Unlike personal loans where the person borrowing the funds and the collateral are not likely to change, loans in the world of business require additional flexibility in order to meet the needs of the business as well as satisfy the requirement of the lender. Accomplishing this seemingly difficult task is done by using a credit facility which is an overall credit line that can be broken into multiple credit lines and collateral.
If you run a business, chances are there'll be some months when you're flush with cash and other months when money's tight. This ebb and flow of money can ruin your business if you don't have access to a pool of money to help you get by during the leaner months. A credit facility is designed to ensure you have access to cash at all times. For many businesses, it's the tool that keeps the lights on when cash is temporarily low.
TL;DR (Too Long; Didn't Read)
A credit facility is a type of bank loan you can draw down in increments, as and when you need the credit. It ensures a company has access to cash at all times.
What Is a Credit Facility?
A credit facility is a type of loan facility given to your business by a bank, which provides capital that you can draw on any time you need it. Picture it as the grown-up version of a piggy bank – you just pull out the exact amount you need when there's something you want to buy. The important point about a credit facility is you don't have to use all of the credit made available with it. Rather, you just use the amount you need at the time and come back to the loan pool when you need some more capital.
How Does a Credit Facility Work?
The easiest way to learn how a credit facility works is through an example. Gruesome Gifts is a joke shop. Like most niche shops in this sector, it makes around 70 percent of its sales during Halloween and the holiday season. The company tends to be tight on cash in the summer months when sales are lower, although the rent still has to be paid! This cash flow variability could force Gruesome Gifts to lay off staff or shut the doors if it didn't have access to a credit facility.
Luckily, Gruesome Gifts has a $500,000 facility from the bank. This allows it to borrow up to $500,000 whenever it wants; though not all at once. Rather, Gruesome Gifts will draw down whatever it needs to get by in July and August, and then repay that cash in December when the cash registers are overflowing.
What's the Difference Between a Credit Facility and a Loan?
When you negotiate a bank loan, you agree to borrow a fixed amount of money for a fixed period of, say, five or 10 years. When the loan closes, the full amount of the loan goes directly into your bank account. It doesn't matter whether you use all of the money: you still have to pay the entire amount back with interest at the agreed rate.
A credit facility opens up a line of financing between the customer and the lender. With this type of financing, the bank agrees to make a pool of cash available, say $50,000, which you can use whenever you want. No money transfers when you close the credit facility. Instead, you draw down the cash whenever you need it. For example, you may take out $10,000 to repair a vehicle in February, then withdraw $5,000 to tide you over an emergency cash flow problem in June. The remaining $30,000 just sits in the bank until you need it.
What's the Deal With Interest Rates?
Another difference worth emphasizing is that you only pay interest on the amount you withdraw, rather than on the entire credit facility you have been granted. So, in the above example, you would pay interest only on $20,000 that you withdrew, not on the full $50,000, when the time comes to repay the money. The interest starts to accrue from the day you borrow the money, so you'd be paying interest on the first withdrawal of $10,000 for a longer period than for the emergency $5,000 that you took out later.
Interest rates vary widely and depend on the usual range of factors, such as the company's creditworthiness and risk profile. Overall, you should expect to pay a higher rate than you would for a regular bank loan. That said, since you're only withdrawing essential amounts for a few months or weeks, the cost of borrowing could work out cheaper in real terms.
What Are the Terms of a Credit Facility?
Most credit facilities run for a fixed period of, say, six months or two years, after which time you can decide whether to renew it. Terms vary, but there's always a maximum facility limit and payment terms that specify when you need to make repayments for the money you've drawn down. You may have to pay an upfront commitment fee for the right to access the facility, and of course, there's a monthly interest charge on the money that you draw down at any one time.
The credit facility agreement will detail the borrower's responsibilities, specify the date when the loan matures, as well as the interest rate, the date for repayment, default penalties and any other terms and conditions.
Since credit facilities are intended for temporary cash flow needs, you generally cannot borrow as much as you could with a regular bank loan. So, you should only rely on it as a type of overdraft substitute to cover your operating expenses when cash reserves are low. No one buys real estate with a credit facility because they wouldn't get a high enough credit limit and the rates would be punitive!
Why Do Businesses Use Credit Facilities?
Imagine that your main customer is late in paying your invoice and you were relying on that money to pay your rent or payroll expenses. Now imagine that a key piece of machinery breaks down and you need to fix it fast before production grinds to a halt. A credit facility offers an instant solution to these and other setbacks that a business might face concerning its cash flow and expenses. In many ways, it acts as a revenue back up or financial insurance policy to the business.
Of all the types of bank facilities, a credit facility is perhaps the most flexible. Growing businesses find it especially helpful to be able to dip in and out of an overdraft-style pot whenever they need some additional support. And drawing funds is just about the fastest way to access capital aside from accessing your own bank account. Since you're not being forced to borrow a predetermined amount, there's much less risk of over-borrowing and paying interest charges or early-payment penalties on money that you didn't need.
What's more, credit lines don't generally require collateral or business valuations. The bank will put you through an application process, and you probably will need to supply some financial information and annual revenue projections. But once the credit line is set up, you can borrow from it over and over as long as your outstanding balance allows.