Guide on Revolving Credit Facility and How Does It Work

For businesses in India, the revolving credit facility is a financial tool that can provide essential liquidity, enabling them to manage cash flow more efficiently and seize growth opportunities. This blog serves as a comprehensive guide on what a revolving credit facility is, how it works, and its specific application and benefits.

What is a Revolving Credit Facility?

A revolving credit facility is a type of credit or loan that allows a borrower to draw down, repay, and redraw funds up to a specified credit limit. Unlike a term loan, which provides a lump sum that is repaid over a fixed period, a revolving credit facility offers continuous access to funds, making it particularly useful for businesses with fluctuating working capital needs.

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How a Revolving Credit Facility Works

1. Credit Limit:

The lender establishes a credit limit based on the borrower’s creditworthiness, financial health, and business needs. This limit represents the maximum amount that can be borrowed at any given time.

1. Drawdowns:

The borrower can draw funds as needed, up to the credit limit. Drawdowns can be made multiple times, providing flexibility to access funds when necessary.

1. Repayments:

Borrowers can repay the personal loan amounts at their discretion. Once repaid, the funds become available for borrowing again, allowing for a continuous cycle of borrowing and repayment.

1. Interest and Fees:

Interest is charged only on the amount drawn, not on the entire credit limit. This interest is typically variable, and linked to market rates. Additionally, lenders may charge processing fees for the facility, such as commitment fees, utilization fees, and renewal fees.

1. Renewal:

Revolving credit facilities usually have a set period, often one year, after which they can be renewed subject to the lender’s approval.

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Application of Revolving Credit Facility in India

In India, revolving credit facilities are widely used by businesses of all sizes, from small and medium enterprises (SMEs) to large corporations. They are particularly beneficial in sectors with high variability in cash flows, such as manufacturing, retail, and services.

1. Working Capital Management:

Indian businesses often face seasonal fluctuations in demand. A revolving credit facility helps manage these variations by providing ready access to funds for inventory purchases, salary payments, and other operational expenses during peak periods.

1. Cash Flow Smoothing:

Businesses can experience delays in receivables due to extended credit terms offered to customers. A revolving credit facility helps bridge the gap between outgoing payments and incoming receivables, ensuring smooth operations.

1. Investment in Growth:

Companies can use revolving credit to finance short-term growth initiatives, such as marketing campaigns or minor capital expenditures, without committing to long-term debt.

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Benefits of Revolving Credit Facility

1. Flexibility:

The ability to draw and repay funds multiple times provides unmatched financial flexibility. Businesses can access funds when needed without the pressure of fixed monthly repayments.

1. Interest Cost Efficiency:

Interest is charged only on the utilized amount, not on the entire credit limit. This can result in significant cost savings compared to term loans where interest is charged on the full principal amount.

1. Improved Cash Flow Management:

By smoothing out cash flow fluctuations, revolving credit facilities help businesses maintain liquidity and avoid the operational disruptions that can arise from short-term cash shortfalls.

1. Quick Access to Funds:

Once the facility is approved, businesses can access funds quickly without going through the lengthy approval processes typical of new loan applications.

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Considerations and Challenges

1. Creditworthiness:

Securing a revolving credit facility requires a good credit history and financial stability. Lenders conduct thorough assessments, including financial statements, credit scores, and business plans.

1. Cost Structure:

While interest is charged on the drawn amount, other fees associated with the facility, such as commitment fees and renewal fees, can add up. Businesses need to consider the overall cost structure before opting for this facility.

1. Discipline in Usage:

The flexibility of revolving credit can sometimes lead to over-borrowing. Businesses must maintain financial discipline to avoid becoming overly reliant on the facility and accumulating unsustainable debt levels.

1. Renewal Risk:

Revolving credit facilities are typically subject to annual reviews and renewals. There is a risk that the lender may not renew the facility or may alter the terms, especially if the business’s financial condition deteriorates.

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Regulatory Framework in India

The Reserve Bank of India (RBI) regulates revolving credit facilities, ensuring that banks and financial institutions adhere to prudent lending practices. Key regulatory aspects include:

1. Prudential Norms:

Banks must follow RBI guidelines on capital adequacy, asset classification, and provisioning for non-performing assets, ensuring that they maintain a sound financial position while offering revolving credit facilities.

1. Credit Exposure Limits:

The RBI imposes limits on the credit exposure that banks can have to individual borrowers and sectors, preventing excessive concentration of risk.

1. Transparency and Disclosure:

Banks are required to disclose all terms and conditions of the revolving credit facility to borrowers, ensuring transparency and protecting borrower interests.

Revolving credit facilities are a vital financial instrument for businesses in India, offering flexibility and efficiency in managing short-term funding needs. However, it is crucial to approach this financial tool with caution, considering the costs, credit requirements, and potential risks involved. With prudent use and careful financial planning, a revolving credit facility can be a powerful ally.

FAQs

1. What is a Revolving Credit Facility? 

A Revolving Credit Facility is a type of credit arrangement where a lender provides a borrower with a maximum credit limit. The borrower can use and repay funds as needed within this limit.

1. How does a Revolving Credit Facility work? 

Borrowers can access funds, repay them, and borrow again up to the credit limit without needing to reapply. Interest is charged only on the amount borrowed.

1. Why choose a Revolving Credit Facility? 

It offers flexibility and ongoing access to funds for businesses or individuals with fluctuating cash needs, such as seasonal expenses or working capital.

1. What are the key features of a Revolving Credit Facility? 

It typically has a variable loan interest rate, requires minimum monthly payments, and may include fees. Repayment terms and credit limits vary based on the borrower’s creditworthiness and lender terms.