Revolving Credit Facility – Meaning
A revolving credit facility is a line of credit wherein the borrower pays a fixed fee to borrow funds up to a predetermined maximum limit. The borrower can borrow funds up to the limit as and when required.
Such credit facility is usually used by businesses to manage their operating cash flow cycle. When a company is running low on cash, the money borrowed from a revolving credit can be used to fund purchase orders, pay utility bills, pay staff salaries, etc. This goes on until the company starts receiving payments and can function on its own cash again.
Let’s understand the advantages and disadvantages of revolving credit facility:
No Fixed Repayment Schedule
One of the best advantages of a revolving credit facility is that it has no fixed repayment schedule. Every other type of credit facility such as an installment loan (term loan), an overdraft, etc. comes with a fixed repayment schedule. However, this is not the case with the revolving credit facility. In this facility, the borrower chooses his own repayment schedule.
Another advantage of a revolving credit facility is that the borrower pays interest only for the actual amount borrowed and the time period of the borrowing. Let’s take an example for better understanding –
Example – ABC Ltd. has a revolving credit facility with its bank for a maximum amount of USD 20,000 for one year at the interest rate of 5% per annum. On 1st January, it withdraws USD 5000.00 to buy raw material. On 31st March it repays the borrowed amount of USD 5000.00. Therefore, the interest under the revolving credit would be –
Revolving Credit Interest – USD 5000.00 (amount borrowed) X 0.05% (rate of interest) X (3/12) (time period of borrowing = USD 62.50
Therefore, ABC Ltd. pays USD 62.50 per year on this line of credit.
In contrast, if ABC Ltd would have taken a term loan for the same amount at the same interest rate, then its interest would be –
Interest on term loan = USD 20,000 X 0.05% = USD 1000.00 annually
This is because regardless of how much money the borrower uses, for any amount of time, the term loan charges interest for entire sanctioned loan amount for the entire borrowing period.
The revolving credit facility is a great tool to manage liquidity in any company. Suppose a company is working at its full capacity, and it gets a new unexpected big order from a customer. In such a situation, it might not have extra cash to fund the purchase order. Here the company can withdraw money from its revolving credit facility, and when the order is completed and the payment is received, it can repay the borrowed cash. This facility is a great back up when liquidity in the business shrinks.
Flexibility can be a Curse
It is human nature that if given too much flexibility, we start slagging. This is exactly what happens with the revolving credit facility. The borrower can choose a repayment schedule for revolving credit. However, without fixed, stringent payment schedule the borrower might keep delaying the repayment. In such cases, the interest compounds fast and before realization hits, the borrower is in huge debt.
Many people are confused among revolving credit and other types of lines of credit such as bank overdraft or credit card. Let’s look into the differences in detail.
Revolving Credit Vs. Bank Overdraft
Revolving Credit and bank overdraft are similar in many ways, i.e.
- The borrower can withdraw cash as and when needed
- The interest is charged on the amount borrowed and the time period of borrowing
- Both lines of credit entail a fixed fee that is to be paid to set up the facility
However, the main difference between revolving credit and a bank overdraft is that the contract of bank overdraft is very stringent. Unlike that, the contract of revolving credit is comparatively flexible and can be customized as per customer’s requirements. For example, in bank overdraft the borrower has to repay his dues in a fixed period of time – say in six months or one year, but, the borrower can choose his repayment schedule in revolving credit facility.
Revolving Credit Vs. Credit Cards
There are many differences between revolving credit and credit cards, some of which are as follows:
- Credit cards are used on actual transactions, such as to purchase things or pay for utility, etc. On the other hand, revolving credit can be used to do all that plus anything else that the borrower wants to do. There doesn’t need to be an actual transaction to use revolving credit, for example – if one wants to show funds in their check-in account for a tender contract, they can use revolving credit to borrow these funds, but they can’t use a credit card for that.
- There is a physical difference as well, that is unlike credit cards, one doesn’t require an actual physical card to use the revolving credit facility.
- The interest on revolving credit is lower compared to interest on a credit card.
Revolving Credit Vs. Term Loan
Revolving credit and term loans are completely different products.
Firstly term loans involve a lump sum borrowing at the beginning of the loan, there is no further borrowing. For example – ABC Ltd. wants to buy an office space worth USD 500,000, from which USD 300,000 must be funded by term a loan. The bank will give you the USD 300,000 at the beginning of the loan. However, in revolving credit the borrower can borrow money multiple time during the term of the facility.
Secondly, the term loans come with a very stringent repayment schedule, and the borrower must adhere to it. In revolving credit the repayment schedule is flexible and the borrower is at the liberty to choose his own repayment schedule.
Finally, as mentioned at the beginning of this article, in a term loan the borrower is charged interest on entire loan amount that is sanctioned by the bank. So whether the borrower uses the fund or not, he must pay interest on the entire amount of the loan. On the other hand, in revolving credit the borrower pays interest only for the funds he has used, regardless of the amount sanctioned by the bank.