Updated July 19, 2023
Introduction to Revolving Credit Facility
Banks or financial institutions offer a revolving credit facility to their customers, allowing them to access a fixed credit limit that increases as the customer pays off their debt. This credit facility provides businesses or individual customers with access to a sum of money whenever necessary, with the amount drawn varying each month based on their cash flow needs and operating expenses.
Explanation of Revolving Credit Facility
A revolving credit facility, as discussed above, is a credit line provided by a bank or financial institution to its customers. They can use this money based on operating expenses and the cash flow required to run the business. The amount drawn each month differs. The credit line provided, though, remains fixed to a certain pre-defined amount, and the customer can use it accordingly based on their needs. A revolving credit facility is a line of credit or a credit card. Both business firms and individuals can apply them. It provides more flexibility to the customers in accessing the predetermined sum of money, also known as the credit limit. Once the customer pays off the opening balance of the credit limit, the funds become available for use again. Banks typically offer this credit facility to both individuals and businesses and secure it with the borrower’s assets. In the event of non-payment of debts within the specified time frame, the bank retains the right to seize the assets.
Features of Revolving Credit Facility
The features are as follows:
- A revolving credit facility is similar to a line of credit or credit card, allowing borrowers to withdraw partial funds up to a pre-approved credit limit.
- As the borrower uses and repays the funds, the available credit sum decreases and increases, respectively.
- The credit facility can be used repeatedly on an ongoing basis.
- The borrower must repay subject to a minimum repaying amount as consecutive payments, or they may repay in full at a single time.
- During some events, the borrower has to pay a certain sum of money as fees for the amount of money that has yet to be utilized, and this is very much seen when corporate banks give revolving credit loans.
- The borrower is charged interest only on the borrowed part of the loan and not on the entire pre-approved amount
- To begin the revolving credit facility, the bank must charge a fee of commitment which compensates the lender for keeping open access to the potential credit facility.
How Does It Work?
Revolving credit facility work on a similar line to a credit card. Credit cards are designed for minor transactions while revolving credit facilities are commonly used by businesses with a higher pre-approved limit than credit cards. Both require the payment of interest on the amount used, and the credit limit reduces accordingly. After the borrower repays the used amount and interest, the revolving credit limit is fully restored to 100%. This is in contrast to credit cards, which typically do not require any collateral or security. The bank also charges a certain sum of commitment to the borrower for provisioning this kind of service of always keeping a loan provision open to the business.
Example of Revolving Credit Facility
Any typical business dependent on seasonal trends will have its flow of income generated during the peak seasons and will have to survive with the generated revenue during the off-season. Now, the business, during the off-season, must keep the company open and continue its services. It has to keep the business going by paying for its essential operating activities, or a business that has made a lot of credit sales has to wait for some time before getting back the account receivables. During these phases revolving credit facility provided by the bank becomes very beneficial as it helps the business to stay afloat till the time when the company goes back to normal.
Revolving Credit Facility vs Overdraft
The bank provides a revolving credit facility to businesses for the short or medium term, allowing them to access a pre-approved amount at any time, up to the approved value. The bank charges interest only on the amount of the loan used by the company.
Banks offer businesses an overdraft feature as a short-term financing option for fluctuating borrowing needs and temporary requirements, providing the company with necessary liquidity at any given time. Overdrafts have fewer restrictions compared to revolving credit facilities.
Benefits of Revolving Credit Facility
The benefits are as follows:
- It provides liquidity to the business when required to carry on its operating expenses.
- Revolving credit facilities are typically secured by the assets of the business, reducing the risk of default.
- The funds become readily available, and one can skip an approval process.
- The interest rates are lower than one would have paid using a credit card.
Drawbacks of Revolving Credit Facility
The drawbacks of revolving credit facilities are as follows:
- The bank needs to pay a specific commitment fee to keep the provision alive.
- They generally will have more interest rates than a traditional loan will have.
- The credit limit set is comparatively low than what a conventional loan would have offered.
Conclusion
As discussed above, we have seen the pros and cons of revolving credit facilities and discussed the difference between overdrafts and traditional loans. This is a very important feature that is handy for every business house that utilizes this facility efficiently.
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