What is a Term Loan? Features and Restrictive Covenants

term loan

What is a Term Loan?

Term Loan represents the long term debt having the maturity period of more than one year. Companies either obtained them from banks or especially created financial institutions for the same purpose. The purpose of the term loan is to finance the company’s capital expenditure.

Debt Capital of a company may consists of either debentures or bonds which are issued to public for subscription or term loans which are obtained directly from banks and financial institutions. Term loans are sources of long term debt. In India, main purpose of obtaining them is to finance large expansion, modernization or diversification projects. Therefore, this method of financing is also known as project financing.

Features of Term Loan

Security – Term loan are always secured. Company’s current assets and future assets are often used to secure them. This is called second or collateral security. Also, the lender may create either fixed or floating charge against the firm’s fixed assets. Fixed charge refers to legal mortgage of specific assets.

Direct negotiation – A firm can also negotiate these types of loans. Firm’s negotiate for project finance directly with a bank or FI. This makes the term loans a private placement. The advantage of private placement are the ease of negotiation and low cost of raising loan.

Maturity – Banks and FIs are the main sources of long term loans in India. FIs provides loan for a period of 6 to 10 years. On the other hand commercial banks provides the term loan for a period of 3 to 5 years.

Restrictive Covenants in Term Loan

In addition to the security, lender likes to protect itself further. Therefore, FIs add a number of restrictive covenants. A financially weak firm attracts the stringent terms of loan from lenders. The borrowing company has generally to keep the lender informed by furnishing financial statements and other information periodically. The restrictive covenants may be categorized as follows –

Asset Related covenants – Lender would like the firm to maintain its minimum asset base. Therefore, restrictions may include to maintain minimum working capital position in terms of minimum current ratio and not to sell fixed assets without lender’s approval. The firm may be also be required to refrain from creating any additional charge on its assets.

Liability related covenants – The firm may be restrained from incurring additional debt or repay existing loan. It may be allowed to do so with the concurrence of the lender. The firm may also be required to reduce its debt-equity ratio by issuing additional equity and preference capital. The freedom of promoters to dispose of their shareholding may also be limited.

Cash flow related covenants – Lenders may restrain the firm’s cash outflows by restricting cash dividends, capital expenditures, salaries and perks of managerial staff, etc.

Control related covenants – Lenders expect that the firm’s management will be competent enough to manage its operations. They may therefore provide for the effective organisational set up and appointment of suitable staff and the broad base Board of Directors.

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