What it means
Businesses face moments when cash is short even though they are healthy, such as a late customer payment, a seasonal peak in stock purchases or an unexpected repair. A standby line of credit lets a company arrange funding in advance so that it can borrow quickly.
The bank agrees a maximum amount, a term and the pricing before any money is drawn. Pricing has two parts.
The borrower pays interest on the amount drawn, usually at a floating rate tied to a benchmark, and a commitment fee on the undrawn part to compensate the bank for reserving its capital. The fee is often a fraction of 1% a year, which makes the facility cheap insurance compared with scrambling for emergency finance.
Standby lines are usually committed, meaning the bank must lend as long as conditions in the agreement are met. Those conditions are often financial covenants, such as a minimum ratio of earnings to interest, that the borrower must keep to.
If the borrower breaks a covenant, the bank may stop lending or demand repayment. Finance teams use these lines to manage liquidity, back up commercial paper programmes and reassure suppliers and rating agencies.
Having a standby line means the business can survive a short-term squeeze without selling assets at a bad moment. Lenders look at the borrower's financial strength, security offered and cash flow forecasts before approving one.
The nuance is the difference between committed and uncommitted lines. An uncommitted line is a courtesy that the bank can withdraw, while a committed one is a legal promise in return for the fee.
Another point is that standby lines in the trade finance sense, sometimes called standby letters of credit, are different instruments in which a bank promises to pay a third party if the customer defaults. Treasurers should review the line regularly.
Check the commitment fee, covenants, expiry date and any conditions that allow the bank to refuse a draw, and make sure the facility is large enough for realistic stress cases. Renew before it expires, not after.
In practice
Real-world examples.
Example
A garden centre arranges a $500,000 standby line before spring. It draws $200,000 to buy stock in February and repays it in June when sales peak. It pays interest only for the months the money was used.
Example
A manufacturer sets up a standby line to back its commercial paper programme. If investors do not roll over the paper, the company can borrow from the bank to repay it. The backup reassures rating agencies.
Example
A software firm has a customer that pays 60 days late, leaving a gap in payroll funding. The finance director draws $150,000 from the line for three weeks. She repays it when the invoice is settled, and the arrangement avoids missing salaries.
Formula
Calculation
Annual cost = (Drawn amount x Interest rate) + (Undrawn amount x Commitment fee rate)
Suppose a company has a $1,000,000 standby line with an interest rate of 8% on drawn amounts and a commitment fee of 0.50% on undrawn amounts. If it draws $300,000 for the whole year, the interest is 300,000 x 0.08 = $24,000. The undrawn balance is 1,000,000 - 300,000 = $700,000, so the commitment fee is 700,000 x 0.005 = $3,500. The total annual cost is 24,000 + 3,500 = $27,500. If the company never draws on the line, the cost is only the fee on the full amount, 1,000,000 x 0.005 = $5,000.Case study
Seen in the real world.
Harbourview Seafood is a fictional wholesaler whose cash needs peak before the holiday season. This illustrative company negotiated a $2 million standby line with its bank, paying a commitment fee of 0.40% on undrawn amounts. This is a fictional scenario, not a real firm.
When a major customer delayed a large payment, Harbourview drew $600,000 for six weeks and paid its suppliers on time. The interest cost was far lower than the discounts it would have lost by paying late. After the customer paid, the company repaid the line and the finance director added a liquidity stress test to the annual budget.
Watch out
Common mistakes.
- Forgetting the commitment fee on the unused portion. The line costs money even when it is never drawn.
- Assuming the bank must lend under any circumstances. A covenant breach or other default conditions can block drawings.
- Waiting until cash is short to arrange the line. Banks lend more readily and on better terms to borrowers who look healthy.
Questions
People also ask.
What is the difference between a standby line and an ordinary overdraft?
A standby line is a formal facility with agreed terms, often committed, while an overdraft is usually a flexible arrangement that the bank can review or cancel.
Is a standby line the same as a standby letter of credit?
No, a standby letter of credit is a bank guarantee to pay a third party if the customer defaults, while a standby line is a borrowing facility for the customer.
How big should the line be?
Size it by testing realistic stress cases, such as a delay in customer receipts, and include a buffer.
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