Revolving Credit Facilities

What is a revolving credit facility?

A revolving credit facility (RCF) is a type of credit facility similar to a business credit card or a bank overdraft. Unlike a bank overdraft, the RCF does not effectively extend the balance of the business bank account. Instead, the lender will set a credit limit and funds can be drawn down and paid back on multiple occasions over a period of time that is within the term of the facility agreement and, within the set credit limit.

How does a revolving credit facility work?

Once the facility is set up you will have an available balance to draw cash from. Upon request, the lender will transfer funds to your business bank account. This is the difference between a business overdraft and an RCF. An RCF is supplying funds to your business bank account from a lender that is most likely not your bank. Whereas, a bank overdraft effectively extends the available balance of your bank account by the agreed credit limit.

Each lender will have its own underwriting methodology but they will likely factor in the following:

• Credit history and credit rating of the business and Directors
• Financial performance of the business with a specific focus on cash flow performance
• The outstanding balance of other debt the business may have
• The reason for the application (the facility should address short-term cash flow issues)

How Companies use Revolving Loan Facilities

Loan facilities are often misused by business leaders that make the mistake of not matching their lending requirement with the correct lending resource.

I've witnessed two business failures resulting from the misuse of this type of business funding. Both businesses were performing poorly but, that was survivable. What was not survivable for either was having their loan facility withdrawn, with no notice, and at a point when they both needed it.

The error they both made was using a short-term resource to address a long-term cash flow issue. If your intended use of an RCF is to leverage the balance for significant periods, please stop immediately and reach out to me. In this instance, and the two failures I've referenced, a term loan rather than a revolving facility, would have most likely meant both businesses would have survived.

The correct way to use an RCF or an overdraft is to cover short-term lending requirements. The measurement of "short-term" is not absolute but is relative to your situation. Below, you will find two worked examples of what I consider appropriate uses of an RCF facility. Both examples have different time frames in which they leverage the RCF correctly as a flexible financing tool.

Example 1: XYZ Company Ltd

XYZ Co Ltd manufactures and installs air conditioning units across the United Kingdom. They also sell a call-out support service that they cross-sell to installation clients.

The profit on the manufacture and installation of air conditioning units is only marginal but the cost of acquiring clients in this space is low and it provides the perfect opportunity to cross-sell the highly profitable support service.

Installation demand peaks in the UK Summer with 80% of installations taking place in this three-day window. XYZ Co requires an army of 500 contract installers, the vast majority of which are only required for the spike in demand.

XYZ Co offers credit terms and third-party finance options to clients. As a result, it typically takes sixty days to recover the installation fees, but, XYZ Co needs to pay its Installers after thirty days.

Throughout the rest of the year, XYZ Co is cash generative and has strong cash reserves. The business is performing well.

In this example, there is a thirty-day funding gap. Thirty days may seem like a long time but in this context, where it's purely seasonality, you should compare the 30 days to the rest of the year. At 8.3% (1/12th) my opinion is that this credit utilisation rate is acceptable.

Example 2: ABC Company Ltd

ABC Company Ltd is a growing outsourced IT support service provider.

Employees are paid on the last working day of every month but clients pay (via direct debit) on the first Monday of the month.

At a steady-state model, the business is performing well with little apparent credit risk. The lending requirement is to cover the few days between paying wages and receipt of the monthly round of direct debits. If ABC Co wasn't paying recruitment fees every month for new employees it would be cash generative and not require the RCF.

Unlike XYZ Co, there is a monthly recurring requirement for utilising the RCF but each month the requirement is only ever for a few days so the credit utilisation rate, in total, is similar to XYZ Co.

ABC Co considered a fixed-term loan which supported a more aggressive expansion but came with higher total borrowing costs. The Directors were also of the opinion that a controlled slower growth was more suitable so decided to stick with the RCF.

Both examples show ways in which RCFs and overdrafts can be used for their intended purpose and in my opinion, both are suitable uses of credit lines.

Revolving Credit Facility Takeaways

As a form of short-term financing, a revolving facility can be a great financing option for a business to manage short-term cash flow issues.

Advantages of revolving credit facilities

• Access to funds is quick so this type of loan is attractive
• Likely to be less expensive than a credit card and have more uses (can make bank-to-bank payments e.g. payroll).
• Can have a lower total borrowing cost than other types of business loans
• Can be suitable for borrowers with a bad credit history or a poor credit score
• The available credit limit can effectively be recycled after repayment, unlike other forms of finance
• The facility can grow as you grow
• Auto-renews after repayment so is less of an administrative burden than a series of short-term loans
• No long term commitment
• Can be a convenient funding option for new companies to access debt
• No early repayment fees
• Only pay interest when the facility is being used
• The use of an online portal makes draw downs convenient
• Enables you to pay suppliers on time
• Don't need to have security or a charge registered

Disadvantages of revolving credit facilities

• The lender will likely require a personal guarantee
• High interest rates (an issue if the facility is abused)
• You'll likely pay a commitment fee even if you never use this funding option
• Typically only offer a credit line equivalent to a months revenue
• If the credit line was withdrawn at short notice you can be left with a solution to find

Summary

The problem with RCFs and overdrafts is in their misuse. Do not use short-term solutions for long-term challenges. Business leaders that misuse RCFs and overdrafts or any other credit agreement this way risk losing their businesses.

Don't be one of the clowns!