While business planning, it is natural for companies to want to invest in new opportunities. It could be for geographical expansion, the introduction of new product/ service lines or to ramp up production. All of these investments require access to funds, which might not be readily available for upfront expenditure. This is especially true for companies in their early growth phase. In such cases, long-term financing options need to be explored by the companies. One of these is a term loan.
In this blog post, we will discuss how to structure term loans for business finances.
Term Loans and their Benefits
In a term loan, the borrower gets a lump sum amount of money which has to be repaid at a pre-decided interest rate, usually in instalments. The tenure of the loan is usually between 1 year and 25 years.
It is also possible to avail of loans with a shorter tenure within 1 year. They are called short-term loans. Qualifying for a term loan for business finances requires high creditworthiness and a good financial state.
Term loans are useful for businesses in the following ways:
Access to funds: With term loans, businesses receive a one-time lump sum payment that can be used for expansion or growth.
Refinance older debt: Term loans can be used to refinance previous debt at an affordable cost if the business is eligible for better liquidity.
Meet working capital requirements: Working capital requirements can be met through term loans for activities like buying inventory, raw materials, etc.
Convenient loan terms: The repayment period and instalment size can be renegotiated at one's convenience.
Improve financial indicators: Debt can be used to increase the return on equity for shareholders.
How to Structure the Right Term Loan for Your Business
A term loan structure may include a bullet repayment of the loan where the borrower pays interest periodically and repays the entire principal in a bullet repayment at the end of the tenure. Or it could be in the form of EMIs where the borrower repays the loan in equal instalments until the end of the tenure. As per the business planning of the company, one can choose one of these options.
Some recommendations that must be kept in mind while negotiating a term loan structure:
Evaluate the net cost of financing
The cost of a loan includes various fees such as origination fee, processing fee, prepayment fee, document processing fee, and post-dated cheque charges.
A lender might charge all or some of these while giving out a loan. One must calculate loan terms and choose the ones that minimise the net costs within requirements.
It is especially important to know the net cost of the loan if it is used to refinance an older debt which might have some prepayment charge.
Map the needs with the available financing options
One must understand the exact need faced by the company. E.g., if the company doesn't realize account receivables in time to be able to buy inventory for the next cycle, it would need a working capital loan. Similarly, if funds are needed to finance equipment and hire more employees, an intermediate-term loan would be best for the company.
Calculate Loan Terms
One must carefully calculate loan terms and understand the repayment structure of the loan. Details like instalment frequency, tenure, prepayment penalties, EMI bounce fee, etc. are important factors that should influence a choice between term loans. Since the loan will be repaid out of the business cash flows, it is important to ensure that the cash flow expectations are carefully aligned with the planned instalment size.
Different Types of Term Loans
There areintermediate and long-term term loans based on the period of repayment. Intermediate-term loans have a repayment schedule of 1 year to 5 years while long-term loan tenures can be up to 25 years.
The different types of term loans are:
Loan against property: A term loan can be availed of by using the property as collateral. A loan amount of up to 70% of the property can be availed, however, this might vary from lender to lender.
Start-up Loan: The start-up loan is a business finance option for new ventures. The creditworthiness of the borrower along with that of the company is important for approval. Proof of the existence of the company in the form of registration and other financials is also required. The interest rate, tenure and amount to be loaned are decided based on the financial state of the start-up.
Business Loan for Women: Some lenders have business finance options for women entrepreneurs, which usually offer better terms to women-owned small and medium-sized enterprises. The motive of these options is to promote social equality.
Equipment Financing: Manufacturing companies require financing of expensive equipment used in production and other value chain activities. Loans to finance the purchase of this equipment are usually at a cheaper interest rate as compared to other business finance options.
There are other short-term loans to meet working capital needs, overdraft facilities and invoice financing that you can avail of to meet your liquidity needs. Your business planning may include any of these financing options depending on your needs.
Pros & Cons Of a Long-Term Loan
Here's a comparative study of the benefits and drawbacks of applying for a long-term loan:
Pros
Cons
A term loan allows one to negotiate convenient loan terms and repayment schedules
A default on an instalment comes with a penalty in the form of an EMI bounce fee
A lump sum amount of funds become accessible which can be repaid as per capacity
Prepayment penalties could prevent an early repayment option
Could be good to build a diversified credit profile if the loan is repaid as planned
Inflexible repayment schedules could be a burden during lean business periods
The interest rate for term loans is relatively lower than for short-term loans and other overdraft facilities.
Stringent eligibility conditions
Therefore, businesses must calculate loan terms carefully to check if the pros outweigh the cons and make a decision accordingly.
Reasonable Repayment Plan for a Business Term Loan
For a reasonable repayment schedule, here are some suggestions:
Track payments and enable auto-pay: Once a term loan is sanctioned, it is important to track payments to ensure zero penalties. Setting up auto-pay of instalments ensures that no instalment is missed out. This leads to a good credit score and no EMI bounce fees.
Pay more than EMIs: It is good to make prepayments to a term loan, if possible. However, prepayment fees must be taken into account to ensure that the interest saved by early repayment of the loan exceeds the prepayment penalty that one could incur.
Increase EMI periodically: It is possible to negotiate terms that allow one to increase instalments periodically. This also enables one to pay off the loan ahead of schedule.
Conclusion
Term loans are a great long-term financing option for a business. It is essential to understand the requirement and tailor the right term loan at the lowest possible cost and the most convenient repayment terms.
Since a long-term is a fixed commitment irrespective of the business performance, it makes sense to factor in the worst-case scenario expected cash flows during business planning. Further, a detailed comparison between the term loans offered by various lenders will go a long way in giving one a good negotiating standpoint.
There are various types of Tata Capital term loans offering various tenure, repayment schedules, etc. that you can explore to match your business planning.
21 February 2023
7 mins read
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