Term Loans
Firms obtain long-term debt mainly by raising term loans or issuing debentures. Historically, term loans given by financial institutions and banks have been the primary source of long-term debt for private firms and most public firms. Term loans, also known as term finance, are a source of debt finance, which is repayable in less than 10 years. They are used to finance acquisition of fixed assets and working capital margin. Term loans differ from short-term bank loans. Short-term bank loans provide finance short-term working capital needs.
FEATURES
Following are the features of Term loans:
.Currency
.Security
.Negotiated
.Interest payment and principal repayment
.Restrictive covenants
Currency
Financial institutions offer rupee Term loans and foreign currency term loans. The most significant form of assistance provided by financial institutions, rupee term loans are given directly to industrial concerns for setting up new projects as well as for expansion, modernization, and renovation projects. These funds are provided for incurring expenditure for land, building, plant and machinery, technical know-how, various fixed assets, preliminary expenses, and pre-operative expenses.
Many financial institutions offer foreign currency term loans to meet the foreign currency expenses towards import of plant & machinery and payment of foreign technical know-how fees. The periodical liability for interest and principal remains in the currency / currencies of the loan and is translated into rupees at the prevailing rate of exchange for making payments to the financial institutions.
Security
Term loans typically represent secured borrowing. Term loans provide prime security of assets.
All loans with interest charges, liquidated damages, commitment charges, and expenses are secured by way of:
.Equitable mortgage of all immovable properties of the borrower;
.Hypothecation of all movable properties of the borrower, subject to prior charges in favor of commercial banks for obtaining working capital advance in the normal course of business.
Negotiated
The borrowers and the lenders negotiate on payment details. They are similar to private placement of debentures as compared to their public offering to investors.
Interest Payment and Principal Repayment
The interest and principal repayment on term loans are definite obligations that are payable irrespective of the financial situation of the firm. To the general category of borrowers, financial institutions charge an interest rate that is related to the credit risk of the proposal, subject to a certain floor rate.
Financial institutions impose a penalty on the borrowers who turn default. For default in repayment of installments of principal; the borrower is liable to pay by way of liquidated damages, additional interest at the rate of 2 percent per annum for the period of default on the amount of principal in default. In addition to interest, lending institutions levy an upfront fee on the sanctioned loan amount usually at the rate of one percent.
The principal amount of a term loan is generally repayable over a period of 4 to 7 years after an initial grace period of 1 to 2 years. Term loans are repayable in equal semi-annual installments or quarterly installments.
Note that the interest burden declines over time, whereas the principal repayment remains constant. This pattern of debt servicing burden differs from the pattern obtaining in western economies where debt is typically amortized in equal periodic installments.
The latter pattern is relatively more acceptable to borrowers because it does not result in a heavy debt-servicing burden in earlier years. However, financial institutions in India do not follow the scheme of equal periodic amortization. Yet, they try to ensure, by suitable modifying the debt repayment schedule, within limits, that the debt-servicing burden is not very onerous.
Restrictive Covenants
In order to protect their interest, financial institutions impose restrictive conditions on the borrowers. While the specific set of restrictive covenants depends on the nature of the project and the financial situation of the borrower, loan contracts often require that the borrowing firm:
Broad base its board of directors and finalize its management set-up in consultation with and to the satisfaction of the financial institutions.
Arrange to bring additional funds in the form of unsecured loans.
Refrain from undertaking any new project and / or expansion or make any investment without the prior approval of the financial institutions.
Obtain licenses from various government agencies.
Abstain from additional borrowings.
Further, loan agreements impose restrictions on the transfer of shareholdings by promoters / associates.
TERM LOAN PROCEDURE
The procedure associated with a term loan involves the following steps:
.Submission of Loan Application
.Initial Processing of Loan Application
.Appraisal of the Proposed Project
.Issue of the Letter of Sanction
.Fulfillment of the Terms and Conditions
.Execution of Loan Agreement
.Creation of Security
.Disbursement of Loans
.Monitoring
Submission of Loan Application
The borrower submits an application form that seeks comprehensive information about the project. The application form entails the following details:
.Promoters' background
.Particulars of the industrial concern
.Particulars of the project
.Cost of the project
.Means of financing
.Marketing and selling arrangements
.Profitability and cash flow
.Economic considerations
.Government consents
Initial Processing of Loan Application
When the application is received, an officer of the financial institution reviews it to ascertain whether it is complete for processing. When the application is considered complete, the financial institution prepares a 'flash report', which is essentially a summarization of the loan application. On the basis of the 'Flash Report', it is decided whether the project utilizes a detailed appraisal or not.
Appraisal of the Proposed Project
The detailed appraisal of the project covers the marketing, technical, financial, managerial, and economic aspects. The appraisal memorandum is usually prepared within two months after site inspection is done. On the basis of the memorandum, a decision is taken to accept or reject the project.
Issue of the Letter of Sanction
On the project approval, a letter of sanction is issued to the borrower. This communicates to the borrower the assistance sanctioned and the terms and conditions relating thereto.
Acceptance of the Terms and Conditions by the Borrowing Unit
On receiving the letter of sanction from the financial institution, the borrowing unit convenes its board meeting at which the terms and conditions associated with the letter of sanction are accepted and an appropriate resolution is passed to that effect. It has to be conveyed to the financial institution within a stipulated period that the terms and conditions have been agreed upon.
Evolution of Loan Agreement
On receipt of letter of acceptance, the financial institution sends the draft of the agreement to the borrower to be executed by authorized persons and properly stamped as per the Indian Stamp Act, 1899. The agreement, properly executed and stamped, along with other documents as required by the financial institution must be returned to it. Once the institution signs the agreement, it becomes effective.
Creation of Security
The term loans and the deferred payment assistance are secured through the first mortgage, by way of deposit of title deeds, of immovable properties and hypothecation of movable properties.
Disbursement of Loans
Periodically, the borrower is required to submit information on the physical progress of the projects, financial status of the project, financial resources, promoters' contribution, estimated funds flow statement, compliance with various statutory requirements, and fulfillment of the pre-disbursement conditions.
Monitoring
The project is examined at the implementation stage and at the operational stage. At the stage of implementation, the project is examined with the help of:
.Regular reports
.Periodic site visits
.Dialogue with promoters, bankers, suppliers, trial production, etc
.Progress reports
.Audited accounts of the company
During the operational stage, the project is monitored with the help of:
.Quarterly progress report on the project
.Site inspection
.Reports of nominee directors
.Comparison of performance with promise
REPAYMENT SCHEDULE / LOAN AMORTIZATION
The term loans have to be amortized according to predetermined schedule. The payment / repayment has two components:
Interest - The interest component of loan amortization is a legally enforceable contractual obligation. The interest on term loans is subject to a minimum prime lending rate.
Repayment of principal - Typically, the principal is repayable over 6-10 years period after an initial grace period of 1-2 years. Whereas the mode of repayment of term loans is equal semi-annual installments in case of institutional borrowings, the term loans from banks are repayable in equal quarterly installments.
EVALUATION
Term loans offer both merits and demerits for the borrower and the lenders.
| |
From the perspective of borrowers, term loan offer all the advantages and disadvantages associated with debenture financing. An additional demerit is that term loan contracts contain restrictive covenants restricting managerial freedom. The right of lenders to nominate directors on the board of the borrowing company may further restrict managerial discretion.
Similarly, the term loans provide all the advantages and disadvantages of debenture financing to the lending institutions together with the additional benefit of restrictive covenants to protect their interests. Term loans do not include negotiable securities.
To conclude, term loans carry low cost and involve high risk. There is no adverse effect on control but there is moderate restraint on managerial freedom.
Related Articles:
Loans
Easy
Loans Company
Loans Business
