Financial Guarantee

What is a Financial Guarantee?

Financial Guarantee refers to the promise which is undertaken by a third party for any financial obligation of another company and therefore, assumes the role of a guarantor for any unpaid financial obligations.

Explanation

A company may undertake any project or risky venture that may require some amount of borrowing from the bank. In this regard, the bank may demand that a certain entity give it a promise in terms of financial guarantee that should the borrowing entity default with regard to its timely completion of the project or the said venture so that the loan amount can be sanctioned and the company may go ahead with the required project work.

Financial-Guarantee

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Source: Financial Guarantee (wallstreetmojo.com)

How Does Financial Guarantee Work?

Let us consider an example of a company:

Example

Small Co, a subsidiary of Big Co wants to venture into building a magnificent residential society in New York and needs an amount of $5 million in this regard. It approaches the Super Lender Bank to finance towards this end. The bank agrees to do so but on the condition that the parent of the subsidiary being Big Co stands as a guarantor in this regard and agrees to make payments if the subsidiary Small Co happens to default on its timely repayments with regard to payments of interest and principal components of the loan. Big Co towards this end, thus stands to act as a financial guarantor for Small Co.

This act can be considered as a form of financial guarantee. In future should Small Co start defaulting on its obligations, Big Co would be called on in his role as guarantor to pay off on the timely repayments as required by Small Co. Hence Large Co becomes an important financial guarantor for its subsidiary being Small Co.

Another example could also be of that of a shipping company that would seek to guarantee the value of a particular shipment from an assurance of that of a maritime insurance company that would act as a guarantor for the financial guarantee in this case.

Why do we Use?

Difference Between Financial Guarantee and Performance Guarantee

  • A financial guarantee tends to make payment by the guarantor if the borrower fails to make the requisite repayments on the borrowed amount. If any default takes place, it is then a financial guarantee comes in place. The guarantor would be then obliged to make the payments on behalf of the borrower.
  • Performance guarantee, on the other hand, tends to provide assurance of payment or any compensation in the event of any kind of inadequate or delayed performance by the party to the contract. It tends to state that if the party does not meet its standards in terms of performance expected it is then that the guarantor will take on the required responsibility to pay off the guaranteed money. Suppose if one were to purchase certain equipment but it does not perform to the standard expected or fails to perform totally, then the guarantor has the responsibility to make good for the loss

Conclusion

The financial guarantee stands as an excellent mechanism of having to ensure continuity of projects by acting as a source of assurance to the party of the underlying contract. It happens to be a win-win situation as the bank or the financial institution is assured of its payment and at the same time, the borrower to gets his required fund thanks to the guarantor that happened to intervene and help secure it.

Recommended Articles

This has been a guide to what is a financial guarantee. Here we discuss how does financial guarantee works along with an example and why to use it. You may learn more about financing from the following articles –

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