Financing, especially term financing, is
the lifeblood of most businesses. But
the savvy executive realizes that there are different kinds of term financing available, each with a special niche in corporate
financial affairs.
“Term loans are granted based on the
level of excess or available cash flow generated from the business to repay the
loan,” says Tim Mauter, vice president of
FirstMerit Bank in Columbus. “Excess
cash flow from operations can be used to
finance additional assets or employee
growth. Obtaining term financing depends
on the overall financial health of the business. The borrower needs to show that
the business has the ability to repay the
loan.”
Smart Business talked to Mauter about
the intricacies of term loans and leases.
Other than a firm repayment deadline, how
do term loans differ from a line of credit?
A term loan is a debt obligation paid back
over time. Payments are usually made
monthly over a one- to seven-year period.
Many times, term loans are used to finance
business growth. Payments can be principal plus interest or principal and interest.
Term debt is usually used to finance a
new office, a new piece of equipment or
other fixed asset acquisition. For a service
company, it might be used to finance a new
contract, a new group of employees needed to serve customer needs or business
growth. Through term loans, lenders are
providing larger amounts of cash than the
business can generate in a short time frame
to purchase the asset or finance the
resources needed.
Lines of credit are typically used to support fluctuation in a business cycle, i.e.,
temporary inventory growth or short-term
growth in receivables. In both cases, the
timing of cash flow determines the appropriate loan product.
What considerations should a business make
when pursuing a term loan?
The payments become a fixed cost, therefore businesses should ask whether they
have the necessary cash flow (with cushion) to service the debt. They should know
the useful life of the asset. Ask what
changes in the work force will be necessary and what facility (plant) changes will
be required.
Term loans can be extended beyond the
original term, but it depends on the reason
for the request; there are good reasons
(strong growth) and bad reasons (decline
in profits and cash flow). Again, it depends
on the overall financial health of the business, including leverage.
How do loans differ from leases?
Leases are normally fixed rate obligations that call for a fixed payment every
month during the course of the lease.
Leases are always 100 percent financing
and also generally have a buyout option
(balloon) that might be required, depending on the lessee’s intention with the equipment at the end of the lease.
Some of the advantages of leasing include tax savings and increased cash flow
for the customer.
Leases have tremendous flexibility and
can be tailored to allow for seasonal payments or to have payments lower in the
early years of a lease and then greater later
on when the equipment is at higher capacity. Leases also can have a variety of end of
term options depending on what the
client’s needs and desires are.
What kinds of leases are there?
The true lease is a lease where the bank
actually owns the equipment for tax purposes and leases it back to the client. This
type of lease typically has a buyout provision that allows the company to purchase
the equipment at the end of the lease.
A TRAC lease is a specific type of true
lease that is designed for over-the-road
vehicles. These leases have set purchase
options and are very common in financing
trucks and trailers.
A conditional sales lease is a lease where
the lessee retains the ownership of the
equipment and the associated tax benefits.
Like all leases, it can include soft costs,
provide 100 percent financing and can
have the payments tailored to meet the
cash flow needs of the business. At the end
of these leases, the lessee will pay $1 or a
stated amount.
Which is better: loan or lease?
Each has its place. At the end of a loan,
you retain the asset purchased. Generally,
loans have more flexible terms that can be
modified if needed. There are tax considerations, too. Businesses should review the
advantages of each with an accountant.
TIM MAUTER is vice president of FirstMerit Bank in Columbus.
Reach him at (614) 545-2769 or [email protected].