Introduction
The financial needs generated by the operation of the company have to do with the daily or productive activity of the company (customers, raw materials, in progress and finished goods, etc.). They are not easily predictable in terms of their exact volume, since, unlike what happens with investments in fixed assets, they do not derive from a specific decision, but from the evolution of the business.
The term short-term financing is used to refer to the satisfaction of financial needs derived from the operation of the company or short financial cycle. For example:
- If sales grow, the item of debtors (the credit granted by the company to customers) increases.
- If purchases grow, usually so does the supplier item (the credit granted to the company by suppliers).
- An increase in defaults implies a delay in the entry of funds into the company.
- A longer payment deferral granted to customers also creates financing needs for the company.
- A foreseeable shortage of raw materials will lead to the decision to store additional quantities of inventory, which will have to be financed.
When selecting a source of financing for these reasons, the type of asset being financed must be taken into account. In any case, the term for repayment of the debt incurred by the company when taking out the financing must be in accordance with the term in which the financed assets are converted into liquid money.
The different sources of negotiated financing available to finance working capital can be classified as follows:
- Related to debtor management. Its purpose is to advance the collection of part of the of debtors amount. It can be carried out through:
- Discount. The financial institution advances the company the amount of a claim against a customer, by assigning that claim to such institution. In addition, the financial institution carries out the collection procedure. For this reason, it receives an interest for the financing and a commission for the collection procedure.
- Factoring. Through factoring, the company assigns the claims it holds against its clients (normally documented in invoices) to a credit institution that takes care of their collection. However, the company can also be advanced the amount of the assigned credits, getting this way financing.
- Related to supplier management. By means of reverse factoring, an administrative-financial service conceived to manage the payment to suppliers, a company can delay the payment of its invoices if it deems it necessary, getting this way financing.
- Generic financing of working capital. The current account credit facility is the instrument specially designed for this purpose. It is a funding availability that can be used at specific times to finance working capital in any of its different circumstances, cash stress situations derived from the gap between collection and payment periods from customers and to suppliers, respectively, increases in production, financing to wholesale customers due to payment deferral, etc.
Definition
A current account credit facility is a contract by which the financial institution undertakes to make a certain credit limit available to its client, during an agreed period. Thus, the company gradually adapts the funds available to its real financing needs, withdrawing only those amounts that are necessary. The client must pay a series of interest for the amounts that they have drawn down (debit interest) or for a drawdown above the credit limit (overdraft interest). Similarly, in case of a credit balance in the credit account, the financial institution must pay interest in favour of the client (credit interest).
The agreed time, due to its purpose (financing of the trade cycle), does not usually exceed one year. This is so because in all financing the maturity term of a debt must always be in line with the maturity term of the asset that is being financed. The assets that make up the working capital usually become liquid in a period not exceeding one year.
Purpose
The generic purpose of a current account credit facility is to meet cash needs, that is, to cover a gap between collections and payments. All treasury budget is based on matching the expected collections and payments (suppliers, payroll, rent, general expenses, taxes, etc.). The difference between the expected collections and payments, combined with the cash balance, gives us the cash position at all times.
In this sense, throughout the operating cycle there are both positive and negative cash balances, which, in the latter case, must be financed.
The current credit account fulfils this function, covering the short-term resource deficit. This is so thanks to the distinctive element of current account credit facility, the existence of an available credit limit.
Distinctive element
The distinctive element of the current account credit facility is the existence of an availability of funds, that is, the possibility that the businessperson can use the specific amount that they need at all times, while the taken out amount remains undrawn in the form of a balance available for new drawdowns, if applicable. The current account mechanism on which your operation is based allows you not only to use the credit facility on one or more occasions, but also to make total or partial reimbursements, generating a new availability. In short, the current account credit facility contract is not terminated by the total or partial refund of its amount, but the client can draw down it again for the agreed period.
To the above, it must be added that the client pays interest only for the balance drawn down. This financing structure would be impossible to cover with the loan product.Since the loan amount to be financed must be fixed from the beginning, the borrower has to draw down the total amount granted and to pay the interest rate for the full amount of the amount borrowed.
As a counterpart to the permanent availability of funds in the current account credit facility, the undrawn amount of the credit facility generates a commitment fee. The fact that there is a commitment fee has a direct impact on the cost of credit facility as a source of financing, so it is convenient to set properly the limit of financial needs.
Characteristics of the current account credit facility
The current account credit facility agreement has the following characteristics:
- It is a contract of a commercial nature.
- It is a consensual contract. It is concluded by the mere consent of the credit institution, an aspect in which it is distinguished from the loan agreement, which is of a real nature (it is concluded with the delivery of the authorized amount).
- It is a bilateral contract. It generates obligations for both parties.
- It is an onerous contract. The client must pay the agreed interest and commissions.
- It is a generally standard-form contract. The creditor (credit institution) presents the borrower (client company) a pre-printed contractual form with standard content, except in their financial conditions.
- It is formalized in writing, in a document usually examined by a Notary Public.
Financial conditions
- Maximum amount available: Risk limit granted, according to the needs derived from the client’s activity and its economic-financial characteristics.
- Term: The current account credit facility is used to finance items of the current assets of the company with turnover terms, normally less than one year. For this reason, the current account credit facility does not usually exceed this annual periodicity in most cases.
- Interests: They are calculated by applying the corresponding interest rate (fixed or variable) on the average balance drawn down during the settlement period (usually quarterly). In variable-rate credit facilities, the most widely used reference, to calculate the applicable interest rate in Europe, is the Euribor at a term equivalent to that of the revision, which, like the settlement term, is usually quarterly. In this case, the three-month Euribor will be added the margin or spread agreed in the contract, to calculate the nominal interest rate. The contract must also include the APR.
- Overdraft interest rate: In the event that the credit institution allows the existence of temporary overdrafts above the maximum available amount contracted, there will be an interest rate applicable to such overdrafts. This interest rate for overdraft may be expressed as a surcharge on the contractual interest rate of the credit facility (for example, four percentage points above the agreed nominal annual interest rate).
- Chargeable commissions:
- Commitment fee: Consists of a percentage of the risk limit granted. It is charged at the beginning of the contract.
- Renewal fee: Similar to the commitment fee, applicable in case of renewal.
- Arrangement fee: It is specified as a percentage over the risk limit granted.
- Undrawn balance fee: Derived from the borrower’s right to have at all times certain resources that the credit institution makes available to them. It is applied to the average balance not drawn down in each payment period.
- Overdraft balance fee: Applicable only when the maximum amount available is exceeded and provided that such possibility be contractually contemplated (in which case, it will also be charged an overdraft interest rate). It consists of applying a certain percentage on the highest overdraft balance that the account presents in the payment period.
- Transaction fee: For each entry made in the account.
- Claims fee: To be paid in the event of any claim in relation to the current credit account.
- Administration fee: Derived from the fact of keeping a current credit account open and operational.
Obligations of the credit institution
The essential obligation of the credit institution is to make available to the client, and deliver at their request, the funds committed within the established time limits, amount and manner of use. This obligation translates in services such as:
- Deliver the amounts requested by the borrower in cash.
- Pay in the name and on behalf of the borrower, upon order, the debts undertaken by them (invoices, receipts, etc.).
- Direct debit payments.
- Transfers.
- Pay the cheques that the borrower draws under the current credit account.
Obligations of the borrower
The borrower is obliged to pay the agreed commissions and, once they have made drawdowns under the credit, through one or successive cash advances by the credit institution, to repay the total amount received within the agreed period of time (normally at maturity), and pay the interest for the amounts drawn down.
Credit facility renewal
When the credit facility fulfils its function correctly, the normal thing is that when it expires, it will be necessary again to continue financing needs derived from the trade cycle of the company, so its renewal is usually considered.
The continuation of the contractual relationship can be carried out through the termination of the existing contract and the conclusion of a new one (novation extinguishing the original contract), or through an extension agreement prior to the expiration date (amending novation or renewal).
Through the renewal, the credit institution and the borrower agree that the initial conditions will remain for a new period, with a possible adaptation of the financial conditions.
There is a third possibility of extension in the current account credit facility agreement, the automatic extension. According to this type, if the borrower does not request the cancellation of the credit facility prior to its expiration, the contract is understood to be extended under the same conditions for one more period.
Termination of the contract
A cause for resolution may be the unilateral revocation by the credit institution, which may be motivated by the breach of any payment obligation by the borrower, or derive from situations in which there is a decrease in the debtor’s solvency, causes of resolution usually provided for in the contract.
Formalization
Although it can be concluded in a public deed, it normally takes the form of a credit facility agreement, which, once supervised by a Notary Public, allows the financial institution to claim in executive proceedings.
The agreement reflects the operation of the credit facility, which uses a current account as a mechanism, where will be received the credit payments and deposits that are made and the debits entries for credit drawdowns. The account balance will be the one resulting from the difference between both entries (credit balance, if it is in favour of the borrower and debit balance, if it is in favour of the institution).
In the event that the current credit account has a credit balance, the financial institution will pay interest in favour of the account holder in the agreed amount.
On the contrary, the debit balances that result daily against the borrower will accrue interest in favour of the credit institution that granted the credit facility, at the fixed annual nominal rate. Interest is calculated based on a 360-day business year or a 365-day calendar year.
The formula to calculate, from the nominal interest rate, the absolute amount of accrued interest is as follows (in the case of business days): (C x R x T) /36,000, where C is the capital, R is the annual rate of interest (expressed as a percentage) and T time in days. If the interest rate is expressed in times one: (C x R x T) / 360.
Liquidation of the current credit account
In order to illustrate the liquidation of a current credit account, a transaction with the following financial conditions and a quarterly payment of interests will be considered:
| Maximum amount available: 30,000 c.u. Debit interest rate: 5.00% (annual) Origination fee: 1.00% Commitment fee: 0.15% quarterly |
The credit facility drawdown (debit balance) throughout the first quarter is as follows (amounts in c.u.):
| Debit balance | Days | Commercial days drawdown amount |
| 300 | 1 | 300 |
| 9,300 | 11 | 102,300 |
| 25,800 | 15 | 387,000 |
| 15,300 | 9 | 137,700 |
| 1,500 | 20 | 30,000 |
| 12,000 | 15 | 180,000 |
| 23,500 | 19 | 446,500 |
| Total | 90 | 1,283,800 |
The column “days” expresses the number of days that the corresponding debit balance remains. The commercial days drawdown amount are derived by multiplying the drawn balance or debit balance by the number of days that such balance remains.
In the example, the 300 c.u. of the first drawdown would correspond to the origination fee (1.00% of the 30,000 c.u. limit amount).
The average balance drawn down for the quarter would be 14,264 c.u. (the sum of the commercial days drawdown amount divided by the 90 days in the quarter).
The amount the borrower will pay for interest is 178.30 c.u. This calculation is carried out using the formula mentioned in the previous section: Interest payable = (14,264 x 0.05 x 90) / 360.
The average undrawn balance would be the difference between the authorized risk limit (30,000 c.u.) and the average drawn balance (14,264 c.u.), that is, 15,736 c.u. For this undrawn average balance, the borrower pays a quarterly commission of 0.15%, that is, 23.60 c.u.
Risk in credit facility transactions
In any credit facility transaction, it is a matter of advancing funds that are self-liquidating by the borrowing company, so the repayment capacity depends directly on the company’s own activity.
A current account credit facility is characterized by financing a need that might be called recurring, so renewals of the authorized risk limit are usually normal. However, on certain occasions it can become a covert permanent financing maintained through renewals. This fact is usually manifested by the permanence of a level of drawn down balance below which no reduction is observed. That is, the credit facility does not show the balance fluctuations that are typical of this type of financing.
