Determining the Right Size for Your Company’s Revolving Credit Facility: A Guide to Liquidity Management
Key Takeaways
A revolving credit facility provides critical capital for short-term funding needs like day-to-day operations and working capital requirements
Longer-term growth initiatives like new funding product development, acquisitions, or paying dividends to shareholders can also be financed through a revolving credit facility
Determining the right size for a revolving credit facility requires a detailed understanding of both short-term and long-term capital requirements
Companies without access to adequate capital might miss new growth opportunities, experience increasing competition, or face financial distress or bankruptcy
Scenario analysis and contingency planning is critical, because lenders tighten access to credit in challenging business and market environments
Due to the cost of excess liquidity, it is possible to have “too much” liquidity
Credit Facilities are Critical Tools for Managing Liquidity
As a CFO or corporate finance professional, one of your most important roles is to maintain access to capital and a steady source of liquidity for your company. A revolving credit facility, set-up with a bank or financial institution, is an effective tool for managing both short-term and long-term liquidity needs. A revolving credit facility can provide the capital needed to fund day-to-day operations and working capital requirements. It can also be used to fund organic growth initiatives, acquisitions, dividends to shareholders, and shareholder buyouts, as well as refinance other debt instruments.
A credit facility is a flexible type of corporate debt financing that allows businesses to borrow money to fund operations. While debt financing comes at a cost, companies that lack access to additional capital are likely to miss new market opportunities, experience increasing competitive pressure and, in extreme cases, face financial distress or bankruptcy. To balance the cost and benefit of obtaining and maintaining access to a revolving credit facility, CFOs and corporate finance professionals must understand their company’s short-term and long-term liquidity requirements and obtain a credit facility that properly reflects their funding needs.
But what size of revolving credit facility is right for your company? This deep dive into measuring short-term and long-term liquidity needs will help you answer that question.
Plan for Short-Term Working Capital Requirements and Long-Term Growth Initiatives
The first step in sizing the revolving credit facility is to project the cash flow needs of the business through the expected maturity of the new revolving credit facility. Think through short-term (less than one-year) working capital requirements and long-term (three to five years) growth initiatives.
The cash flow projection should take into consideration:
Capital expenditures
Investments in new business / product lines
Acquisitions
One-time costs related to operational improvements or restructuring
Upcoming debt maturities
Expected shareholder distributions
Other short-term and long-term cash needs
Cash flow modeling should take the form of a three-statement model with accompanying debt and interest schedules.
Prepare a Short-Term Liquidity Analysis
First, model your monthly cash flow needs over a twelve-month period to determine the amount of liquidity you need to manage the day-to-day working capital requirements of your business. For highly seasonal businesses or businesses that are growing rapidly, monthly forecasts that extend twenty-four or thirty-six months may be necessary.
The following is an example of a company experiencing strong revenue growth and steady margins. The company builds inventory throughout the year (reflected in current assets) in anticipation of a significant increase in year-end activity.
To build and hold inventory necessary to meet seasonal demand, the cash needs of the business expand significantly. Without the detailed monthly view of working capital requirements, the CFO of this company could significantly underestimate the required size of a revolving credit facility to fund working capital needs.
The company’s short-term liquidity requirement builds throughout the year as they increase inventory and reaches a maximum of $70 million in month 10.
Prepare a Long-Term Liquidity Analysis
Next, model your annual cash flow needs for the duration of the credit facility, at least three to five years. While it can be more challenging to predict longer-term revenue and expenses with accuracy, the company should build a reasonable forecast and incorporate all known cash inflows and outflows. In this example, the business is ramping up capital expenditures to support future growth and will make two earn-out payments from a prior acquisition. The company pays a regular dividend to shareholders and has upcoming debt maturities that need to be addressed as part of this refinancing. Despite a strong underlying cash flow profile, near-term investments will require that the company increase the size of the new credit facility to support growth.
Note: This analysis above does not consider financing fees or pro forma interest expense from the refinancing which will impact the cumulative cash requirement
Not taking into account the longer-term needs of the business, including a $200 million debt maturity in year two, as well as capital requirements to fund growth initiatives could leave the company without adequate resources.
The short-term working capital requirements and long-term capital needs should form the basis for the sizing of the credit facility. Conventional wisdom is that short-term capital requirements should align with short-term funding sources (revolving credit facility) and long-term capital requirements should align with long-term funding sources (term loan, bonds, etc.).
In the illustrated example, the CFO needs to have at least $70 million of short-term liquidity to meet seasonal borrowing needs and at least $230 million of capital to meet long-term cash flow requirements. After giving consideration to contingency planning, the total size of the credit facility, including the revolver, should be greater than $300 million.
In addition to the long-term and short-term funding needs, consideration should be given to the amount of total debt and implied leverage levels, assuming a fully funded revolver. Banks and lenders will take this into consideration when determining the risk profile for the loan and pricing levels.
Perform Scenario / Contingency Planning
Scenario / contingency planning is important to perform prior to finalizing a revolving credit facility. The planning should evaluate an upside scenario and a downside scenario to evaluate the impact of those on the company’s cash flow and liquidity.
Lenders are most willing to extend credit when companies (borrowers) are performing well and when the broader economy and market are strong. When borrowers begin to struggle, lenders will look for opportunities to limit potential losses by increasing pricing, reducing funded and unfunded debt, and tightening operational controls through financial covenant negotiations.
Scenarios will be as unique as your business, and a revolving credit facility is a great flexible funding instrument meant to meet these cash flow fluctuations. Just be sure to project some of the most common scenarios in your industry and for your company, then work those through your short-term and long-term projections to see how they impact your capital requirements.
Some scenarios may include:
Inventory sells faster than expected causing an increase in short-term cash. However, to avoid stock-outs, your company may have to pay more per unit to rush additional production to keep up with demand
Conversely, inventory sells more slowly than expected, causing a shortfall in cash and an increase in carrying and inventory storage costs
The company’s planned growth capital expenditures for an upcoming product launch are not as high as planned as your team was able to leverage AI in rapid product prototyping, causing a decrease in future capital expenditures
Alternatively, the upcoming product launch is more expensive than anticipated as the company had to hire more product developers and production costs increased. This causes an increase in both short-term and longer-term capital requirements
We also recommend performing scenario / contingency planning during annual budgeting and whenever there is a fundamental change in the business or market environment to ensure that your business will have sufficient liquidity going forward and that you will remain in compliance with credit facility covenants.
Big Enough, but not too Big: Excess Liquidity has a Cost
Most of this perspective has focused on securing a credit facility that is large enough to meet the short-term and long-term liquidity needs of your business. But there is a limit.
If lenders perceive that a company has too much debt capacity, even though it may not all be fully drawn at closing of the credit facility, it can increase the risk profile of the borrower and increase the pricing of the loan. Increases in the pricing of the funded portion can have a big impact on cash flow and on interest coverage or fixed charge coverage ratios (FCCR), two common covenants that borrowers must adhere to in their lending agreement. In addition, there is a carrying cost associated with the portion of a revolving credit facility that is not used. This is often 50 basis points (0.5%) on the undrawn portion. Therefore, it is a critical job of the CFO and other finance professionals to size the revolving credit facility appropriately to avoid unnecessary costs on the business.
An Independent, Third-Party Financial Advisor Can Help
A financial advisor, like Keene Advisors, can help you to evaluate your current and projected financial performance, perform short-term and long-term liquidity analysis, run scenarios and plan for contingencies. All these elements will help determine the optimal revolving credit facility for your business.
Keene Advisors is experienced in advising companies on a wide range of leveraged finance transactions and corporate finance matters. Our team has advised clients in connection with over $20 billion of financing commitments and corporate debt capital-raising transactions. We have helped clients fund organic growth, dividends to shareholders, buyouts of existing shareholders and acquisitions, as well as to refinance existing debt. In addition, our team has advised clients on credit agreement amendments, operational and balance sheet restructurings, and a range of bankruptcy-related matters.
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