This is a common type of debt and is available in different terms usually short term. Medium term loans vary from 2 – 5 years. Long-term loans vary from 6 years and above The terms are relative and depend on the borrower. This finance is used on the basis of Matching approach i.e. matching the economic life of the project to the term of the loan.
It is prudent to use short-term loans for short-term ventures i.e. if a venture is to last 4 years generating returns; it is prudent to raise a loan of 4 years maturity period.
Features of loans
1. Direct negotiation – A firm negotiates a term loan directly with a bank of financial institution i.e. a private placement.
2. Security – term loans are usually secured specifically by the assets acquired using the funds. (Primary security). This is said to create a fixed charge on the company’s assets. A fixed charge can also be referred to as specific charge.
3. Restrictive covenant – financial institutions usually restrict the firms so as to safeguard their funds. They do this by way of restrictive covenants which include asset based covenant, cash flow, liability etc.
4. Convertibility – they are usually not convertible to common shares unless under special cases. e.g. a financial institution may agree to restructure the firm’s capital structure.
5. Repayment schedule – this indicates the time schedule for payment of interest and principle. It may occur.
- Where interest & principle are paid on equal periodic installments.
- Where principles is paid on equal periodic installments & interest on the outstanding balance of the loan.
Conditions under Which Loans Are Ideal
- When the company’s gearing level is low (the level of outstanding loans is low.)
- The company’s future cash flows (inflows and their stability) must be assured. The company must be able to repay the principal and the interest.
- Economic conditions prevailing. The company must have a long-term forecast of the prevailing economic condition. Boom conditions are ideal for debt.
- When the company’s market share guarantees stable sales.
- When the company’s anticipated future expansion programs, justify such borrowing.
Requirements for Raising Loan
- History of the company and its subsidiaries.
- Names, ages, and qualifications of the company’s directors.
- The names of major shareholders – 51% plus i.e. owner who must give consent.
- Nature of the products and product lines.
- Publicity of the product.
- Nature of the loan – either secured, floating or unsecured.
- Cash flow forecast.
Reasons Why Commercial Banks Prefer To Lend Short Term Loans
- Long-term forecasts are not only difficult but also vague as uncertainties tend to jeopardise planning e.g. political and economic factors.
- Commercial banks are limited by the Central Bank of Kenya in their long term lending due to liquidity considerations.
- Short-term loans are profitable. This is because interest is high as in overdrafts.
- Long term finance loses value with time due to inflation.
- Cost of finance – in the long term, the cost of finance may increase and yet they cannot pass such a cost to borrowers since the interest rate is fixed.
- Commercial banks do credit analysis that is limited to short term situations
- Usually security market favours short term loans because there are very few long term securities and as such commercial banks prefer to lend short term due to security problems.