including acquisitions of other companies, are typically
financed with term loans covering periods of one to 10 years,
with terms between three and five years being the most common.
Term loans are designed to finance a major cash outlay
and spread the repayment of the loan, including interest, over
a period of time roughly corresponding with the cash flow that
will be available to service the debt. Permanent increases in
working capital, such as those that may arise from entering
new markets, may also be financed in this way.
Term loans are usually tailored to the needs of the borrower,
so no two are exactly alike. However, these loans typically
include a common set of terms and conditions. Besides
the obvious elements required in any loan contract, such as the
interest rate and the payment period, borrowers are subjected
to a series of covenants that mandate certain actions while
prohibiting others. For example, the contract may specify that
the borrower agrees to continue in essentially the same business
over the term of the loan, to grant the bank access to its
books, and to maintain adequate insurance. Submission of financial
statements on a regular basis will also be required. In
addition, the borrower may be prohibited from taking on
other debts without the bank’s consent.
It is also common for banks to impose certain financial tests
on the borrower. For example, the company will be required to
maintain minimum levels of working capital and not to exceed
maximum levels of indebtedness, lease obligations, and dividend
payments. There may also be constraints imposed on the
pay raises that are granted over the loan period to certain corporate
employees. Failure to meet any of these requirements
will put the borrower in “technical default.” This means that
even if all interest and principal payments are made on time,
the company has still violated the loan contract. As a result, the
borrower may be required to renegotiate the debt, with new
terms that are certain to be more onerous and expensive than
the original contract. For many banks, technical defaults are
more common than borrowers defaulting because of their inability
to make the required cash payments.
Another popular form of bank lending is the “revolving
credit,” which combines elements of term loans and lines of
credit. These are formal agreements that require the bank to
lend money provided the borrower is not in default on any of
the terms and conditions in the agreement. The terms and conditions
of the loan are extensive, and the bank expects a commitment
fee in exchange for the service. As with lines of credit,
revolving credits are used mostly for funding working capital.
But there are two important differences. First, the term for revolving
credits can be far longer than for informal lines of
credit, with one, two, or three years being the most common.
Second, revolving credits are not subject to the “cleanup” provision
that is a normal requirement for unsecured lines of
credit. Under a cleanup, typically invoked on an annual basis,
the borrower is expected to pay off all outstanding borrowings.
The cleanup is designed to demonstrate that a company’s need
for the bank’s funds is only temporary and that it has adequate
capital resources to operate the business. Secured lines of credit
don’t follow this practice because the collateral pledged against
the loan is considered sufficient protection for the bank. Likewise,
revolving credits don’t require cleanup. Instead, the borrower
expects to be on the bank’s books for the entire term of
the agreement. But just as for any line of credit, banks insist on
commitment fees before agreeing to revolving credits.
Read More : Long-Term Loans
