Considerations of security form an important basis of lending. In fact, they constitute necessary adjunct to financial appraisal. Lending institutions have to examine the loan proposals from the point of view of nature and extent of security offered. Sometimes, there is a greater reliance on security due to inadequate financial appraisal, which in its turn may be due to non-availability of the necessary data. The security cover of the loan should, however, not be regarded as a substitute for an adequate financial assessment.
Security considerations are of particular importance in less developed countries like India where information on the character, integrity and credit-worthiness of the borrowers is not readily available and much ground work has yet to be done in the establishment of credit information bureaus. A prudent term lending institution, therefore, secures its loan by adequate collateral and, where necessary, guarantees. It also embodies in the loan agreement suitable protective and restrictive covenants such as maintenance of certain minimum financial standards, supplying to the lender adequate financial information, earlier repayment of loans under certain conditions, restriction on the payment of dividend and any other payments like managing agency or selling agency commission. Taking of adequate security infuses the necessary responsibility in the borrower. A general tendency exists among term lending institutions in India to depend more on collateral for the repayment of loans than on the integrity and policy of management and the borrowing concern’s past and prospective earnings..
The types of security generally accepted by the term lending institutions are the existing industrial assets as well as those to be acquired out of the granted loans. Most financial institutions also obtain, as a measure of caution, the personal guarantees of the directors/ managing agents since the future of the concern is largely dependent on the efficiency of management.
While approving an application for term loan, certain restrictions are incorporated in the loan agreement with a view to protecting the interests of the lending institutions and ensuring the maintenance of soundness of the financial position of a concern. The borrower may be required to agree that the loan in question will receive the higher priority for repayment. Provision may be made that the borrower should not borrow further sums on long-term basis without the consent of the lending institution. A statement may also be made that debt- equity ratio should not exceed a specific limit. Sometimes, the agreement specifies conditions regarding the maintenance of minimum working capital so as to possess enough cushion for withstanding unexpected financial shocks such as fall in prices. At other times, in order to ensure that the borrower is not short of funds for meeting the current obligations including the servicing of the loans, it may be provided that the selling commission or the managing agency commission, if any, will not be disturbed during the currency of the loan, except after meeting the interest on and installments of the loan. Similarly, the borrower may be required not to declare dividend for specified periods or beyond an agreed rate. These restrictive covenants are considered necessary in case of term-loans, which run over a period of years for giving protection to the lending institution.