A revolving credit facility, also known as a revolving line of credit, is a line of credit between a bank or other financial institution and a business.
Using a revolving credit facility, a business can borrow money from the bank when it is needed, typically up to a predetermined limit. Revolving credit is designed for short-term cash needs, meaning any money that’s borrowed is usually paid back fairly quickly.
Businesses that use revolving credit often have significant net working capital needs. Using this type of credit facility, a business that has irregular cash flow can manage its day to day spending without having to rely on options like longer-term loans.
Below, we’ve explained revolving credit facility in further detail. We’ve also looked at the advantages and disadvantages offered by a revolving line of credit for small and medium-sized businesses.
What is a Revolving Credit Facility?
A revolving line of credit is a type of line of credit that exists between a business and a banking partner or other financial institution.
Revolving credit is short term in nature. Many businesses make use of a revolving credit facility for things such as new product inventory, supplies, payroll and other expenses that need to be paid on a regular basis.
Like other forms of credit, a business will pay interest when it borrows money from a bank using a revolving credit facility. Because a revolving line of credit is typically used for short-term use, it will typically have a higher interest rate than a conventional, long-term business loan.
Revolving credit is a form of non-installment credit. When a business borrows money this way, it doesn’t need to make monthly installment payments. Instead, the business can withdraw and/or repay the loan as frequently as necessary and to any extent.
In many ways, a revolving credit facility is like a consumer credit card. Unlike a traditional bank loan, there are no fixed monthly payments—instead, the businesses that uses the credit facility is free to withdraw and repay on its own terms, as long as the credit facility is valid.
Most of the time, the bank that provides a revolving credit facility will place a limit on the amount a business can borrow. This limit is often adjusted over time based on the business’s revenues, cash reserves, general risk profile and other factors.
Advantages of a Revolving Credit Facility
The biggest advantage of a revolving credit facility is that it allows a business to easily pay for its recurring expenses and current liabilities, all without having to worry about fluctuations in its cash flow.
For example, a business in the construction industry might only receive a full payment from its client upon reaching a certain milestone in a project. In the meantime, the business still has to pay its workers, suppliers and subcontractors on a biweekly or monthly basis.
Using a revolving credit facility, this type of business can access the cash it needs to pay staff, suppliers and subcontractors without having to take out a separate loan or worry about normal fluctuations in its cash flow.
This type of credit is also commonly used by seasonal businesses. For example, a resort near the beach might generate huge profits during summer but lose money during winter. Revolving credit allows a business like this to easily deal with seasonal changes in its cash flow.
Revolving credit facilities also offer several advantages over other common forms of business credit.
First, since a revolving credit facility is a form of non-installment credit, a business can use it as needed. If a business needs to borrow money in the short term, it can. If it generates a greater amount of revenue than expected in a certain quarter, it can pay the debt back immediately.
Second, as revolving credit is designed for the short term, businesses that use it aren’t locked into long-term loan agreements. There’s also no fixed amount of cash that needs to be loaned to the business—instead, a business can borrow only what it needs, when it needs it.
Disadvantages of a Revolving Credit Facility
Despite its numerous advantages, a revolving line of credit can also have a few disadvantages, especially when it’s not used properly.
First, revolving credit is typically more expensive than a long-term business loan. Interest rates tend to be higher and there are often more fees involved in the use of this type of credit facility than there are with a conventional loan.
Sometimes, a business can get lower interest rates by providing assets as a form of security for a revolving credit facility. In the event of default, the bank will repossess these assets in order to pay off the outstanding loan balance.
Because of this, a revolving credit facility only makes sense if it’s intended for use in the short term. For long-term borrowing, a more traditional business loan is almost always a significantly more affordable option.
Second, as with all forms of credit, a revolving credit facility can create the temptation to spend more money than is necessary. Because of this, as a business owner, it’s important to set limits on the use of credit to avoid borrowing excessively.
Revolving credit is essential in many industries, particularly for businesses that have consistent short-term expenses and fluctuations in cash flow.
Like all forms of credit, revolving credit can be an excellent option for a business when it’s used responsibly. Thanks to its flexibility, it’s a particularly good option for businesses that often need cash on short notice for expenses such as supplies, payroll and purchasing.