Term Out

Term out is a financial concept used to describe the transfer of debt internally, within a company's balance sheet. This is done through the capitalization of short-term debt to long-term debt. Changing the classification of debt on the balance sheet allows companies to improve their working capital and take advantage of lower interest rates.

Term out is the accounting practice of capitalizing short-term debt into long-term without acquiring any new debt. The ability for a company or lending institution to "term out" a loan is an important strategy for debt management and normally occurs in two situations.

A facility loan is a banking agreement that allows a company to borrow short-term financing periodically. Bank facilities are put in place by a company to ensure it has consistent access to cash and liquidity at any point in time. Businesses with cyclical sales cycles or seasonality normally take out a bank facility loan to ensure they have enough cash on hand to purchase inventory during busy times, and pay employees during quiet periods.

Manufacturing companies, for example, face high seasonality. Often, most of a manufacturer's business comes in the summer months, when it makes products to be sold by retailers in the fourth quarter. This means manufacturers have slow periods at the end of the year, when retailers typically have their busiest sales period. However, retailers do not make a lot of purchases during this time, and some manufacturers are strapped for cash as they try to maintain payroll.

When a situation like this occurs, a manufacturer can take out a facility loan to cover expenses in the fourth quarter. Then, if the loan balance is particularly high, the company can term out the loan and extend the repayment period, effectively reclassifying it from short-term debt to long-term debt. Terming out a facility loan is very advantageous for companies that have cash flow issues.

Evergreen loans are revolving debt instruments. This means a company can use an evergreen loan, pay the money back and immediately use it again. The loan is reviewed by the lending institution annually, and if the company continues to meet certain requirements, it can draw on the loan continuously. The most common type of evergreen loan is a revolving line of credit.

However, there are situations that arise where companies fully extend the loan and never repay the principal, instead paying only the monthly interest payments. When this happens, the lending institution can term out the loan by amortizing the principal, effectively converting the company's interest-only payments to monthly payments that combine interest and principal.