In business, cash flows are the bedrock indicator of an entity’s financial health. There will be events wherein every entity stands in need of money that are in excess of what it has. This could be met either out of infusion funds by owners/shareholders or the borrowings from an external party. Borrowing is a loan contract entered to receive money from one or more person with a precondition to repay the amount at a specified date or on demand. The borrower will borrow money from a lender for a consideration called interest which will be linked to the time value of money. Financially, the interest paid is called as borrowing cost or finance cost.
Types of borrowing
At a broad level, borrowings can be classified into secured and unsecured. Borrowings which are based against a security interest are called secured borrowing. Secured interest are popularly referred to as primary security and collateral. Primary security being the asset procured out of borrowing and collaterals are other asset provided for additional security. Unsecured borrowings are extended without security interest. Unsecured borrowings are extended where the risk level of the borrower is very low/minimal. Normally, the interest rates of unsecured borrowings will be higher as compared to the former in view of the risk element.
The secured and unsecured borrowing can further be categorised into short-term borrowing and long-term borrowings based on the tenure of the loan. The short-term borrowings obtained are due to be paid on demand or within 12-month period and long-term borrowings will be paid over a period of more than one year
Based on the needs, entities will explore options to borrow money to bridge gaps in the cash flows. Entities who are looking for working capital requirements (i.e. operations) would prefer short-term borrowings and those who require funds for fixed assets will go for long-term borrowings. One of the cardinal principles of borrowing is the necessity to match the borrowings to its use. For example, short-term borrowings should never be used for long-term uses as it will inevitably lead to challenges in meeting commitments.
Modes of borrowing
The 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 seeking financial assistance for capital expenditure such as expansion of project and purchase of capital-intensive machineries. Term loan comes with fixed loan amount, fixed tenure, and fixed repayment schedule.
Working capital facilities are obtained to finance the borrowers daily operations. This would assist the borrowers to match the gap, in terms of credits extended, in the business production cycle.
Presently, External Commercial Borrowings are the growing avenue where the domestic entities will borrow amounts from outside India. The borrowings are available at much lower rate as compared to the amounts borrowed in India. They, however, run the risk of having to repay the same in the currency in which it was borrowed. Any adverse movement of the currency could hurt the borrower. Generally, this is only recommended when the borrower has a natural hedge where they are exporting.
The lenders evaluate the borrowing proposal with credit score or rating, business model, future cash flows, management, track record, to name a few.
Parameter for rating
Extent of existing borrowings is one of the primary factors evaluated by the rating agencies while arriving at the rating of the entities as it would assist in ascertaining the financial position and the going concern ability.
Some of the ratios used as a benchmark for analysis are, Debt to Asset Ratio indicate the borrowings availed by the company to finance its asset; Debt to Capital Ratio reflects the proportion funded by debt and aid to identify the risk level; Debt to EBITDA Ratio measures how many years it would take for a company to pay back its debt under present condition; Debt Service Coverage Ratio aid in understanding the ability to honour immediate due borrowing at present level income. Ratio of less than one means negative cash flow and will not be able to honour its commitments.
The ratios will assist in understanding the financial health of the company and alarming indication. The credit scores based on the above parameters and the borrowers track record plays a significant role at the time of borrowings appraisal.
Implications of default
It is critical to honour the commitments of borrowings to ensure credibility is maintained. Not adhering to any of the commitments would in legal parlance be called “default” that could have serious implications for the borrower. This would further lead to legal proceeding including initiation of insolvency cases against the borrowers to realise the amount lent.
In secured loans, the lenders will initiate action to realise the security interest under the respective statutes invoking their rights. Further, the lenders will scrutinise the reason for default to understand if there is any diversion of funds or fraudulent activities. This will impose serious implications on the borrower including initiation of criminal proceeding.
It is to be noted that while borrowings assist in meeting business requirements, it is to be kept in mind that too much of borrowing would push the borrower into the stressed space. Constant monitoring of an entity's financial position is critical to ensure ability to honour repayments and borrowings are within the limit. This would aid the borrower to leverage the borrowing to attain effective performance and value maximisation.
(The writer is Partner, RVKS and Associates.)