What it means
Short-term debt, such as a revolving credit line (a limit the company can borrow against and repay repeatedly), is flexible but needs regular renewal. If a lender refuses to renew, the company must find cash quickly.
Terming out replaces that uncertainty. The balance outstanding on the revolver is turned into a term loan, with scheduled repayments over several years, so the company knows exactly what it owes and when.
Companies do this when they have used short-term borrowing to pay for something that lasts a long time, such as equipment, an acquisition or a building. Matching the length of the debt to the life of the asset is a basic rule of sound financing.
The cost can be higher or lower. Longer loans often carry a higher interest rate because the lender takes more risk, but the borrower gains security, and may also avoid the cost of repeated renewal fees.
Accountants pay attention to how terming out changes the balance sheet. Debt due within a year is shown as a current liability (due soon), whereas debt due later is shown as non-current, so moving the maturity can improve measures such as the current ratio.
Lenders usually set conditions for terming out. They may ask for security over the asset, require financial covenants (promises about maintaining certain ratios), and charge an arrangement fee.
Understanding these conditions before agreeing helps the borrower avoid a breach later.
In practice
Real-world examples.
Example
A construction firm used its revolving credit line to buy a crane. The finance director converts the $750,000 balance into a five-year loan, so the debt is repaid from the crane's earnings over its working life. The lender no longer has to approve the line every year. He shows the board a schedule of repayments for the next five years.
Example
A restaurant group has funded a refurbishment through short-term borrowing for two years. As the line comes up for renewal, it terms out the balance into a seven-year loan. The lower monthly burden helps the group through a quiet season. The move frees up the credit line so that it can be used for day-to-day needs again.
Example
A retailer's accountant notices that most of its debt is due within 12 months, which makes the current ratio look weak. By terming out part of the debt, the retailer moves it to non-current liabilities. Lenders and suppliers see a stronger liquidity position. The change does not alter the amount borrowed, only the timing.
Formula
Calculation
Annual principal repayment = amount termed out / number of years
First-year interest = opening balance x annual rate
A company terms out a $600,000 revolving balance into a 5-year loan with equal principal repayments at 7% interest.
Annual principal = 600,000 / 5 = $120,000
First-year interest = 600,000 x 0.07 = $42,000
First-year total payment = 120,000 + 42,000 = $162,000
In year 2 the opening balance is 480,000, so interest falls to 480,000 x 0.07 = $33,600.
Total interest over the five years, with equal principal repayments, = 7% x (600,000 + 480,000 + 360,000 + 240,000 + 120,000) = 0.07 x 1,800,000 = $126,000.
Compare this with interest of 600,000 x 0.07 x 5 = $210,000 if the balance had stayed at $600,000, which shows how the declining balance cuts the cost.Case study
Seen in the real world.
Kestrel Components is an illustrative, fictional manufacturer that drew $900,000 on a revolving line to buy a new production machine. The line needed renewal every twelve months, and the lender's appetite was uncertain.
The chief financial officer negotiated a term loan of nine years' length, using the machine as security. The rate was a little higher than the revolver, but the monthly repayments were fixed and affordable.
When the bank later tightened lending to manufacturers, Kestrel was unaffected because its debt no longer needed renewal. The illustrative lesson is that terming out trades a slightly higher cost for protection against refinancing risk. Kestrel's chief financial officer also kept a smaller revolving line for working capital, so that long-term investment and day-to-day needs were funded separately.
Watch out
Common mistakes.
- Terming out without checking the new interest rate and fees, which can erase the benefit. Fees for arranging the loan and any early repayment charges should be compared with the benefit of certainty.
- Choosing a term longer than the useful life of the asset, so the company is still repaying after the asset is worn out. A longer loan also means more total interest unless the rate is lower.
- Using up the revolving line again after terming out, which leaves the company with both debts. Keep the revolver for working capital only, and track both facilities together.
Questions
People also ask.
Why would a lender agree to term out a loan?
The lender gets a predictable repayment schedule and often a higher return for the longer commitment.
Does terming out change the amount owed?
No, the balance is the same on day one, but the repayment timetable and sometimes the rate are different.
How does it affect financial statements?
It usually moves debt from current to non-current liabilities, which can improve liquidity ratios. Lenders also look at the new maturity profile, which can be useful in negotiations.
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