Qualitative Analysis
May 3, 2024
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This guide explains what revolver debt is in business and it explains how revolving lines of credit work. Additionally, we will look at why revolver debt is valuable to a business. Finally, we’ll learn about who provides revolver debt and what these arrangements typically look like. Here are four key takeaways about revolver debt:
There are two major types of revolver debt, revolving lines of credit and credit cards. This guide will focus on revolving lines of credit.
In business, revolver debt is a line of credit that is given to a company by a commercial bank. These lines of credit are a form of debt that is structured differently than traditional term loans are.
When most people think of a loan, they think of an arrangement like a residential mortgage. With a residential mortgage, the borrower (home buyer) agrees to make monthly payments of interest and principal back to the lender for the term of the loan.
So, if a family borrows $500,000 to purchase a house, they need to make monthly payments of that $500,000 (principle) plus the interest, for the length of the loan—usually 15 or 30 years.
Residential mortgages are an example in personal finance how term loans work in business. There is a fixed sum of money being lent, interest to be paid on that amount, and a period of time where payments are to be made, as per the agreement. Term loans are another type of senior debt that is typically available to a business in addition to revolving lines of credit.
So, if mortgages give us a way to understand how traditional term loans work in business, let’s try to understand revolver debt through another personal finance product readily available to consumers worldwide—credit cards.
Credit cards are a type of revolver debt available to both businesses and consumers. With a credit card there is a maximum limit. You can’t charge more to the credit card than the maximum limit, until you’ve paid that balance down. When you make a payment to the card, the maximum limit doesn’t change as a result of the payment. You, as a consumer, are given constant access to the maximum amount and you owe interest on the outstanding balance—until you’ve paid it back.
If you understand how residential mortgages work and you understand how personal credit cards work, you understand the basic concept of how term loans and revolver debt work in business. As you’ve seen, revolving lines of credit work differently than term loans. Instead of a term loan that is typically amortized, with a revolving line of credit, the borrower is given constant access to a sum of money, up to the maximum amount. The borrower can make withdraws against that balance and they will only owe interest on the amount they’ve borrowed against the line of credit.
So, if a business has a revolving line of credit for $100,000 and they borrow $9,000 to pay a supplier, then they only owe interest on the $9,000—until they repay that amount to the account. Then they will owe no additional interest until they make a withdraw from the line of credit again.
A business has access to both business credit cards and revolving lines of credit, just as a consumer may have access to personal credit cards and a personal (or home equity) line of credit.
Revolving lines of credit are different than credit cards, but they are both types of revolver debt. This guide focuses more specifically on the revolving lines of credit a business uses.
Both term loans and revolving lines of credit are classified as senior debt in business. Senior debt is debt with the highest claim to a business’ cash flow in the capital stack. This means that lenders providing revolving lines of credit will be paid back before other lenders and investors in the event the business can’t repay all of its debt. This makes senior debt less risky than loaning other types of debt or than investing for an equity stake. To learn more about senior debt, read this guide.
We’ll look more at why revolver debt is useful in the following sections.
Revolver debt has some distinct advantages over term loans or other debt products. To understand these, we need to understand why revolving lines of credit are valuable to a business.
We’ve already explained that revolving lines of credit give the borrower constant access to the maximum amount—and they only owe interest on the amount they’ve borrowed. The borrower can make withdraws from and repayments to the line of credit as needed.
A useful advantage of these revolving lines of credit is that the borrower doesn’t need to apply for and get reapproved for each transaction they need money for. Compare this to term loans where once the borrower has repaid the loan, they would need to reapply for a second loan to get more money.
With a revolving line of credit, the borrower can re-access any amount that’s been repaid to the line of credit and they can borrow from the line of credit again without the additional approval process.
This makes revolving lines of credit extremely useful to a business with inconsistent cash flow. Early-stage businesses benefit from revolving lines of credit in particular, because sales are inconsistent in the early stages of business when the entrepreneur is still figuring their market out and dialing in their offer. During this period, sales can be irregular or inconsistent.
In addition to the above, revolver debt is extremely useful for working capital management as well as for managing other circumstances where cash needs to be paid up front, but revenue isn’t fully collected until later on.
Working capital management deals with a business’ cash conversion cycle. When a business buys inventory, that cash is tied up until that inventory is ultimately sold to and paid for by the customer. Some businesses have a gap in between when they need to pay for inventory or supplies and when they get paid by their customers. This is known as a working capital funding gap.
This funding gap can be extremely challenging for some businesses, especially the ones that need to pay suppliers up front, but offer customers financing options, potentially greatly increasing the time from when they need to pay cash out, to when they receive cash back from their customers.
Working capital funding gaps are a key focus point in the business turnaround process as they can result in huge outflows of cash. Often businesses can manage a large working capital funding gap over long periods of time only to find increased competition, increased supplier costs, or other marketplace changes can quickly get a business with a long working capital funding gap into serious hot water.
Businesses can also run into the same issue, albeit in a different light, with their hiring process.
Hiring top talent is a process and it can be an expensive one. When a business needs to pay recruiters to hire people that will then need training before they can generate cashflow for the business—the business can run into the same problem from a different angle. If a company hires a new salesperson and owes $25,000 to a recruiter at the time of hiring, but it takes them 90 days to train the new sales rep, then they have a period where cash leaves that can’t be made back until the new hire is trained.
To further drive this point home, the cost of a bad hire is high. Companies often hire a person, train them, and then measure performance. So, if the employee doesn’t work out, they have to repeat that process with another new hire. Both the high costs, the extended periods of time, and employee attrition rates can make hiring top talent a frustrating bottleneck for some businesses.
In light of these examples, it’s easy to see why both working capital funding gaps and other instances that result in cash flowing out long before it comes back in can benefit greatly from revolving lines of credit. When cash flows out, they can use the revolving line of credit to help them finance the gap—and when cash comes in from sales, the business can then use that money to pay down the line of credit.
Now that we’ve explained the value and the usefulness of revolving lines of credit, this guide will look at who provides revolver debt to a business and what these arrangements can ultimately cost a business owner.
Revolver debt is provided by commercial banks directly to businesses. A business would apply for a line of credit directly with their bank and typically pay an application fee of between $100 to $200.
Once they are approved, this line of credit can be accessed very quickly—in as little as a few business days. This speed to financing is another advantage of revolving lines of credit, as quick access to cash can be important to a small business. This speed to financing is made possible because the revolving line of credit is typically issued by the same bank the business already has a checking account with.
Revolving lines of credit typically have annual maintenance fees of between $100 and $250 and this is charged to the business owner in addition to any interest paid when borrowing against the line of credit.
Revolving lines of credit are usually structured as fixed-rate loans. Interest rates on revolving lines of credit are typically calculated as: Bank rate + x% (or LIBOR + x%). The interest rates are usually between 2 and 5 percent but can go as high as 20 percent.
Revolving lines of credit are usually for between $50,000 and $1,000,000 depending on the financial strength of the business. Typically, lines of credit are negotiated on factors that include the length of time in business and the strength of their cash conversion cycle. Revolving lines of credit can be for more than $1,000,000 for larger, more established businesses with stronger cash conversion and a proven track record.
According to the Federal Reserve there is currently $1.162 trillion in outstanding revolving credit available to businesses. As of September 2022, revolving credit had increased at an annual rate of 12.9 percent as compared to the previous year.
[ source: Federal Reserve November 7, 2022 ]
