A credit facility is a type of loan made in a business or corporate finance context. It allows the borrowing business to take out money over an extended period of time rather than reapplying for a loan each time it needs funds. Essentially, a credit facility lets a company borrow money as needed up to a pre-specified limit.
There are several types of credit facilities:
- Revolving Credit Facilities: Similar to a credit card for a business, this facility allows businesses to borrow, repay, and borrow again up to a certain limit. The interest rate is typically variable.
- Term Loans: These are traditional loans with a fixed repayment schedule, interest rate, and maturity date. They are often used for large, one-time investments, such as equipment purchases or facility expansions.
- Letters of Credit: This is a letter from a bank guaranteeing a buyer’s payment to a seller will be received on time and for the correct amount. In the event that the buyer is unable to make payment on the purchase, the bank will be required to cover the full or remaining amount of the purchase.
- Bridge Loans: Short-term loans that provide cash flow until long-term financing can be arranged.
- Asset-based Facilities: These loans are secured by a company’s assets, such as inventory or accounts receivable, and are typically used by companies with cash flow problems.
A credit facility can provide a business with flexibility, allowing it to manage its cash flow more effectively, respond to opportunities quickly, and fund its ongoing operational needs. The specific terms of a credit facility, such as the interest rate and borrowing limit, are typically set based on the borrower’s creditworthiness.
Example of a Credit Facility
Let’s take the example of a mid-sized manufacturing company, “BestMade Inc.” They manufacture home appliances and they’ve just secured a large contract to supply kitchen appliances to a nationwide retail chain. This contract has the potential to significantly increase BestMade’s revenue, but it also requires them to ramp up production more quickly than they had planned.
To fund the necessary increase in production, BestMade decides to seek a credit facility from their bank.
- Revolving Credit Facility: The bank agrees to provide a revolving credit facility of $5 million. This allows BestMade to borrow as needed to purchase materials, hire additional workers, and cover other expenses associated with increasing production. They can borrow, repay, and borrow again, as long as they don’t exceed the $5 million limit. The interest rate on this facility fluctuates with market rates.
- Term Loan: In addition to the revolving credit facility, BestMade also takes out a term loan of $2 million to purchase new machinery for their factory to meet the increased production demand. This loan has a fixed interest rate and a repayment schedule that spans 5 years.
These credit facilities provide BestMade with the flexibility and funds needed to successfully fulfill their new contract. They can manage their cash flow more effectively, ensuring they can meet the increased production demand without overextending their financial resources.