Term-Out: a Worked Example

A revolving line or an overdraft assumes that the money comes back: stock is sold, invoices are paid, and the balance falls. When a floor forms under the balance, part of the line has stopped doing that. The lender is carrying a permanent exposure it reviews as a short-term one, and the borrower is paying interest and repaying nothing on a debt that cannot be run down by trading.

A term-out puts that part on a schedule. It suits the lender because the exposure starts to fall and the instalments test the borrower's cash every month. It suits the borrower because a schedule and a committed term replace a balance that depends on the next renewal. The cost is cash: payments that were interest alone now include principal.

The working parts are the amount, the schedule and the limit. The amount usually starts from the hardcore on the statements. The schedule should follow what the money bought, so a machine paid for through the line can be spread over its working life, while standing stock and debtors have no such life and a lender has to decide what pace the cash can bear. The limit is the part most easily missed, and the example shows why. The new loan will also carry its own margin, fees, security and covenants, and may need the clean-down on the remaining line to be reset.

There are two routes. Many mid-market term-outs are negotiated when the need is recognised, usually at an annual review. The other is a term-out option written into a revolving facility, which lets the borrower convert what is drawn into a term loan when the revolving period ends. Such options are typically conditional on there being no default, and commonly require prior notice and a fee, and after conversion the amount cannot be redrawn.

A maker of warehouse racking, constructed for this page like every figure in it, has grown sales from US$14m to US$19m on a US$2.5m line due for renewal each year. Over two years the balance has peaked at US$2.3m and not fallen below US$1.4m. Of that floor, US$0.9m paid for a powder-coating plant and US$0.5m is stock and debtors that the larger business carries all year. The bank proposes a five-year loan at 8%, repaid monthly, and a smaller line. The terms belong to the example.

Without the cut in the limit, the bank has lent another US$1.4m without deciding to. The borrower could run the line back up, and a year later there would be a floor on the line and a term loan beside it. With the cut, the commitments are unchanged on day one and fall every month after. Interest on the swing is left out on both sides so that the two lines compare.

The fall in cover is the point of the exercise. At 1.66 the file looked comfortable because a permanent debt was paying no principal. At 1.18 it shows what that debt requires. Whether that level is acceptable is the lender's decision on this borrower; it is no benchmark.

A maturity extension moves the date and leaves the shape alone. A term-out changes the shape: a balance that could go up and down becomes one that only goes down. Evergreening is the opposite of a sound term-out in spirit, because new credit or a rollover is used to keep a loan looking current without any real repayment. A term-out with a schedule the cash can meet is a repair. One with a schedule set to fail, or sized without asking why the floor formed, comes close to the same thing.

The classification can matter too. In Australia, APRA's APS 220 treats an exposure as restructured where the borrower is in financial difficulty and the bank grants a concession it would not otherwise consider. A term-out for a sound, growing borrower is ordinary lending. The same paper for a borrower who cannot meet its line may be forbearance, and banks in New Zealand and the UK apply their own reporting rules to it.

DEFINED IN ONE PARAGRAPH → · TEMPORARY OR PERMANENT? → · LINE OF CREDIT VS TERM LOAN →

The desk's first question is why the floor exists, and the guide to temporary and permanent need sets out the possible answers. Here, the plant belongs on a schedule and the growth in stock and debtors is at least explicable. If the floor had come from losses, a term-out would put a schedule on money already gone, and the borrower would be back for more.

The reader of the accounts has a separate trap. A line due within twelve months sits in current liabilities. After a term-out, only the next year's principal does. The ratios improve with nothing having changed:

A current ratio covenant, or a reader comparing two years, can take that for an improvement in trading. The figures in the second column are the same business, reclassified.