What it means
"Senior" describes priority. If a company fails and its assets are sold, holders of senior debt are paid before subordinated lenders, bondholders without security and shareholders.
Because the risk of loss is lower, banks accept a lower interest rate than other lenders would demand. Most senior bank loans are secured, meaning the bank has a legal claim on specific assets such as property, equipment, receivables or inventory.
The lender will also normally attach covenants, which are promises the borrower must keep, such as maintaining a minimum interest coverage ratio or not paying out too much in dividends. Breaking a covenant can allow the bank to demand early repayment.
Pricing is typically a benchmark rate plus a margin. The benchmark moves with the market and the margin reflects the borrower's credit quality, so the total cost floats up and down over the life of the loan.
Companies often agree an amortisation schedule that repays part of the principal each period, and a larger final payment, called a balloon, may fall due at maturity. Borrowers use senior bank loans to fund expansion, acquisitions, equipment and working capital.
They also sit at the foundation of the capital structure, because other creditors and investors look at the amount of senior debt already in place before deciding whether to lend or invest. The main limits are capacity and flexibility.
Banks size the loan against earnings, usually as a multiple of EBITDA (earnings before interest, tax, depreciation and amortisation), and will not lend beyond what they think the business can service. When more money is needed, companies turn to more expensive layers such as mezzanine debt or equity.
In practice
Real-world examples.
Example
A packaging manufacturer borrows $6,000,000 from its bank to buy a new production line. The loan is secured on the machine itself and repaid over seven years. The bank sets a covenant that debt must stay below three times EBITDA.
Example
A private equity buyer finances an acquisition of a logistics company with a senior bank loan covering half the price. The rest comes from the buyer's own equity and a subordinated loan. The senior lenders get first claim on all assets, so they accept a lower margin than the other investors.
Example
A growing restaurant group arranges a revolving senior facility of $2,500,000 secured on its kitchen equipment and leases. It draws on the line to cover seasonal stock purchases and repays during busy months. Finance monitors the covenants monthly so the bank has no surprises.
Formula
Calculation
Annual interest = principal x (benchmark rate + margin)
Senior leverage = senior debt / EBITDA
Suppose a company borrows $10,000,000 on a senior loan priced at a benchmark rate of 4% plus a margin of 3%. The all-in rate is 4% + 3% = 7%, so annual interest is 10,000,000 x 7% = $700,000. If the company's EBITDA is $4,000,000, senior leverage is 10,000,000 / 4,000,000 = 2.5 times. Interest cover, measured as EBITDA divided by interest, is 4,000,000 / 700,000 = 5.7 times, which most banks would regard as comfortable.Case study
Seen in the real world.
Greenfield Bakeries is an illustrative, fictional company with $5,000,000 of EBITDA that wanted to buy a rival. Its bank offered a senior loan of $12,000,000 at 2.4 times EBITDA, secured on all assets, with a covenant that leverage must not exceed 3 times.
The CFO also considered a cheaper-looking alternative of raising more from a junior lender. She calculated that the extra layer would lift total debt to 3.4 times EBITDA, break the senior covenant and raise the blended interest cost.
Greenfield chose the senior loan and funded the rest of the price with new equity from the founders. The illustrative lesson is that the structure of debt, not just its total, determines how much risk a company is taking.
Watch out
Common mistakes.
- Assuming senior means the loan is large, when the word refers only to its ranking for repayment.
- Ignoring covenants and focusing only on the interest rate, then discovering a breach gives the bank the right to call the loan.
- Treating a floating rate as fixed, so the budget does not allow for the interest cost rising if the benchmark rate moves.
Questions
People also ask.
Is a senior bank loan always secured?
Most are, but some strong borrowers obtain senior unsecured loans, which still rank ahead of subordinated debt even without specific collateral.
Why is a senior loan cheaper than other debt?
Because the lender is repaid first if the company fails, so the risk of loss is lower and the lender asks for a lower return.
What happens if a covenant is breached?
The bank can charge a fee, reprice the loan, demand extra security or, in serious cases, require immediate repayment, although many lenders negotiate a waiver.
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