A term loan is a general category of loans that describes a loan with a repayment structure over an intermediate to extended period of time. Term loans are unique in that principal is usually, but not always, paid back in periodic installments over an agreed upon period of time.
Term loans are usually provided by banks or finance companies against the value of a company’s hard asset collateral. However, a term loan can also refer to a second lien loan or mezzanine loan which are uncollateralized for the most part.
Term loans are essential components of a corporate finance strategy, due to their long term nature.
Term loans provide significant cash flow flexibility. The ability of a company to pay back the loans over the course of 5 to 10 year increments is very beneficial for lower middle market sized companies.
This gives a company the ability to engage in a long term project such as an acquisition or product line development without worrying about having to repay the loan back ina short time period. Interest rates can vary for term loans and can be either fixed or floating.
For low credit risk loans, the rate can be Libor plus 250 basis points. For high risk credit loans, the rate can run up to 12%. The longer the term of the loan, the more value the loan has for the borrower because it spreads out the principal repayment.
In bullet maturity term loans, the principal is all paid back at the maturity date, which is very beneficial to the borrower. Term loans are usually allocated to the non-liquid and intangible asset value on a company’s balance sheet.
Term loans can be used for business expansion where a company purchases more equipment to increase capacity. Term loans can also be used in buyout transactions.
Banks provide term loans in conjunction with revolving lines of credit to give companies extra liquidity for working capital and growth.
The companies that are best suited for a term loan are companies that are in need of quick capital but unable to turn a large profit right away. Term loans benefit by bringing companies a flexible time period of repaying its debt. As in all debt scenarios, companies need to ensure that the returns from the term loan funding will be sufficient to repay the debt.
This funding strategy works best for companies that will make a steady and long term improvement to their cash flow where the extra profit will be able to cover the incremental debt payments.
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