In business, cash flow is the basic indicator of the financial health of an entity. There will be events where each entity will need more money than it has. This could be covered either by injection funds by owners / shareholders or by borrowing from an external party. Loan is a loan agreement entered into to receive money from one or more people with a precondition to repay the amount on a specified date or on demand. The borrower will borrow money from a lender for a consideration called interest which will be tied to the time value of the money. Financially, the interest paid is called the cost of borrowing or finance cost.
Types of borrowing
At a general level, borrowings can be classified into secured and unsecured. Borrowings based on collateral are called secured borrowings. Secured interests are commonly referred to as primary security and collateral. The primary security being the asset obtained by borrowing and collateral are other assets provided for additional security. Unsecured loans are made without security. Unsecured borrowing is extended when the borrower’s risk level is very low / minimal. Normally, the interest rates of unsecured loans will be higher than the former due to the element of risk.
Secured and unsecured borrowings can further be classified into short-term borrowings and long-term borrowings depending on the term of the loan. Short-term loans obtained are payable on demand or within 12 months and long-term loans will be repaid over a period exceeding one year.
Based on need, entities will explore options for borrowing money to fill gaps in cash flow. Entities that are looking for working capital (i.e. operations) needs would prefer short-term borrowings and those that need capital funds will choose long-term borrowings. One of the cardinal principles of borrowing is the need to adapt borrowing to its use. For example, short-term borrowing should never be used for long-term uses as this will inevitably lead to difficulties in meeting commitments.
Long-term borrowings are extended in the form of term loans and short-term borrowings are extended in the form of working capital facilities. Term loans are obtained when the borrower seeks financial assistance for capital expenditures such as project expansion and the purchase of capital-intensive machinery. The term loan has a fixed amount, a fixed term and a fixed repayment schedule.
Working capital facilities are obtained to finance the day-to-day operations of borrowers. This would help borrowers to close the gap, in terms of loans granted, in the production cycle of companies.
At present, external commercial borrowing is the growing avenue where domestic entities will borrow amounts outside of India. The loans are available at a much lower rate as compared to the amounts borrowed in India. However, they run the risk of having to repay the same amount in the currency in which it was borrowed. Any unfavorable movement of the currency could harm the borrower. In general, this is only recommended when the borrower has natural cover where they are exporting.
Lenders evaluate the loan proposal with credit score or rating, business model, future cash flow, management, track record, to name a few.
The extent of existing borrowings is one of the main factors assessed by rating agencies when they come to rating entities, as it would help determine financial condition and operating capacity.
Some of the ratios used as a benchmark for the analysis are as follows: the debt-to-asset ratio indicates the borrowings used by the company to finance its assets; The debt-to-capital ratio reflects the proportion financed by debt and helps identify the level of risk; The debt / EBITDA ratio measures the number of years it would take for a company to repay its debt under current conditions; The debt service coverage ratio helps in understanding the ability to honor loans owed immediately at current income level. A ratio less than one means negative cash flow and will not be able to honor the commitments.
The ratios will help to understand the financial health of the company and the alarming indications. Credit scores based on the above parameters and borrower history play an important role when appraising loans.
Implications of the fault
Honoring loan commitments is essential to maintain credibility. Failure to comply with one of the commitments would, in legal parlance, be qualified as a “default” which could have serious consequences for the borrower. This would further lead to legal proceedings including the opening of insolvency proceedings against the borrowers to realize the loaned amount.
In secured loans, the lenders will take action to realize the security under the respective laws by invoking their rights. Additionally, lenders will carefully consider the reasons for failure to understand any embezzlement or fraudulent activity. This will impose serious implications on the borrower, including the initiation of criminal proceedings.
It should be noted that while borrowing helps meet the needs of the business, it should be remembered that excessive borrowing would push the borrower into the stressed space. Constant monitoring of the financial position is essential to ensure the ability to honor repayments and loans within limits. This would help the borrower to leverage the loan to achieve efficient performance and value maximization.
(The author is partner, RVKS and Associates.)