Loan or lease? Featured

8:00pm EDT March 26, 2007

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 Robert.carpenter@firstmerit.com.