Line of Credit

By definition, a line of credit is a prearranged loan between an organization and a lender, from which an organization can borrow at will up to a maximum loan amount.1 Terms of the line of credit vary from case to case but are often short in duration, with repayment of principal and interest accrued within a year. A line of credit is often used to shelter the organization from short-term drops in revenue or periodic spikes in operating expenses. Under such conditions, “drawing down” the line of credit allows an organization to continue normal operations by funding fixed and variable operating expenses despite a scarcity of available cash.

For instance, a hospital may have a short-term drop in revenue collections caused by change in insurance providers for a major employer within its patient service area. If the hospital is unable to reduce its costs in a timely manner, a shortfall in available cash may result. This situation may provide optimal use of a line of credit to fund normal operating costs until reimbursement for patient services returns to normal or changes in the organization can reduce operating expenses to a point that generates a positive cash flow. However, if the hospital borrows the maximum amount under the line of credit or revolving credit agreement, the lender may chose to deny the hospital an extension of credit under the prearranged agreement until the balance is paid. This scenario may force the hospital to search for alternate means to finance operations.

A line of credit is assigned to financial statements as a note payable and is thus considered a liability for the organization. Large organizations such as health systems and medical insurers may often need to utilize a line-of-credit hedge against sizable swings in cash flow. Large lines of credit are often called “revolving credit” or a “revolver.” Under circumstances where a large “revolver” is outstanding, a syndication of financial institutions may fund a portion of each draw. Therefore, the risk of a large drawdown will be spread among a number of financial institutions, leaving no one institution at risk for the full amount.

As a rule of thumb, the interest rate on a revolver or line of credit is pegged to the prime rate, a specified Treasury bill rate, or other common interest rate indicators.1 Under each arrangement, the interest rate is delineated as fixed, variable, or otherwise determined by the amount of borrowings. An important difference between a revolver and a line of credit is that the revolver is a legal obligation of the bank, whereas a line of credit is not. In addition, a line of credit may have a “cleanup clause” stating that the account must carry a zero balance for a cumulative term over the life of the agreement. This cleanup clause ensures that this financing vehicle will not become a permanent source of funds for the organization.2

[Page 327]Although a line of credit allows flexibility for an organization to manage cash flows, it may also leave an organization at risk. Variable interest rates often fluctuate in response to general economic conditions. If economic conditions deteriorate over a period for which an organization has drawn on its line of credit, then the interest rate may rise on the organization' outstanding balance. If the organization is experiencing financial difficulties during this time, and the organization has a great deal of outstanding debt, then a large increase in short-term interest rates could force a company into bankruptcy.

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