What is a Financial Guarantee?
In general, a financial guarantee is a promise to take responsibility for another company's financial obligation if that company cannot meet its obligation. The entity assuming this responsibility is called the guarantor.
How Does a Financial Guarantee Work?
Let's assume XYZ Company has a subsidiary named ABC Company. ABC Company would like to build a new plant and thus would like to borrow $10 million from a bank. The bank will probably require XYZ Company to provide a financial guarantee of the loan. By doing so, XYZ Company agrees to repay the loan using cash flows from other parts of its business if ABC Company is unable to generate enough cash on its own to repay the debt.
Often a parent company will offer a financial guarantee of bonds issued by one of the parent's subsidiaries, but there are plenty of other situations that might involve guarantees. For example, vendors sometimes require financial guarantees from their customers if the vendor is uncertain about the customer's ability to pay (this most often happens in transactions involving expensive equipment or other physical property). In these situations, a customer's bank might financially guarantee the customer's payment, meaning that the bank will pay the vendor if the customer does not.
Financial guarantors don't always guarantee the entire amount of a liability. In bond issues, for example, the financial guarantor might only guarantee the repayment of interest or principal, but not both. Sometimes more than one company might financially guarantee a security. In these cases, each guarantor is usually responsible for only a pro rata portion of the issue, but in other cases, each guarantor may be responsible for the other guarantors' portions if they also default on their responsibilities.
Railroad companies are well-known for their guaranteed bonds because in order for a railroad company to lease another company's railroad, the lessee must often guarantee the debt of the lessor.
Why Does a Financial Guarantee Matter?
Financial guarantees mitigate risk, but it important to note that they do not make a security risk-free. After all, it is still possible that even the guarantor can default on the liability if the liability is too large or if the guarantor is already struggling for other reasons. Regardless, guarantees provide an extra layer of security, which is why guaranteed securities often get higher credit ratings.
Historically, financial guarantors disclosed the nature and size of their guarantees in the notes to their financial statements. It is important to note that guarantees issued between parents and their subsidiaries do not have to be booked as balance sheet liabilities. Examples of this include a parent's guarantee of a subsidiary's debt to a third party or a subsidiary's guarantee of the parent's debt to a third party or another subsidiary.
All financial guarantees must, however, be disclosed. The guarantor must disclose the nature of the guarantee (terms, history and events that would put the guarantor on the hook), the maximum potential liability under the guarantee and any provisions that might enable the guarantor to recover any money paid out under the guarantee.