Credit Facility Meaning
The credit facility is a preapproved loan facility provided by the bank to the companies wherein they can borrow money as and when required for its short term or long term needs without the need to reapply for a loan each time.
Types of Credit Facilities
Credit facilities are broadly classified as two types, and we will mainly focus on credit facilities meant for businesses or corporates. The two types are i) Short term facilities as working capital requirement ii) Long term facilities required for capital expenditure or acquisition-related expenses.
#1 – Short Term Facilities
Short Term Loans
These are generally limited up to a year and are mainly borrowed by businesses for its working capital requirement. It may or may not be a secured one, which also is dependent on the credit rating of the borrower. At times the borrower may have to give its current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. such as inventories or receivables as collateral when the credit rating of the borrower is of non-investment grade.
To facilitate structures cash conversion cycleCash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation. of business, this type of credit facility is very useful and can be of the following types:
- Export credit: This kind of loan is granted by government agencies to export houses to enhance the growth of exports
- Letter of credit: Generally, three parties are involved in such scenarios: Bank, supplier, and company bank here guarantees the payment from the company to the supplier, and this is a much more secure form of credit facility. The bank issues the letter of creditLetter Of CreditA letter of credit is a payment mechanism in which the issuer's bank gives an economic guarantee to the exporter for the agreed payment amount if the buyer defaults. In international trade, buyers employ LC to reduce credit risk. based on the collateral from the company, and this type of arrangement is more preferred by suppliers as it mitigates the risk of default to a great extent.
- Factoring: Factoring is a more advanced form of borrowing, where a company would involve a third party (Factor) to sell its account receivables at a discount to help them transfer the credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. from their books. It helps the company to remove the receivables from its balance sheetIts Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company., which can further act as a source to fulfill its cash requirements.
- Credit from suppliers: This is more of a relationship-based where the supplier who has a strong relationship with its customers will be in a better position to provide credit after good negotiation of the payment terms to secure a profitable transaction.
Cash credit and overdraft
It is a type of facility where a borrower can withdraw money/funds more than what it has in its deposit. Interest rates apply to the extra amount, which has been withdrawn apart from the amount in its deposit. The borrower’s credit score plays a crucial role in the size of credit and interest rate charged.
#2 – Long Term Facilities
These are generally unsecured and raised from capital markets. They are generally costlier to compensate the elevated credit risk lenders are willing to take. It can be considered as an option when banks are in a denial state to provide any further credit line. They are generally meant for large tenure like 7-10 years.
It is one of the most common forms of credit facility where the amount, tenure, and repayment schedule are predefined. These loans can be secured (high-risk borrowers} or unsecured (investment gradeInvestment GradeInvestment grade is the credit rating of fixed-income bonds, bills, and notes as assigned by the credit rating agencies like Standard and Poor’s (S&P), Fitch, and Moody’s to express the creditworthiness of and risk associated with these investments. borrowers) and are usually given on floating interest rates. Before giving such loans, banks need to perform crucial checks or due diligence to mitigate credit risk.
A bridge loanBridge LoanA bridge loan is a short-term financing option for homeowners looking to replace their current home and pay off their mortgage either by paying interest on a regular basis or by paying a lump sum interest when the loan is paid off. is a loan which is utilized by companies for working capital requirements for an interim period when a company awaits long term financing or source of fund
It is a blend of equity and debt. This type of capital is usually not guaranteed by assets and is lent solely based on a company’s ability to repay the debt from free cash flowCash FlowThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).. Mezzanine financingsMezzanine FinancingsMezzanine financing is a type of financing that combines the characteristics of debt and equity financing by granting lenders the right to convert their loan into equity in the event of a default (only after other senior debts are paid off). can be structured either as debt or preferred stock. It gives the lender the right to convert to an equity interestEquity InterestEquity Interest is the percentage of ownership rights either individual or a company holds in one company which gives holder voting right in that company. They have residual rights in economic benefits obtained from the business or realization from assets. in the company in case of default, generally, after venture capital companies and other senior lenders are paid.
This technique is pretty much similar to factoring. The only distinction is the institution involved and liquidity of the assets. In factoring the financial institution is the factor that purchases the trade receivablesTrade ReceivablesTrade receivable is the amount owed to the business or company by its customers. It is also known as account receivables and is represented as current liabilities in balance sheet. of a business, whereas, in securitization, there could more than one party who will purchase its long term receivables. Securitized assets can be NPANPANon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days., mortgage receivables, and credit card receivables.
Credit Facility Examples
The following are examples of credit facilities.
Under credit facility, for example, suppose Customer X is given a $50000 credit facility or LOC for investment in a new venture which is secured against some collateral by a bank. The bank fixes loan term of 10 years for the repayment of the loan, and Customer X is permissible to utilize the funds within the overall limit ($50000), and an interest rate of 20% is charged.
Customer X spent $10000 and will be charged 20% of the amount spent only and not on the entire $50000 LOC. Thus the interest charged will be 20% * $10000 = $2000.
Example #2 – Using Letter of Credit
Suppose the company “Atlantis” sells electronics in New York, and Company “Proline” manufactures electronics in Detroit. “Atlantis” wants to import $500,000 worth of electronics manufactured by “Proline” and is concerned about “Atlantis’s” ability to pay for them. “Atlantis” is offered a letter of credit from its tied up bank, i.e., Bank of America, meaning that it will produce the required goods on the $500,000 payment, suppose in 90 days, or the bank will take responsibility for paying by itself. Bank of New York will then be sending LOC to “Proline,” which further takes charge of shipping the electronics.
Once shipped, “Proline” or its respective bank will claim for its $500,000 by bringing forward a written note (also called a bill of exchange) to Bank of New York. Letters of credit are more beneficial to sellers. Still, they also safeguard buyers, because “Proline” must bring forward Bank of America evidence or receipts of the electronics shipment to facilitate the payment.
This evidence is generally a bill of ladingA Bill Of LadingBill of lading is the legal document issued by the carrier to the shipper. It captures all the details about the shipment, such as quantity, type, and destination of the consignment. It serves as the shipment receipt when the carrier hands over the consignment to the intended merchant., invoices, or an airway bill. Following this, Bank of New York pays “Proline” and looks over to “Atlantis” for reimbursement generally by debiting “Atlantis’s bank account.
Difference Between a Loan vs. Credit Facility
Both loan and credit facility is the two most commonly used products for both individuals and corporates. However, there are a few differences between the two.
- When the loan is granted, it provides the borrower access to all the money at one go, whereas for a credit facility, money can be obtained whenever there is a liquidity crunch.
- The loan is like a piggy bank where you break it and take out all your money, whereas, in a credit facility, you only use what you require. Secondly, there lies also a difference in terms of the interest paid.
- A loan requires an interest payment for all the capital that has been lent to an individual or company.
- On the other hand, interest is charged only on the amount of money used and not on the amount of money made available to the individual or company.
- However, at times, one can be subjected to an unused balance fee, when one does not make use of the money at all. Loans have greater term duration and thus bear a higher interest payment when compared to credit facilities.
- Lastly, the way the customer pays back the money received also differs in loans and credit facilities. In loan, the concept of EMI or monthly installments arises where when the entire money is repaid; the operation is closed without the possibility of borrowing more money without a fresh loan agreement.
- How credit facility works is different. Here customers renew their contract every year to use the line of creditLine Of CreditA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business. whenever required.
Thus, credit facilities have a lot of importance from a business point of view. One of the best things about a credit facility is that no one dictates how the cash should be utilized, unlike a bank loan. Sometimes certain loans come with clauses attached where the financier has full authority on how the cash has to be utilized.
They are much more flexible as whenever a need arises; businesses can make use of it. Also, a business needs to build a strong credit history, which makes it easy to obtain such facilities. Being charged low-interest rates as compared to credit cards, these are highly beneficial to the company.
This article has been a guide to Credit Facility and its meaning. Here we discuss the top 2 types of credit facilities (short term and long term) along with the examples. You can more about finance from the following articles –