In business finance, what is a line of credit and how is it typically used?

Introduction / Context:
Lines of credit are flexible financing arrangements widely used by businesses and individuals to manage short term cash needs. Accounting and finance students often encounter this term in corporate finance, working capital management and banking courses. Understanding what a line of credit is and how it differs from a term loan is important for evaluating liquidity strategies and bank relationships.

Given Data / Assumptions:

• A borrower, such as a company or individual, has a relationship with a bank.
• The bank assesses creditworthiness and approves a maximum credit limit.
• The borrower can draw funds as needed up to that limit, repay them and draw again.
• Interest is usually charged only on the amount actually used, not on the entire limit.

Concept / Approach:
A line of credit is a revolving credit facility. The bank and borrower agree on a maximum amount, but the borrower is not required to take that amount at once. Instead, the borrower can access funds as needed, often by transferring to an operating account, writing cheques or using a card linked to the line. As repayments are made, the available credit is restored. This structure contrasts with a term loan, where the full amount is disbursed in a lump sum and repaid on a fixed schedule, without re borrowing rights. The correct option must highlight the revolving and pre approved nature of a line of credit.

Step-by-Step Solution:
Step 1: Identify that a line of credit is an agreement rather than a single disbursement. Step 2: Recognise that the agreement sets a maximum limit, for example a certain sum that can be outstanding at any one time. Step 3: Understand that the borrower can draw amounts up to the limit, repay them and draw again within the approved period. Step 4: Note that interest is charged on the utilised portion, making it flexible for variable cash needs. Step 5: Choose the option that describes this revolving, pre approved facility accurately, not a one time loan or savings scheme.

Verification / Alternative check:
To verify, consider a small business with a working capital line of credit of 1,000,000 units of currency. During a busy season, it may draw 800,000 to pay suppliers, then repay 300,000 as customers pay their invoices. Later, it may draw another 200,000 to cover payroll, remaining within the limit at all times. Interest is charged on the outstanding balances, not on the unused portion of the limit. This pattern of drawing and repaying repeatedly within a defined limit is characteristic of a line of credit and distinct from a fixed term loan that is disbursed only once.

Why Other Options Are Wrong:
Option B is wrong because it describes a lump sum term loan that cannot be redrawn after repayment, which is not a line of credit. Option C is a description of a recurring deposit or savings plan, not a borrowing facility. Option D is about regulatory policy on interest rates and has nothing to do with a specific customer facility. Option E simply lists past debts and does not describe any ongoing credit arrangement with a bank. None of these alternatives capture the revolving credit nature of a line of credit.

Common Pitfalls:
A common pitfall is to treat a line of credit as free cash because the limit is approved, forgetting that interest and fees apply to any used portion. Another mistake is confusing lines of credit with overdraft protection, although the two can be linked: an overdraft facility may be structured as a line of credit tied to a current account. Students may also forget that banks can review and adjust or cancel lines of credit based on changes in borrower risk. Understanding these features helps in evaluating liquidity strategies and answering exam questions accurately.

Final Answer:
A pre approved maximum amount of credit that a bank agrees to make available, which the borrower can draw, repay and draw again as needed up to the limit.