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Term Loans (Cash Flow Financing)
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Posted On: Monday December 29th, 2003 at 12:00am EST
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When is a term loan used and how is cash flow evaluated?
A term loan is used when a business borrows money for a period exceeding one year. Term loans, in general, are considered long term financing. Examples of long term borrowing needs include equipment purchases, change in ownership and new business acquisition.
Financial institutions and other funding sources evaluate a company's cash flow for long-term borrowing needs. The company's cash flow is evaluated to structure a term loan. It is important to structure the term loan so that debt repayment matches the business' cash flow. The approval and amount of the loan depends on the adequacy of the firm's:
(a) Historical cash flow,
(b) Projected cash flow, and
(c) Adequate debt coverage.
A lender’s primary focus is to evaluate if the business generates sufficient cash flow to repay its debt.
The term loanis a lump sum disbursement with payback over a specified period of time.
The debt coverage ratiorequired will vary depending on each financial institution's lending parameters. However, generally the debt coverage ratio required will be between 1.50 to 1 to l.25 to 1.
Debt coverage of 1.5 to 1 is calculated as follows:
(Net Income + Depreciation Expense + Amortization + Interest Expense)/(Current Portion of Long Term Debt + Interest Expense)
Cash flow is generally defined as the net income of a firm plus non-cash expenses. The non-cash expenses will include depreciation, depletion and amortization, which are accounting deductions not paid in actual dollars and cents. |
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