Aterm loan is a debt obligation paid
back over time, usually by making
monthly payments over one to seven years.
“Many times, term loans are used to
finance business growth,” says FirstMerit
Bank executive vice president Robert W.
Carpenter Jr., who oversees the bank’s
commercial lending, business banking,
commercial real estate and leasing in
Cleveland. “Payments can be principal plus
interest, or principal and interest.”
Smart Business talked to Carpenter
about the intricacies of term loans and
leases.
Other than a firm repayment deadline, how
does a term loan differ from a line of credit?
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.
Lines of credit are typically used to support fluctuation in a business cycle — that
is, temporary inventory growth or short-term growth in receivables. In both cases,
the timing of cash flow determines the
appropriate loan product.
Is a term loan usually easier or more difficult
to obtain?
Term loans are granted based on the level
of excess or available cash flow generated
from the business to repay the loan.
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.
Term loans are usually provided to help a
business grow and/or to replace assets that
wear out in the normal course of business.
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.
What other 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. Business managers 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 loan agreements differ from leases?
Loan agreements usually have financial
operating covenants that the borrower is required to keep. Many times these are
based on historical financial performance
of the company. Leases typically do not
require financial covenants.
With the many variables in a lease, a business can adjust the payment to meet the
customer’s budgeted payment. The variables are structure (or end-of-lease
option), equity invested in the lease, stepping payments up or down according to
customer needs, setting up ‘skip payments’
to help seasonal customers, and deferring
payments to allow customers to receive
the equipment and allow the customer to
generate receivables.
A lease is also 100 percent financing,
where a loan often requires a down payment or will cover only a percentage of the
value of the equipment.
What kinds of leases are there?
The true lease (with fair market value
end-of-lease option) allows a business to
purchase the equipment for its fair market
value at the end of the term. It can include
some soft costs. Payments can be structured to fit a business’s cash flow needs.
A TRAC lease is usually for motor vehicles. It allows the lessee to purchase equipment for a predetermined residual price.
No down payment is required. Payments
can be structured to fit cash flow needs. It,
too, can include some soft costs.
A conditional sales lease offers 100 percent financing (no money down). The lessee gets the tax benefits. It can include
some soft costs. Payments can be structured to fit a business’s cash flow needs.
And, at the end of the lease, there can be a
$1 buyout or a balloon buyout.
ROBERT W. CARPENTER JR. is executive vice president and
senior commercial lender for FirstMerit Bank in Cleveland. Reach
him at (216) 694-5690 or [email protected].