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.
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.
How Does Financial Guarantee Work?
Let us consider an example of a company:
- InNeed Co that would require some amount of project financingProject FinancingProject Finance is long-term debt finance offered for large infrastructure projects depending upon their projected cash flows. Moreover, an investor has to form a Special Purpose Vehicle (SPV) to acquire the same. for one of its upcoming projects. However, the bank seeks some sort of surety that, should InNeed Co default on its performance or completion, and not be able to repay it would need backing from another significant entity in terms of financial guarantee if there are any defaults on part of InNeed Co.
- The company InNeed Co would now seek assistance from another friendly or parent companyParent CompanyA holding company is a company that owns the majority voting shares of another company (subsidiary company). This company also generally controls the management of that company, as well as directs the subsidiary's directions and policies. with significant net worth so that the bank would be satisfied that the performing entity would meet its entire obligation and should default that there is sufficient backing from the parent company.
- The parent company- VeryStrong Co would now stand as a financial guarantor if InNeed Co happens to default on any of its timely payments to the banks, and the bank is assured and has the right to claim the same from VeryStrong Co should the need arise given that there are defaults if any.
There also happens to be times when more than one guarantor would tend to provide the underlying guarantee and under such circumstances, each guarantor would tend to be responsible for the pro-rata portion of the issue.
- Sometimes the parent company may also guarantee the bonds which its subsidiary companySubsidiary CompanyA subsidiary company is controlled by another company, better known as a parent or holding company. The control is exerted through ownership of more than 50% of the voting stock of the subsidiary. Subsidiaries are either set up or acquired by the controlling company. happens to issue, and this too stands as an 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?
- Should a corporate or a business owner engage in any risky project by resorting to borrowing usually through forms of a loan from any financial institution or bank, more often than not the financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. is concerned about the recovery from the concerned entity. It thereby demands surety in terms of repayment through the mechanism of something called a financial guarantee from any other business/entity that would guarantee on the payment which has to be recovered.
- Hence it is at this stage that the entity would be required to take the assistance of a guarantor to act as a source of assurance so that there isn’t any delay in terms of securing the required finance for the project. It is here that the savior happens to be a guarantor who would oblige for repayments if the borrower defaults if any. Hence to ensure there is no delay and timely finance that is being available, it becomes imperative that one depends on the financial guarantee. Even from the perspective of the bank or the financial institution, they need to ensure that the underlying borrowing does not turn into a non-performing assetNon-performing AssetNon-Performing Assets (NPA) refers to the classification of loans and advances on a lender's records (usually banks) that have not received interest or principal payments and are considered "past due." In the majority of cases, debt has been classified as non-performing assets (NPAs) when loan payments have been outstanding for more than 90 days. and thus seek a guarantor in this regard.
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
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.
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 –