A new innovation in the Indian banking during the last decade is the growing role of
commercial banks in the field of long term industrial finance. Though the medium and long term loans are popularly known as term loans, are provided by specialized financial institutions specially set up for this purpose, participation of the commercial banks in this type of financing was felt necessary because of their network of their branches and their intimate collection with the borrowing concerns, which facilitates close follow up and supervision. The business of term lending also known as developmental banking has gradually developed in India with the effect that the entire pattern of industry financing in India has changed beyond recognition.
What it is: Term loans typically carry fixed interest rates, monthly or quarterly repayment schedules and a set maturity date. Bankers tend to classify term loans into two categories.
(1) Intermediate-term loans: Usually running less than three years, these loans are generally repaid in monthly installments (sometimes with balloon payments) from a business’s cash flow. Repayment is often tied directly to the useful life of the asset being financed, according to the American Bankers Association (ABA).
(2) Long-term loans: These loans commonly set for more than three years. Most are between 3 and 10 years, and some run for as long as 20 years. Long-term loans are collateralized by a business’s assets and typically require quarterly or monthly payments derived from profits or cash flow. These loans usually carry wordings that limits the amount of additional financial commitments the business may take on (including other debts but also dividends or principals’ salaries), and they sometimes require a profit set aside earmarked to repay the loan, according to the ABA.
Term loans, also referred to as term finance; represent a source of debt finance which is generally repayable in more than one year but less than 10 years. Even the maturity could be as long as 25 years. Term loans include medium term and long term loans that are raised from banks or financial institutions. The duration of the loan is from 3 to 10 years. Such loans are raised for expansion and modernization of the enterprise. They are employed to finance acquisition of fixed assets and working capital margin. Term loans are repayable in fixed monthly, quarterly or half-yearly installments and secured by term loan agreements between the borrower and the bank. The purpose of term loans may be for purchase of fixed assets such as land, construction of factory shed, acquiring machinery, movable or heavy machinery or both.
Bank term loans are the basic ‘vanilla commercial loan’. Theory typically carry fixed interest rates, monthly or quarterly repayment schedules and a set maturity date. The maturity date is typically more than one year but less than ten years. Bankers tend to classify term loans into three categories based on the pay back period.
The term loans are, depending upon the period of repayment, classified as short term, medium-term and long term loans.
1. Short Term Loans:
The loans which are generally repayable within a period of 36 months including moratorium period are called as short term loans.
2. Medium Term Loans:
The loans which are repayable in more than 36 months and less than 72 months are called medium term loans.
3. Long Term Loans:
The loans which are repayable in more than 72 months are called long term loans.
Some of the basic features of term loans:
1. Maturity: Term loans are generally for a period of 6 to 10 years. In some cases grace period of 1 to 2 years is also granted.
2. Direct Negotiation: Term loan is a private placement. It avoids underwriting commission and other flotation costs.
3. Formal Agreement: Such loans are provided on the basis of a formal agreement which contains the terms and conditions on which the loan is provided.
4. Project Appraisal: These loans are granted on the basis of a detailed appraisal of the project.
5. Security: Term loans are always secured. They are secured specifically by the assets acquired using term loan funds. This is called primary security. Term loans are also generally secured by the company’s current and future assets. This is called as secondary or collateral security.
Primary security is taken for the asset for which term loan is given.
Collateral security: Upto term loan of a certain amount, no collateral security is needed. For term loan more than that amount, minimum 30% to 35% security is needed. It depends on credit ratings of the borrower and relations of borrower with the bank.
Verification of Security:
A registered company has to register all its charges with the registrar of companies. Once a charge has been created on an asset, the lender can register the charge with the registrar of companies. Thus the security is verified.
Also the lender may create either fixed or floating charge against the firm’s assets. Fixed charges means legal mortgage of specific assets. Floating charge is a general mortgage (equitable mortgage) covering all assets.
Charge – may be defined as the transfer on an interest or right in the assets of a person in favour of a lender for the purpose of securing the repayment of loan.
First Charge and Second Charge:
Loans are granted to borrowers against securities. Sometimes a borrower might use the same asset for raising finance from two or more lenders. In this case the lender who has first lent to the borrower against the asset will have a right on the asset, before the second lender, in case of default. This is known as the first charge.
Only after the dues of the first lender are cleared, after selling off the asset, the second lender can claim his dues. This is known as the second charge. Generally the lender who has a second charge will price his loan higher, considering the fact that he has to bear a greater risk.
Fixed and Floating Charge:
Lenders lend money to borrowers against securities. A lender can have either a fixed or a floating charge on the securities. In case of a fixed charge, the lender can recover his dues from a certain predecided asset only, in case of a default by the borrower. On the other hand, a lender who has a floating charge can recover his dues from a gamut of fixed assets. The lender who lends on a fixed charge therefore has to bear higher risk than the one lending on a floating charge.
Lien: Lien is the right of retention. Right of retaining goods/securities until the debt due is paid off as per the statutory agreement. The term lien refers to the right of a party to retain goods belonging to another party until a debt due to him is paid. The lien can be of two types: particular lien, and general lien. Particular lien is a right to retain goods until a claim pertaining to these goods is fully paid. On the other hand, general lien can be applied till all dues of the claimant are paid.
Mortgage: Mortgage involves transfer of immovable property for securing payment. The possession of goods may or may not be handed over to mortgagee.
Hypothecation: Hypothecation means securing repayment against movable property. In hypothecation goods continue to remain in the possession of the owner. Generally, bank given loan against hypothecation of stock of raw-materials.
Pledge: Pledge means securing repayment by transferring possession of goods in favour of lender. Bank gives loan by keeping in possession of shares and debentures.
Pari Passu (with equal pace): On equal footing or proportionately. Paari-passu is equal rights over the asset by two lending institutions. It means equally, without preference. E.g. a series of debentures may be issued subject to the condition that they are to rank pari passu as a first charge on the property charged by the debentures.
For instance, a company may issue Series A debentures at 9.00 a.m. on the same day if it issues Series B debentures having a pari passu charge at 10.00 a.m. then Series B debentures will rank at par with Series A debentures and the debentureholders of Series B debentures will have equal and first charge on the company assets alongwith Series A debentureholders.
6. Restrictive Covenants:A financially weak firm attracts stringent terms of loan from lenders. The restrictive covenants may be catergorised as follows:
a. Asset-related covenants:
i. Borrowing company should maintain its minimum asset base.
ii. Minimum current ratio to be maintained.
iii. Not to sell fixed without the lender’s approval.
iv. Refrain from creating any additional charge on its assets.
b. Liability-related covenants:
i. Restrained from incurring additional debt.
ii. Repay existing loan.
iii. Reduce its debt-equity ratio by issuing additional equity and/or preference capital.
iv. Limits the freedom of promotes to dispose of their shareholding.
c. Cash flow-related covenants:
Restrain on the firm’s cash outflow by:
i. Restricting cash dividends.
ii. Restricting capital expenditures.
iii. Restricting salaries and perks of managerial staff, etc.
d. Control-related covenants:
i. Broad base Board of Directors.
ii. Appointment of nominee directors by financial institutions to safeguard the interests of financial institutions.
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