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 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. A highly-levered company may burden the company’s operations and the stock price. Consequently, the payment terms, the interest rates, the collateral, and the entire negotiation process of every loan remain the key to devising the capital strategy of a company.
In this article, we discuss the different types of creditTypes Of CreditTrade credit, bank credit, revolving credit, open credit, installment credit, mutual credit, and service credit are some of the different types of credit. facilities and their typical usage in the course of the business..
Table of contents
- Types of credit facilities are broadly categorized into short-term and long-term credit facilities.
- Short-term credit facilities are typically used for meeting working capital requirements, such as paying off creditors and bills. In contrast, long-term credit facilities are utilized for capital expenditure needs and are often funded through banks, private placements, and bonds.
- Short-term credit facilities include cash credit, overdraft, short-term loans, and trade finance, which address immediate working capital needs.
- Long-term credit facilities encompass bank loans, Mezzanine debt, notes, securitization, and bridge loans, which fund long-term capital expenditure and expansion plans.
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 (consisting mainly of building manufacturing facilities, purchase of machinery and equipment, and expansion projects) or acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion. (which could be bolt-on, i.e., smaller in size or could be transformative, i.e., comparable size).
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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 applies only to the amount that has been overdrawn. The size and the interest rate charged on theOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer. overdraft facilityOverdraft FacilityOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer. are 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 defined as borrowings undertaken for a short period to meet immediate monetary requirements. 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 borrower’s credit rating. 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 the borrower’s receivables and inventories (in storage or transit). Several large corporations also borrowA 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. 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 involve a commitment fee and a slightly higher interest rate for the increased flexibility than traditional loans (which do not replenish after payments are made).
A borrowing base facility is a secured short-term loan facility provided mainly to commodities trading firms. Of course, theThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in value. loan to value ratioLoan To Value RatioThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in value., 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 providing credit to its customers, with whom it has strong relationships. Negotiating 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 supplier’s purchase price would be offered at a 2% discount if paid within ten days. Alternatively, the company would need to pay the 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 guaranteesBank GuaranteesThe term “Bank Guarantee,” as the name suggests, is the guarantee or assurance given by a financial institution to an external party if the borrower cannot repay the debt or meet its financial liability. In such an event, the bank will repay such an amount to the party that has been issued with the guarantee. 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 (LC) is issued by a buyer’s bank to ensure timely, full payment to the seller. If the buyers default, the bank pays the sellers on their behalf. to the supplier) performs its due diligence and usually asks for collateral from the company. A supplier would prefer this arrangement, as this helps address the credit risk issue concerning 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. The company sells itsAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. accounts receivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. to another party (called a factor) at a discount (to compensate for transferring the credit risk). This arrangement could help the company get the receivables removed from its balance sheet and fill its cash needs.
Long-Term Credit Facilities
Now, let’s look at how long-term credit facilities are typically structured. Banks, private placementPrivate PlacementPrivate placement of shares refers to the sale of shares of the company to the investors and institutions selected by the company, which generally includes banks, mutual fund companies, wealthy individual investors, insurance companies., and capital markets can be borrowed from several sources and are in a payment default waterfall at varying levels.
#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, 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 EURIBOREURIBOREuribor stands for Euro Interbank Offer Rate, which is the interest rate at which European Union banks lend funds to one another. It is a benchmark and reference interest rate that changes daily and covers tenures ranging from a week to a year. ). Before lending a long-term facility, a bank performs extensive due diligence to address the credit risk 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 ofCovenant 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. 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 corporation from taking on additional debt beyond a certain limit.
- Change of controlChange Of ControlThe term "change of control" refers to a situation in which the majority ownership of a company, and thus its business decision-making powers, shifts from one person to another. provision means that a specified portion of the term loan must be repaid if 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 due to increased tenor and credit risk (owing to late principal payment).
#2 – Notes
These 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. 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 bank loans and is larger in the tenor (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 a “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 ranks 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. The enhanced risk requires a return rate of 18-25% and is 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 provide the lenders the option to buy the company’s stock at a predetermined low price if the lender views the company’s growth trajectory positively. The mezzanine debt is typically used in a leveraged buyout situation. 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) to maximize its returns on equity.
#4 – Securitization
This type of credit facility is very similar to the factoring of earlier receivables. 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’sTrade 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. 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, there could be multiple parties (or investors) and longer-term receivables involved in securitization. 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 capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It's a measure of a company's liquidity, efficiency, and financial health, and it's calculated using a simple formula: "current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)" purposes. A bridge loan is typically short-term (for up to 6 months) and is borrowed for interim usage while the company awaits long-term financingLong-term FinancingLong term financing means financing by loan or borrowing for a term of more than one year by way of issuing equity shares, by the form of debt financing, by long term loans, leases or bonds, done for usually extensive projects financing and expansion of the company.. 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 capitalEquity CapitalEquity Capital refers to the capital collected by a company from its owners and other shareholders in exchange for a portion of ownership in the company., 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. Several credit facilities aim to tie these aspects together for a company to function well.
Frequently Asked Questions
The types of export credit facilities typically include pre-shipment financing, post-shipment financing, and export credit insurance. Pre-shipment financing provides funding to exporters to cover production and shipment costs before goods are shipped. Post-shipment financing provides working capital to exporters after shipping goods, but payment from the buyer has not yet been received. Finally, export credit insurance protects exporters against the risk of buyer non-payment.
Loans are a form of credit facility that provide borrowers with a lump sum of money that must be repaid with interest over a specified period, usually in installments. On the other hand, credit facilities refer to a broader range of financial arrangements that provide borrowers with access to a predetermined amount of credit that can be used as needed within certain terms and conditions.
A credit facility is a general term encompassing various types of borrowing arrangements provided by financial institutions, including revolving credit lines, overdraft facilities, or term loans. On the other hand, a term facility specifically refers to a loan with a fixed term, usually with a specified repayment schedule. In addition, it may have a fixed or variable interest rate.
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