Updated July 13, 2023
What is a Financial Guarantee?
A financial guarantee refers to a promise made by one entity or person to the lender for the debt obligation of another entity or person. If that entity cannot meet the obligations, the entity taking the responsibility would pay on behalf (i.e., make good the default).
The entity assuming the responsibility for payment is the financial guarantor. Now an obvious question would hit your mind, why would anyone on Earth an entity guarantee another person’s liability? Well, that’s how relations work! The guarantor has some relation with another entity, thus assuring payment to the lender.
However, not always the entire liability is guaranteed. That means the guarantor may only provide assurance regarding the principal or interest component.
How to Value Financial Guarantee?
Valuation here refers to recognizing the probable liability in the books of accounts of the guarantor. Remember the basic meaning of financial guarantee. The guarantor’s liability crystallizes when the obligee (i.e., the person on whose behalf the 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 Recognition
- 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 receives.
- If no premium receives, the fair value should calculate such that the economic benefits of the guarantee are reflected in the value. Compute the two present net contractual cash flow values 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
Subsequent recognition means revaluation at the end of the reporting period. The guarantee liability recognize as higher than 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 creditor’s default risk.
- Liability recognized earlier less amortization till date. Amortization deducts since, as time passes, the risk of default decreases.
Example of Financial Guarantee
- A classic example is when a parent company offers a financial guarantee for a subsidiary company. Say Company A has a subsidiary, Company X. Company X wishes to construct a plant for its factory and would require $ 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. If Company X defaults, Company A will make good the default.
- Any vendor uncertain about the customer’s ability to pay for the goods may ask for a financial guarantee. In such a case, the customer’s bankers may provide a payment guarantee. This way, the bank will pay the vendor if the customer defaults.
Types of Financial Guarantees
Below are the different examples of Financial Guarantees:
|
Types |
Explanation |
| Individual financial Guarantee |
|
| Bond 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.
- The lender is assured of its money and provided with an additional layer of security through a financial guarantee, contributing to the high credit quality rating of bonds covered with guarantees.
- It is important to disclose the financial guarantees in the financial statements via notes to accounts. Let the readers know about the probable outflow 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. A higher credit rating refers to lower risk; thus, lower interest rates charges. Thus, the creditor enjoys the inflow of money with lower finance costs.
- The transaction happens through financial guarantees, which otherwise may not have happened without a guarantee. Thus, a financial guarantee facilitates financial transactions.
Key Takeaways for Financial Guarantee
- The lender assures about recovering its principal and return components through a financial guarantee, which functions similarly to an insurance policy.
- 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 the default good if the creditor cannot make timely payments.
- In a few cases, the bankers may pledge the parent company assets to cover 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.
Conclusion
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 if it is assured about the parent’s creditworthiness. 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 subsidiary’s business.
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