“Term loans are granted based on the level of excess or available cash flow generated from the business to repay the loan,” says Tim Mauter, vice president of FirstMerit Bank in Columbus. “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.”
Smart Business talked to Mauter about the intricacies of term loans and leases.
Other than a firm repayment deadline, how do term loans differ from a line of credit?
A term loan is a debt obligation paid back over time. Payments are usually made monthly over a one- to seven-year period. Many times, term loans are used to finance business growth. Payments can be principal plus interest or principal and interest.
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. 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.
Lines of credit are typically used to support fluctuation in a business cycle, i.e., temporary inventory growth or short-term growth in receivables. In both cases, the timing of cash flow determines the appropriate loan product.
What 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. They 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 loans differ from leases?
Leases are normally fixed rate obligations that call for a fixed payment every month during the course of the lease. Leases are always 100 percent financing and also generally have a buyout option (balloon) that might be required, depending on the lessee’s intention with the equipment at the end of the lease.
Some of the advantages of leasing include tax savings and increased cash flow for the customer.
Leases have tremendous flexibility and can be tailored to allow for seasonal payments or to have payments lower in the early years of a lease and then greater later on when the equipment is at higher capacity. Leases also can have a variety of end of term options depending on what the client’s needs and desires are.
What kinds of leases are there?
The true lease is a lease where the bank actually owns the equipment for tax purposes and leases it back to the client. This type of lease typically has a buyout provision that allows the company to purchase the equipment at the end of the lease.
A TRAC lease is a specific type of true lease that is designed for over-the-road vehicles. These leases have set purchase options and are very common in financing trucks and trailers.
A conditional sales lease is a lease where the lessee retains the ownership of the equipment and the associated tax benefits. Like all leases, it can include soft costs, provide 100 percent financing and can have the payments tailored to meet the cash flow needs of the business. At the end of these leases, the lessee will pay $1 or a stated amount.
Which is better: loan or lease?
Each has its place. At the end of a loan, you retain the asset purchased. Generally, loans have more flexible terms that can be modified if needed. There are tax considerations, too. Businesses should review the advantages of each with an accountant.
TIM MAUTER is vice president of FirstMerit Bank in Columbus. Reach him at (614) 545-2769 or firstname.lastname@example.org.