What it means
A revolving credit facility is agreed with a bank or lender for a set period, such as three or five years, with a maximum limit the business can borrow against. The business can draw funds whenever it needs them, and each time it repays part of the balance, that amount becomes available to borrow again.
This is the difference from a term loan, where repaid money cannot be reborrowed. This type of credit is particularly useful for managing cash flow, especially when a business faces seasonal swings or unexpected expenses.
Instead of applying for a new loan each time cash runs short, the company simply draws on the facility that is already in place. That saves time and gives the finance team confidence that money will be available to pay suppliers and staff.
The cost has two parts. The business pays interest only on the amount it has actually drawn, and it usually pays a smaller commitment fee on the undrawn portion for keeping the line available.
Lenders often attach covenants, which are agreed financial tests such as a maximum debt level, and a breach can allow the lender to cancel the facility. For non-finance managers, the key point is that a revolving facility is meant for short-term working capital rather than long-term investment.
If it is used to fund permanent assets, the business may find it is relying on borrowing it cannot easily repay. Think of a reusable gift card for your favourite store: you can spend it, top it up and spend again, but never beyond its limit.
In practice
Real-world examples
Example 1
A small retailer uses a $100,000 revolving credit facility to buy extra stock before the holiday season. It draws $60,000 in October, knowing sales will rise in November and December, and repays the amount by January. The facility is then fully available again for the next buying cycle.
Example 2
A manufacturing SME uses its facility to cover payroll during a slow season. It draws $40,000 for two months while customers are late paying, then repays the balance when the invoices are settled. Without the facility it would have had to delay wages or sell stock cheaply.
Example 3
A construction contractor holds a $1,000,000 facility to bridge the gap between paying subcontractors and receiving milestone payments from clients. It draws and repays several times during a project. Because interest is charged only on the drawn amount, the average cost is far lower than borrowing the full sum all year.
Think of it
Imagine having a reusable gift card for your favorite store. You can spend it, and each time you add more money to it, you can spend again, up to the card's limit.
Formula
Calculation
Available Credit = Facility Limit - Amount Drawn
Quarterly Cost = (Drawn Balance x Interest Rate x Months / 12) + (Undrawn Balance x Commitment Fee Rate x Months / 12)
Worked example. A company has a $500,000 facility and draws $200,000 for a three-month period. The interest rate is 8% a year and the commitment fee is 0.5% a year.
1. Available credit = $500,000 - $200,000 = $300,000.
2. Interest = $200,000 x 8% x 3 / 12 = $4,000.
3. Commitment fee = $300,000 x 0.5% x 3 / 12 = $375.
4. Total cost for the quarter = $4,000 + $375 = $4,375.
If the company repays $50,000, its drawn balance falls to $150,000 and its available credit rises to $350,000, ready to be used again.Case study
Seen in the real world
This is a fictional, illustrative scenario. Harbour Foods, a food distributor, supplied supermarkets that paid 60 days after delivery, while its own suppliers wanted payment within 30 days. Every month it faced a cash gap of about $150,000, and it had been relying on an expensive overdraft that its bank could withdraw at short notice. The finance director negotiated a $400,000 revolving credit facility with a three-year term, a commitment fee of 0.5% a year on unused funds and interest on drawn amounts.
In a typical month the company drew about $150,000, paid its suppliers on time and repaid the balance when supermarket payments arrived. Average drawings of $150,000 at 8% a year cost about $1,000 a month in interest, and the unused $250,000 cost roughly $104 a month in commitment fees. The finance director also set an internal rule that the balance must return to zero at least once each quarter, so the facility was not quietly turning into permanent debt. Harbour's supplier relationships improved because bills were paid on time, and the bank could see in its monthly reports that the facility was being used as intended.
Watch out
Common mistakes
- Using the facility to fund long-term assets, which leaves no cash available when short-term needs arise.
- Ignoring commitment fees and covenants, and being surprised when the facility costs money even when it is not drawn.
- Letting the drawn balance creep up and never repaying it, so the facility turns into permanent debt.
Questions
People also ask
How is a revolving credit facility different from a term loan?
A term loan is paid out once and repaid on a schedule, and the repaid money cannot be borrowed again. A revolving facility lets you borrow, repay and borrow again within the limit.
Do I pay interest on the whole limit?
No. Interest is normally charged only on the amount you have drawn, though lenders usually charge a smaller commitment fee on the undrawn amount.
What happens if I breach a covenant?
The lender may restrict further drawings, increase the margin or even demand repayment. It is therefore important to monitor covenant tests regularly and talk to the lender early if a breach looks likely.