What is a Financial Guarantee?
- Financial guarantee refers to a promise made by one entity or person to the lender for the debt obligation of another entity or person such that if that entity is unable to meet the obligations, the entity taking the responsibility would pay on behalf (i.e., make good the default).
- The entity assuming the responsibility of payment is called a financial guarantor. Now an obvious question would hit your mind, why would anyone on the Earth an entity would guarantee another person’s liability?
- Well, that’s how relations work! The guarantor has some relation with another entity, and thus it assures payment to the lender.
- However, not always the entire liability is guaranteed. That means the guarantor may choose to provide assurance only in respect of principal or interest component only.
How to Value Financial Guarantee?
Valuation here refers to recognition of the probable liability in the books of accounts of the guarantor. Remember the basic meaning of financial guarantee. The liability of the guarantor crystallizes when the obligee (i.e., the person on whose behalf guarantee is given) defaults on any payment. So, the readers of the financial statement of the guarantor have the right to know about such events that may happen. Hence, the following recognition rules are followed:
- Initial, i.e., first recognition, is done at fair value.
- The initial recognition is done at the premium received, and liability is booked if the premium is received.
- If no premium is received, the fair value should be calculated such that the economic benefits of the guarantee are reflected in the value. Compute the two present values of net contractual cash flows in the present debt contract with a guarantee (Say A) and net contractual cash flows in a debt contract without guarantee (say B). Fair value is A-B here.
Subsequent recognition means revaluation at the end of the reporting period. The guarantee liability is recognized as higher of
- Loss allowance, i.e., the expected credit loss of the creditors in the next 12 months. Expected credit loss means an increase in the risk of default of the creditor.
- Liability recognized earlier less amortization till date. Amortisation is deducted since, as time passes, the risk of default decreases.
Example of Financial Guarantee
- One of the classic examples is where a parent company offers a financial guarantee for a subsidiary company. Say Company A has subsidiary Company X. Company X wish to construct a plant for its factory and would require funds to the tune of $ 50 million from a banker. The banker has lower assurance on the repaying capacity of Company X & thus asks for a guarantee. Company A provides a guarantee for the same. Now, if Company X defaults, Company A will make good the default.
- Any vendor who is uncertain about the ability of the customer to pay for the goods may ask for a financial guarantee. In such a case, the bankers of the customer may provide a guarantee of payment. This way, the bank will pay the vendor if the customer defaults.
Types of Financial Guarantee
Below are the different examples of Financial Guarantee:
|Individual financial Guarantee||
|Guarantees by parent Companies||
|Bank guarantee for customers||
Importance of Financial Guarantee
- The basic job of a financial guarantee is to mitigate the risk involved in the transaction. However, a financial guarantee does not make security free from all risks. For example, there are possibilities that the guarantor may go bankrupt in the time being & may default in case the liability is large enough.
- A Financial guarantee provides an additional layer of security for the lender, and the lender is assured of its money. This is the reason why bonds covered with guarantees are rated high in terms of credit quality.
- It is important to disclose the financial guarantees in the financial statements via notes to accounts. Let the readers know about the probable outflow that may if the liability crystallizes. The guarantor should also specify any provision made to cover up the risk.
- Financial guarantee attracts investors and makes them feel comfortable about their money.
- It further provides a better credit rating. Higher credit rating refers to lower risk, and thus lower interest rates are charged. Thus, the creditor enjoys the inflow of money with lower finance costs.
- The transaction happens through financial guarantees, which otherwise may not have happened had there be no guarantee. Thus, a financial guarantee facilitates financial transactions.
Key Takeaways for Financial Guarantee
- A Financial guarantee works like an insurance policy for the lender who is assured about its principal and return component recovery.
- The financial guarantee may cover either the principal part or interest or both parts. Therefore, it depends on the risk-bearing capacity of the guarantor.
- The guarantor is liable to make good the default if the creditor is unable to make payments in time.
- In few cases, the bankers may also pledge the parent company assets to cover up the guarantee payments.
- It increases the credit rating, and thus the investor demands lower interest. Therefore, it helps the issues with lower finance costs.
- A Financial guarantee facilitates financial transactions.
Financial guarantees become a weapon for the creditor to get the funds at a lower cost. However, please note that the banker is ready to accept the parent Company’s guarantee only it is assured about the creditworthiness of the parent. Thus, the coin rolls down to the creditworthiness of someone who can take responsibility. Therefore, it provides a win-win situation for the banker and creditors. Further, the parent company is at lower risk since it controls the business of the subsidiary.
This is a guide to Financial Guarantee. Here we also discuss the definition, Value, example, types of financial guarantee, and importance. You may also have a look at the following articles to learn more –