Types of Credit Facilities
There are majorly two types of credit facilities; short term and long term, where the former is used for working capital requirements of the organization including paying off creditors and bills, while the latter is used for to meet the capital expenditure requirements of the enterprise, generally financed through banks, private placements, and banks.
While raising equity (using IPO, FPO, or convertible securities) remains one method to raise funds for a company, business owners may prefer raising debt as it could help retain their control over the business. Of course, this decision is strongly dependent on the sufficiency of cash flows to service the interest and principal payments, and a highly-levered company may put a burden on the company’s operations and on the stock price. Consequently, the payment terms, the interest rates, the collateral and the entire negotiation process of every loan remain the key to devise the capital strategy of a company.
In this article, we discuss the different types of credit facilities and their typical usage in the course of the business.
Two Types of Credit Facilities
Broadly, there are two types of credit facilities:
1) Short term loans, mainly for working capital needs; and
2) Long-term loans, required for capital expenditure (comprised mainly of building manufacturing facilities, purchase of machinery and equipment, and expansion projects) or acquisition (which could be bolt-on i.e smaller in size or could be transformative i.e comparable size).
Short-Term Credit Facilities
The short-term borrowings can be predominantly of the following types:
#1 – Cash credit and overdraft
In this type of credit facility, a company can withdraw funds more than it has in its deposits. The borrower would then be required to pay the interest rate which is applicable only to the amount that has been overdrawn. The size and the interest rate charged on the overdraft facility is typically a function of the borrower’s credit score (or rating).
#2 – Short-term loans
A corporation may also borrow short-term loansShort-term LoansShort term loans are the loans with a repayment period of 12 months or less, generally offered by firms, individuals or entrepreneurs for immediate liquidity requirements. These are usually provided at a higher interest rate, these short term loans often have a weekly repayment schedule. for its working capital needs, the tenor of which may be limited to up to a year. This type of credit facility may or may not be secured in nature, depending on the credit rating of the borrower. A stronger borrower (typically of an 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. category) might be able to borrow on an unsecured basis. On the other hand, a non-investment grade borrower may require providing collateral for the loans in the form of 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 receivables and inventories (in storage or transit) of the borrower. Several large corporations also borrow revolving credit facilitiesRevolving Credit FacilitiesA revolving credit facility refers to a pre-approved loan facility provided by banks to their corporate clients. It states that the companies are free to borrow funds from these financial institutions to fulfill their cash flow needs by paying off the underlying commitment fees., under which the company may borrow and repay funds on an ongoing basis within a specified amount and tenor. These may span for up to 5 years, and involves commitment fee and slightly higher interest rate for the increased flexibility compared to traditional loans (which do not replenish after payments are made).
A borrowing base facility is a secured form of short-term loan facility provided mainly to the commodities trading firms. Of course, the loan to value ratio, i.e the ratio of the amount lent to the value of the underlying collateral is always maintained at less than one, somewhere around 75-85%, to capture the risk of a possible decline in the value of the assets.
#3 – Trade finance
This type of credit facility is essential for an efficient 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 a company, and can be of the following types:
- Credit from suppliers: A supplier is typically more comfortable with providing credit to its customers, with whom it has strong relationships. The negotiation of the payment terms with the supplier is extremely important to secure a profitable transaction. An example of the supplier payment term is “2% 10 Net 45”, which signifies that the purchase price would be offered at a 2% discount by the supplier if paid within 10 days. Alternatively, the company would need to pay the entire specified purchase price but would have the flexibility to extend the payment by 35 more days.
- Letters of Credit: This is a more secure form of credit, in which a bank guarantees the payment from the company to the supplier. The issuing bank (i.e the bank which 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. to the supplier) performs its own due diligence and usually asks for collateral from the company. A supplier would prefer this arrangement, as this helps address the credit risk issue with respect to its customer, which could potentially be located in an unstable region.
- Export credit: This form of loan is provided to the exporters by government agencies to support export growth.
- Factoring: Factoring is an advanced form of borrowing, in which the company sells its accounts receivablesAccounts ReceivablesAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet. to another party (called a factor) at a discount (to compensate for transferring the credit risk). This arrangement could help the company to get the receivables removed from its balance sheet, and can serve to fill its cash needs.
Long-Term Credit Facilities
Now, let’s look at how long-term credit facilities are typically structured. They can be borrowed from several sources – banks, private placement, and capital markets, and are at varying levels in a payment default waterfall.
#1 – Bank loans
The most common type of long-term credit facilityCredit FacilityCredit Facility is a pre-approved bank loan facility to businesses allowing them to borrow the capital amount as & when needed for their long-term/short-term requirements without having to re-apply for a loan each time. is a term loan, which is defined by a specific amount, tenor (that may vary from 1-10 years) and a specified repayment schedule. These loans could be secured (usually for higher-risk borrowers) or unsecured (for investment-grade borrowers), and are generally at floating rates (i.e a spread over LIBOR or EURIBOREURIBORThe Euro Interbank Offer Rate (Euribor) is the interest rate at which European Union banks lend funds to each other. It is a daily changing benchmark and reference interest rate that includes terms ranging from a week to a year.). Before lending a long-term facility, a bank performs extensive due diligence in order to address the credit risk that they are asked to assume given the long-term tenor. With heightened diligence, term loans have the lowest cost among other long-term debt. The due diligence may involve the inclusion of covenantsCovenantsCovenant refers to the borrower's promise to the lender, quoted on a formal debt agreement stating the former's obligations and limitations. It is a standard clause of the bond contracts and loan agreements. such as the following:
- Maintenance of leverage ratiosLeverage RatiosDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity. and coverage ratios, under which the bank may ask the corporation to maintain Debt/EBITDA at less than 0x and EBITDA/Interest at more than 6.0x, thereby indirectly restricting the corporate from taking on additional debt beyond a certain limit.
- Change of control provision, which means that a specified portion of the term loan must be repaid, in case the company gets acquired by another company.
- Negative pledge, which prevents borrowers from pledging all or a portion of its assets for securing additional bank loans (even for the second lien), or sale of assets without permission
- Restricting mergers and acquisitions or certain capexCapexCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.
The term loan can be of two types – Term Loan A “TLA” and Term Loan B “TLB”. The primary difference between the two is the amortization schedule – TLA is amortized evenly over 5-7 years, while TLB is amortized nominally in the initial years (5-8 years) and includes a large bullet payment in the last year. As you guessed correctly, TLB is slightly more expensive to the Company for the slightly increased tenor and credit risk (owing to late principal payment).
#2 – Notes
These types of credit facilities are raised from private placement or capital marketsCapital MarketsA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets. and are typically unsecured in nature. To compensate for the enhanced credit risk that the lenders are willing to take, they are costlier for the company. Hence, they are considered by the corporation only when the banks are not comfortable with further lending. This type of debt is typically subordinated to the bank loans, and are larger in the tenor (up to 8-10 years). The notes are usually refinanced when the borrower can raise debt at cheaper rates, however, this requires a prepayment penaltyA Prepayment PenaltyThe prepayment clause states that if payment is made in advance before the due date, then terms and conditions of the mortgage are not adhered to by the borrower and would be liable to pay the penalty known as the prepayment penalty. in the form of “make whole” payment in addition to the principal payment to the lender. Some notes may come with a call option, which allows the borrower to prepay these notes within a specified time frame in situations where refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure. with cheaper debt is easier. The notes with call options are relatively cheaper for the lender i.e charged at higher interest rates than regular notes.
#3 – Mezzanine debt
Mezzanine financingMezzanine FinancingMezzanine 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). debt is a mix between debt and equity and rank last in the payment default waterfall. This debt is completely unsecured, senior only to the common shares, and junior to the other debt in the capital structure. Owing to the enhanced risk, they require a return rate of 18-25% and are provided only by private equity and hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques., which usually invest in riskier assets. The debt-like structure comes from its cash pay interest, and a maturity ranging from 5-7 years; whereas the equity-like structure comes from the warrants and payment-in-kind (PIK) associated with it. PIK is a portion of interestPIK Is A Portion Of InterestPIK Interest, also known as a Payment in Kind, is an option to pay interest on preferred securities or debt instruments in kind instead of cash. PIK interest is also referred to as dividend payments to investors of securities or equity in kind instead of cash., which instead of paying periodically to the lenders, is added to the principal amount and repaid only at maturity. The warrants may span between 1-5% of the total equity capital and provides the lenders the option to buy the company’s stock at a predetermined low price, in case the lender views the company’s growth trajectory positively. The mezzanine debt is typically used in a leveraged buyout situation, in which a private equity investorEquity InvestorAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc. buys a company with as high debt as possible (compared to equity), in order to maximize its returns on equity.
#4 – Securitization
This type of credit facility is very similar to the factoring of receivables mentioned earlier. The only difference is the liquidity of assets and the institutions involved. In factoring, a financial institution may act as a “factor” and purchase the Company’s 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.; however, in securitization, there could be multiple parties (or investors) and longer-term receivables involved. The examples of securitized assets could be credit card receivables, mortgage receivables, and non-performing assets (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.) of a financial company.
#5 – Bridge loan
Another type of credit facility is a bridge facility, which is usually utilized for M&A or working capital purposes. A bridge loan is typically short-term in nature (for up to 6 months), and are borrowed for an interim usage, while the company awaits long-term financing. The bridge loan Bridge 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. can be repaid, using bank loans, notes, or even equity financing, when the markets turn conducive to raising capital.
In conclusion, there needs to be a balance between the company’s debt structure, equity capital, business riskBusiness RiskBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand. and future growth prospects of a company. Several credit facilities aim to tie these aspects together for a company to function well.
It has been a guide to Types of Credit Facility – Short-Term Credit Facility and Long-Term Credit Facility. Here we discuss its features and usages in various stages of the business. You may also have a look at the other recommended articles –