revolving.

A borrowing base can cap how much the lender will let you draw. Receivables and inventory often set that cap, and a covenant can tighten it.

Reconcile the ledger to the lender statement and to the debt schedule. A draw that was never recorded will leave cash high and this liability too low.

On cash-basis books, the cash still moves when you draw or repay. The revolving owe may be less visible if the shop only watches the bank balance.

Example

A florist has a $15,000 line of credit and draws $5,000 in November to buy holiday inventory. The unused limit is then $10,000.

The florist records:

Debit: Cash $5,000

Credit: Line of credit $5,000

Cash goes up by $5,000, and this liability goes up by $5,000. The Income Statement does not show a $5,000 expense.

The Balance Sheet now holds the $5,000 owe in current liabilities. Interest will accrue only on the $5,000 drawn, not on the $15,000 limit.

In January the florist repays $2,000 and records:

Debit: Line of credit $2,000

Credit: Cash $2,000

This account falls to $3,000, and cash drops by $2,000. The florist can draw again later, up to the remaining unused limit.

Common mix-ups

A line of credit is not Notes Payable. A note is a formal loan with a set balance; this line is revolving, so you can draw and repay as needs change.

The drawn balance is not the approved limit. The unused limit is capacity; only the amount drawn is the liability.

Interest is not charged on the full line. The P&L feels interest on what you have drawn, not on what you could still draw.

Related terms

• Borrowing Base: The pool of receivables and inventory that determines how much a lender will advance.
• Interest Expense: The cost of borrowing recorded for the period.
• Cash Flow From Financing: Cash from borrowing, repayment, owner contributions, and distributions.
• Covenant: A condition in a loan agreement the borrower must keep meeting.
• Working Capital: Current assets minus current liabilities, showing short-term operating cushion.
• Current Liabilities: Obligations due within the next twelve months.
• Debt Schedule: A supporting schedule tracking each loan's balance, payments, rate, and maturity.
• Liquidity: How readily the business can cover near-term obligations with available cash.