Revolving Credit Facility

What is a Revolving Credit Facility?

A revolving credit facility (RCF) is a flexible funding facility which can be drawn down by a business subject to a pre-agreed limit. The RCF is used to support a business’s short term cash fluctuations such as seasonality of operating working capital (OWC). A revolving credit facility is also known as a revolver.

Here is how an RCF works. Suppose, a business has taken an RCF of 10 million. It is facing a delay in recovering accounts receivables and needs cash of 5 million to fund working capital needs such as payroll. The business can withdraw 5 million from its RCF. This will reduce its RCF to 5 million (10-5). Once it receives cash from its customers, it can repay the bank.  Its RCF will again be back at 10 million.

Features of a Revolving Credit Facility

Maximum Amount

An RCF comes with a maximum borrowing limit, which depends on a company’s credit history and the strength of its cash flows. Banks may review the maximum limit of an RCF and increase/decrease it depending on the default risk.

Interest Expenses

Companies need to pay interest on an RCF, similar to any other credit line. The interest is charged based on the withdrawn amount and not the maximum amount.

Commitment Fees

If a bank gives an RCF of 50 million, it won’t necessarily have distributed funds to the borrower. However, it should have the funds ready if the borrower demands it. To meet such potential demand for funds, banks need to allocate equity capital as part of regulatory requirements. For this reason, banks charge a commitment fee on an RCF. The commitment fee helps them get a return on the equity capital allocated against the RCF, if the facility is not drawn. The commitment fees is charged on the unutilized portion of the RCF.

RCF and Cash Sweep

Cash sweep refers to the use of excess cash flows to repay debt. If the surplus cash exceeds the revolver balance, then the revolver will be repaid and the ending balance will be zero. If, on the other hand, the surplus cash is below the revolver balance, it will be used to reduce the revolver. In the case of cash shortfall, a draw down of the line of credit will be used to make up the shortfall.

Due to their seniority, mandated long-term debt repayments must be included as an outflow before the revolver issuance/repayment.

Revolving Credit Facility: Example

Based on the information below, we have been asked to calculate the commitment fee and interest expense on a revolving credit facility.

These are the details of the company’s cash flows available for debt repayment each year. These are calculated after deducting interest expenses and mandatory debt repayments.

We will see how these cash flows get affected by an RCF. The RCF at the beginning is at 50.0 (assuming the company had already withdrawn 50.0 out of its total RCF of 100.0).

We have used the Min function in excel to calculate the repayment/drawdown amount. It picks up the lower of the cash flow available for debt repayment and the beginning balance of RCF. Interest expense is calculated on the average of the beginning balance and the ending balance.

In year 1, the company has negative cash flows of 20.0 after fulfilling its other debt obligations. The company uses the RCF to fund this shortfall. As a result, the RCF increases to 70.0.

In years 3 and 4, the company has some positive cash flows, which help in repaying some of the RCF. In year 5, the company repays the balance amount, and the ending balance is 0. The interest expense is the lowest in year 5.

The unused facility is the difference between the total available RCF and the ending balance. In year 1, the unused facility is 30.0 (100.0 – 70.0 used). In year 5, the unused facility is 100 as the company’s ending balance is 0.

The commitment fee is charged on the average of the opening and ending balances of the unused facility. It increases with the unused facility and is the highest in year 5.

The total interest expense to be shown on the income statement is the sum of the interest expense and the commitment fee.

Revolving Credit Facility & Acquisitions

RCF can help in the financing of operating working capital (OWC) in acquisitions. In a nutshell, a positive OWC indicates cash is tied up in the operations and the business needs short-term funding.  A negative OWC indicates the business has access to a “free” source of short-term funding.

If the OWC is seasonal, its balance fluctuates during the year. For example, a toy manufacturer will have an unusually high OWC before a holiday season (as a lot of its cash will be tied up in inventory). If at the completion date of the acquisition, the OWC is at the seasonal peak, the business seller will want to be compensated for the additional OWC.

However, the extra payment for the unusually high OWC is a short-term requirement. In such cases, acquirers may use RCF to finance the seasonal OWC as it’s a cheap form of short-term financing. They can repay the RCF as the OWC liquidates into cash.