A credit facility is a specific kind of loan given in the context of corporate or commercial financing. Instead of reapplying for a loan every time it needs money, it enables the borrowing company to borrow money over a longer period of time. A credit facility effectively enables a business to get an umbrella loan for producing money over a protracted period of time.

Traditional banks are the main lender for this type of debt facility. If the borrowing amount is high in value, multiple institutions might form a syndicate to finance the borrower’s total available credit.

How Does Credit Facility Work?

Credit facilities can function as a revolving line of credit, allowing the company receiving the line of credit to withdraw funds up to a certain maximum as necessary, although this is not always the case. A credit facility can also serve as a term loan in situations when the money is advanced all at once and can't be borrowed again.

Credit facilities are widely used in the financial sector as a means of providing money for various reasons. In combination with concluding a round of equity financing or obtaining money via the sale of shares of their company, businesses usually implement a credit facility.

Why Do Companies Use Credit Facility?

When a company's operations demand them to finance continuing activities using a combination of equity and debt, they should take credit facilities into consideration. Credit facilities may provide a solution for businesses that have recently received equity funding to include debt into the capital stack while lowering the long-term cost of capital.

Large, one-time expenditures that must be repaid over an extended period of time should not be made using credit facilities, especially if they cannot be paid off immediately. For instance, it would make more sense for a firm to obtain a long-term loan with a low interest rate to finance the building of a factory.

This is because credit facilities might be more expensive overall than long-term loans. Credit facilities are better suited for purchases that can be paid for more rapidly and for businesses that need flexibility in addition to capital since they offer constant access to funds but at the cost of an access charge (and sometimes a higher interest rate).

Types of credit facilities

You can categorize a credit arrangement as either short-term or long-term. Due to their short duration, short-term credit facilities frequently employ inventory or operational receivables as collateral and come with more benevolent lending conditions. Some of the common short term credit facilities are: Short Term Loans, Trade Finance (ie. Factoring, Credit from suppliers, etc.), and Cash credit and overdraft

Long-term credit facilities provide a corporation the most flexibility, but they are more expensive to cover risk. Long term credit facilities include Notes, Bank Loans, Bridge Loan, Mezzanine debt, Securitization

Pros and cons of using credit facility

Pros of using credit facility:

• Flexibility: The most flexible type of funding for a business is a credit facility. When a business wishes to obtain a traditional loan, it frequently has to provide a particular justification, choose a certain loan amount, and specify the precise timing of the debt. Credit facilities are readily available and not required to be utilized should the firm decide to modify its intentions.
• Scalability: A credit facility allows a firm greater resources to operate profitably, even if they are often not used to fund ongoing operations and secure a company's existence. The firm can expand by reserving operational cash flow for strategic expansion, while credit facility cash flow can be utilized for one-time or emergency expenses. A credit facility also improves an organization's resilience to cyclical or seasonal business conditions.
• Build a relationship with debt providers: A corporation and financial institution that have a solid commercial connection will frequently create a credit facility. The business holding the credit facility may get advantageous terms with the lender by collaborating with a bank (or syndicate of lenders). The security of future debt or the ability to negotiate debt covenant flexibility may depend on this connection.

Cons of credit facility

• Not an infinite source of funds: a credit facility's maximum is frequently set at a sum that a business won't typically need to use in full. However, if debt covenants are not being maintained, lending institutions may place limitations on the time or amount drawn from the credit facility.
• Require careful maintenance: the management of the credit facility requirements may add to a company's administrative workload. A corporation frequently has to monitor and uphold financial covenants as part of the loan arrangement and disclose specific metrics as part of external financial reporting. Even though the initial payment required is merely interest, the business is sometimes forced to engage into an installment plan arrangement after drawing on a line of credit that calls for continuous maintenance.
• Unwanted additional fees: a corporation frequently has to pay extra fees for the debt in order to make up for the flexibility of a line of credit. There may be monthly maintenance costs, yearly administrative agency fees, and one-time startup fees to establish the line of credit, but lender prices differ from deal to agreement. The credit conditions, such as the interest rate, may be more unfavorable compared to other loans since the lender has less control over the time or use of the line of credit.
• Hard to obtain: a lengthy business history and good creditworthiness will be requested by lenders together with the application. Lenders frequently review a company's formation papers, organizational structure, competitive analysis, cash flow forecasts, and tax filings. Although a lender may still choose to grant a line of credit, it may choose to set a limited credit limit or make up for risk by charging a higher interest rate.

Difference Between a Loan and a Credit Facility

There are some fundamental differences between credit facility and a traditional loan provided by banks.

A loan is frequently a stricter type of contract between a bank and a borrower. The borrower often has to submit a loan application for a specific purpose, explaining how the money will be utilized, and is then charged an interest rate in line with the amount of risk involved. Traditional loans provide the borrower with money up front; the lender then requires the borrower to repay the principal and interest charges through an amortization schedule of installments. A credit facility allows a borrower to only take on debt as needed, making it more adaptable. Additionally, the borrower frequently has more latitude in terms of how much debt it may take on and the justifications for doing so. A credit facility, as opposed to a loan, permits a corporation to be burdened with debt should it ever require more funding.

How interest is calculated is also a difference between these debt instruments. Regarding loan, interest must be paid for all the money that has been lent to the business. However, in the case of a credit facility, interest is only assessed on funds that are actually spent, not on funds that were just made accessible to the person or business.

Even though a corporation does not utilize the money at all, they may occasionally be charged an unused balance fee. When opposed to credit facilities, loans have a longer term period and a larger interest payment.

Lastly, how startups repay the proceeds is also different. In loan, startups must follow an EMI until the principal is repaid, and there is no possibility of obtaining more capital without starting out a fresh loan agreement which is not the case of a credit facility in which the contract is renewed annually and the fund can be drawn whenever required.