Revolving Credit Facility

A Revolving Credit Facility (often called an 'RCF' or a 'revolver') is like a high-powered, flexible credit card for a business. It's a formal credit agreement with a bank or a group of banks that allows a company to borrow money up to a preset limit, repay it, and then borrow it again over a specific period. Unlike a standard term loan, where you get a lump sum upfront and make fixed payments, a revolver provides ongoing access to liquidity. The company only pays interest on the amount it has actually 'drawn down' or borrowed, not on the total available credit line. This makes it an extremely useful tool for managing short-term cash flow ups and downs, such as funding seasonal inventory buildups or covering unexpected expenses. For a healthy company, it’s a financial safety net and a sign of prudent planning. However, for a struggling one, it can become a lifeline that masks deeper problems, making it a crucial area for investors to scrutinize on the balance sheet and cash flow statement.

Think of an RCF as a financial reservoir. A company establishes a facility with, say, a $100 million limit for a five-year term.

• Drawing Down: If the company needs $20 million to purchase raw materials, it 'draws down' that amount from the facility. It now has $80 million of available credit remaining.
• Paying Interest: It pays interest only on the $20 million it has borrowed. This interest rate is typically variable, calculated as a benchmark rate (like SOFR in the U.S. or EURIBOR in Europe) plus a 'spread' or margin.
• Paying for Availability: For the unused $80 million, the company pays a smaller 'commitment fee'. This fee compensates the bank for keeping that capital on standby, ready for the company to use at a moment's notice.
• Repaying and Revolving: A few months later, after selling its finished goods, the company generates cash and repays the $20 million. The full $100 million credit limit is restored, ready to be used again. This 'revolving' nature is its key feature.

For a value investor, an RCF isn't just a line item on a financial statement; it’s a window into management's competence and the company's operational health. The key is to understand why and how the company is using it.

A well-managed RCF is a sign of a prepared and efficient business. An abused one is a serious red flag.

• Good Use Cases (Green Flags):
  1. Managing Working Capital: A retailer using it to stock up on inventory before the holiday season and paying it back in the new year is a classic, healthy use.
  2. Bridging Finances: Temporarily funding a small, strategic acquisition while more permanent, long-term financing is arranged.
  3. A “Rainy Day” Fund: Maintaining an undrawn RCF as a backup source of liquidity shows prudence and a strong relationship with its bankers.
• Bad Use Cases (Red Flags):
  1. Funding Chronic Losses: If a company is constantly borrowing to cover its day-to-day operating expenses, it means the core business is not generating enough cash. This is unsustainable.
  2. Financing Long-Term Assets: Using short-term debt like an RCF to pay for a new factory or other long-term projects creates a dangerous asset-liability mismatch. It's like paying your 30-year mortgage with a credit card.
  3. “Maxing Out” the Facility: A company that is constantly fully drawn on its revolver is under financial stress.

The devil is always in the details, which you can find in the “Notes to Financial Statements” section of a company's annual report.

• Covenants: These are the rules of the game set by the lenders. They are promises the company must keep to avoid defaulting on the loan. Common covenants include:
  1. Maintaining a maximum debt-to-equity ratio.
  2. Keeping the interest coverage ratio above a certain level.
  3. A breach of a covenant is a major event. It can allow the bank to demand immediate repayment of all borrowed funds, potentially triggering a financial crisis for the company.
• Security and Seniority: Most RCFs are a form of senior debt and are often secured with collateral, such as a company's accounts receivable or inventory. This means that in a bankruptcy, the RCF lenders get paid back first, before other creditors and shareholders. As an equity investor, you are last in line, so understanding this pecking order is vital.