Term Loans from Financial Institutions and Banks
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 installment. 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 picture. Term loan or project finance is a long term source of finance for a company normally extended by financial institutions or banks for a period of more than 5 years to a maximum of around 10 years. One common feature which helps management in relatively substituting equity by term loans is the longer term of the 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 its equity shareholders. This helps the management of a company achieve the core objective of wealth maximization for its shareholders and also preserve the control and share of existing shareholders.
Features of a Term Loan:
1. Loan in any Currency: These loans are provided both in-home or foreign currency. Home currency loans are offered normally for the purchase of 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 for the import of certain plants or machinery, payment of foreign consulting fees, etc.
2. Secured Loan: Term loans come under the secured category of loans. Two kinds of securities are there – primary and collateral. Primary security is the asset that is purchased using the loan amount and collateral security is the charge on other assets of the borrower.
3. Loan Instalments: Repayment of the loan is done in installments. These installments cover both principal and interest. Normally, loan installments are decided by banks based on the borrower’s cash flow capacity. There may be installments paid monthly, quarterly, biannually, or even annually. Installments are normally equal but they may be structured based on the borrower’s business. 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 making the later installments higher than the initial ones.
4. Maturity: Normally a term loan is ranging between 5 to 10 years. Forecasting for more than 10 years in the current changing business environment is very difficult.
5. Loan Agreement: 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 the bank.
6. Loan Covenant: Covenants are a part of the loan agreement. They are certain statements in the agreement that state certainly do’s and dont’s for the company. They are normally related to the use of assets, creation of liabilities, cash flow, and control of the management. They are positive/affirmative or negative in nature.