The term loan is a long-term secured debt extended by banks or financial institutions to the corporate sector for carrying out their long-term projects maturing between 5 to 10 Years which is normally repaid in monthly or quarterly equal installments. They are an external source of finance paid in installments governed by loan agreements and covenants.
All the capital requirements cannot be fulfilled by the promoters or equity share issues, and that is where the term loans come into the picture. A term loan or project finance is a long-term source of finance and a credit appraisal for a company. It is normally extended by financial institutions or banks for more than 5 years to a maximum of around 10 years. One common feature which helps management in relatively substituting equity with term loans is the long term of the loan.
The term loan is the most suitable type of funding for projects involving hefty investments, which is not possible by an individual or promoters. Big projects cannot be concluded in a year or two.
To yield a return from them, a long-term perspective is required. Big banks and financial institutions normally finance such big ventures. If the investment is too large, several banks come together and finance it. Such type of term loan funding is also called a consortium loan.
The term loan is acquired for new projects, diversification of business, expansion projects, or modernization or technology upgrades. Here also, the underlying fact is that the investment in these projects is normally very huge. Lack of option of funding from other sources such as equity etc., for any reason also directs a company to go for the term loan.
Financial Leverage and Term Loan
At times, an important reason for selecting a term loan is financial leverage. By opting for debt finance like a term loan, a company tries to magnify the returns to their equity shareholders. This helps a company’s management achieve the core objective of wealth maximization for its shareholders and preserve the control and share of existing shareholders.
Features of a Term Loan
Loan in any Currency
These loans are provided both in the home or foreign currency. Home currency loans are generally offered to purchase fixed assets such as land, building, plant and machinery, preliminary and preoperative expenses, technical know-how, working capital, etc. On the other hand, foreign currency loans are offered to import certain plants or machinery, payment of foreign consulting fees, etc.
Term loans come under the secured category of loans. Two kinds of securities are there – primary and collateral. Primary security is the asset purchased using the loan amount, and collateral security is the charge on other assets of the borrower.
Repayment of the loan is made in installments. These installments cover both principal and interest. Typically, loan installments are decided by banks based on the borrower’s cash flow capacity. Installments may be paid monthly, quarterly, biannually, or even annually. Installments usually are equal, but they may be structured based on the borrower’s business. A moratorium or grace period is also given by banks in which no installment or very low installment is asked from the borrower. Sometimes, small installments are kept in the initial year or two, and then the remaining loan is split into the remaining maturity period. And making the later installments higher than the initial ones.
Normally a term loan ranges between 5 to 10 years. Forecasting for more than 10 years in the current changing business environment is very difficult.
An agreement is drafted between the borrower and the bank regarding the terms and conditions of the loans, which are signed by the borrower and are preserved with a bank.
Debt covenants are a part of a loan agreement. They are certain statements in the contract that state certainly do’s, and dont’s for the company. And these are related to the use of assets, the creation of liabilities, cash flow, and management control. They are positive/ affirmative or negative in nature.