How Do Credit Facilities Work?

Credit facilities allow self-employed individuals and small businesses to draw up to a predetermined amount of money. To avail funds, a company can simply request to draw money from the credit facility and pay the amount back on the repayment date. Upon repayment, the availability of funds increases once again. In essence, a credit facility operates much in the same manner as a credit card does.

However, banks impose certain restrictions on credit facilities. For starters, credit facilities can only be used for business purposes. Also, most banks require that the balance of the credit facility be repaid once every year. This allows businesses to have ready availability of funds. However, this is not an absolute requirement for some banks.

Credit facilities are a very flexible financing product that includes different types of credit lines. However, credit facilities are broadly classified into two groups – secured credit facilities and unsecured credit facilities. The terms and structure of these types of credit facilities differ from one bank to another.

In a secured facility, banks require some collateral to secure repayment, while there is no collateral associated with unsecured facilities. The collateral accepted by banks for secured credit facilities include inventory, machinery, accounts receivable, cash, securities, certificates of deposit and real estate, among others. In case of an unsecured credit facility, the company and its owner must provide some guarantees to the bank.

Also, there are certain eligibility criteria associated with credit facilities and not every small business will qualify for it. While different banks have different eligibility criteria, they are all based on some common factors. These factors include proper cash flow, a good credit score and a collateral (for secured credit facilities). To ensure eligibility, a company must declare reasonable financial ratios, company assets and income and guarantees.

All banks have a thorough review process to examine these factors in order to determine eligibility for a credit facility. Banks also perform various background checks on business owners before offering a credit facility. This includes checking the professional history, personal background, assets and the personal credit rating of business owners.

A credit line facility also requires that a business complies with certain covenants (rules and conditions). While these covenants vary from one bank to another, some common covenants include:

– A minimum net worth of the company
– Monthly certification of company financials
– A minimum performance of liquidity ratios (cash conversion cycle, current ratio, quick ratio)
– A minimum performance of debt ratios (fixed charge ratio, debt service coverage ratio)
– Material changes that can negatively impact the business
– A confession of judgement clause

To apply for a credit facility, a company needs to approach a bank with a proposal letter. Several supporting documents need to be provided along with the proposal letter. When the bank receives the application, verification of the eligibility criteria take place. Once everything has been verified, the terms and structure of the facility are formulated and the credit facility can be availed by a business.”