What is a Revolving Credit Facility?
A revolving credit facility is a line of credit that is arranged between a bank and a business. It has an established maximum amount, and the business has access to the funds at any time when needed. This type of credit is mostly useful for operating purposes, especially for any business experiencing sharp fluctuations in their cash flows and some unexpected large expenses. In other words, it is needed for companies that may sometimes have low cash balances to support their net working capital needs. Because of this, it is often considered a form of short-term financing that is usually paid off quickly.
When a company applies for a revolver, a bank considers several important factors to determine the creditworthiness of the company. This includes the income statement, cash flow statement, and balance sheet statement.
The other names for a revolving credit facility are operating line, bank line, or, simply, a revolver.
Features of a Revolving Credit Facility
#1 Cash Sweep
The revolver is often structured with a cash sweep (or debt sweep) provision. This means that any excess free cash flow generated by a company will be used by the bank to pay down the outstanding debt of the revolver ahead of schedule. Doing so forces the company to make repayment at a faster rate instead of distributing the cash to its shareholders or investors. In addition, it minimizes the credit risk and liability that comes from a company burning through its cash reserves for other purposes, such as making large, excessive purchases.
#2 Interest Expense
The borrower is charged the interest based only on the withdrawal amount and not on the entire credit line. The remaining portion of the revolver is always ready for use. This feature of built-in flexibility and convenience is what gives the revolver its main advantage. As for its outstanding balance, a business can have the option to pay the entire amount at once or simply make minimum monthly payments. The interest rate is usually close to the rate found on the company’s senior term debt. However, it may be variable and is based on the bank’s prime rate plus a premium, with an additional premium determined based on the company’s creditworthiness.
#3 Maximum Amount
When a company experiences a shortfall in cash flows to meet financial obligations, this can be corrected promptly by borrowing from a revolver. There is a maximum borrowing amount set by the bank. However, the bank may review the revolver annually. If revenues of a business drastically fall, the bank may lower the maximum amount of the revolver to protect it from default risk. Conversely, if a company has a good credit score, strong cash reserves, a steady and rising bottom line, and is making regular, consistent payments on a revolver, the bank may agree to increase the maximum limit.
#4 Commitment Fee
To commence the revolving credit facility, a bank may charge a commitment fee. This compensates the lender for keeping open access to a potential loan, where interest payments are only activated when the revolver is drawn on. The actual fee can either be a flat fee or a fixed percentage.
This type of loan is named a revolver because once the outstanding amount is paid off, the borrower can use it over and over again. It’s a revolving cycle of withdrawing, spending, and repaying any number of times until the arrangement expires – the term of the revolver ends. This is different from an installment loan, where there are monthly fixed payments over a set period. Once an installment loan is fully paid, you can’t use it again like the revolver. The borrower has to apply for a new installment loan.
Revolver in a Financial Model
A revolving credit facility is an important part of financial modeling because it underscores changes in a company’s debt based on operating assumptions. For instance, if it’s projected that revenues will drastically fall in the coming years, a company will look for additional sources of financing to fund, for example, R&D or capital expenditures as ways to grow the business. It may issue more debt to make these necessary expenses.
As mentioned before, the company can perform a revolver drawdown if it has insufficient cash on hand to service debt. Thus, a change in the revolver is triggered by a change in a company’s debt level. Furthermore, a revolver helps with keeping a financial model balanced because it calculates any excess cash generated or cash shortfall for a given year.
An example of a Revolving Credit Facility:
In the hospitality industry, which is considered seasonal, a ski resort may experience a shortage in operating income during the summer months; therefore, it may not be able to cover its payroll. Additionally, if it’s making most of its sales on credit, then the company will be waiting to cash its receivables before making inventory expenses. Having a revolver will allow the company to have access to funds at any time when it requires money for its day-to-day operations.
Calculation of Sweep (see figure below)
To calculate the cash available for sweeping, we take the beginning cash balance that is found on last year’s balance sheet under assets and subtract from it the estimated minimum cash balance required to keep a company running. Further diligence is performed if we need an accurate minimum cash balance.
The difference is then added to the cash flow from operating activities, investing activities, and financing activities in the period. We now have cash that is available for debt service. After that, we take the sum of all the scheduled debt repayments and subtract it from the cash available for debt service.
If the difference turns out to be positive, then we have enough cash to make the scheduled debt repayments and can even pay down a portion or all of the revolver’s outstanding balance. The company can even make early full repayments of other debt balances. But if the difference is negative, then there wouldn’t be enough cash to make debt repayments; therefore, the company will have to draw from the revolver to cover the shortage of cash.
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We hope this has been a helpful guide to understanding how a Revolving Credit Facility works and how to incorporate it into your financial modeling. Additional relevant CFI resources to help you in your career include: