For many companies, a term loan will be the right solution. But before making an application it is important to consider whether this form of finance is appropriate to the particular circumstances and requirements of your business.
Any business taking out a term loan repays the capital and interest at agreed intervals over a set timeframe. Interest rates can be fixed or variable, although in most cases payments include an element of capital sum and interest. Some repayments may be ‘interest only’, with the amount borrowed repayable at the end of the term, an arrangement that reduces the short-term cost of servicing the loan. There are also options in terms of the frequency of repayments; monthly or quarterly, for instance.
The lifespan of a typical loan will be between one and seven years. Approval may take several months.
How Much Can I Borrow?
Banks assess loan applications in terms of the borrower’s ability to meet the repayment commitment. A prerequisite, therefore, is reliable cashflow sufficient to service the debt without placing stress on the company’s finances. Each application is handled on a case-by-case basis with the lender looking at the company’s trading history and credit worthiness. The lender will also assess the risk. A business borrowing a sum that is relatively small (relative to cashflow) will be seen as a lower risk than a business borrowing a large amount. Risk is generally priced into the loan through the interest rate, and term loans are often secured against assets.
There is no set formula dictating how much a company can borrow. However, as a rule, businesses seeking a loan amounting to more than 2.0% of cashflow should expect very close scrutiny of their business plan.
Is A Term Loan Right For My Business?
Term loans are simple, easy to understand and can provide substantial sums of money without the owner or existing shareholders having to sacrifice equity to new investors. And compared to private equity investment, for example, term loans are relatively cheap, with interest margins below 5% per annum.
With options such as fixed and variable interest rates or interest-only payments, there is a certain amount of flexibility available, enabling businesses to secure the loan that best suits their requirements and circumstances.
However, there are some potential disadvantages. Perhaps chief among these is the drain on cash. Once an agreement is in place, payments must be made whenever they fall due and that can cause problems for companies with irregular cashflow.
In addition, companies borrowing large sums will be bound by terms and conditions known as ‘covenants’. A covenant may stipulate minimum cashflow levels, for example. If a company falls short, the covenant is broken, which could trigger a renegotiation of the loan.
What Can Term Loans Be Used For?
Term loans are typically used to finance the purchase of assets such as machinery or property. In theory, they can also be used to provide growth capital. However, in practice, a lender may be unwilling to advance a sum that represents a high multiple of cashflow on the basis of projected revenues and profits. If your company requires funding for an ambitious growth strategy, mezzanine finance or private equity may be more appropriate.
Term loans can also be used to provide working capital. However, in this case, a more appropriate solution may be short-term funding such as an overdraft or invoice finance (under which money can be borrowed against unpaid invoices).
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