Debt Financing

What is Debt Financing?

Financing is crucial to businesses of all sizes. Businesses can raise funds by issuing debt or equity instruments. This article gives an overview of debt financing, which involves businesses receiving a loan in exchange for a legally enforceable promise to repay the principal amount of the loan plus interest.[1]

Examples of Debt Instruments[2]

•    Loans

Loans are contracts, usually bilateral in form. There are secured and unsecured loans. In practice, however, most lenders will ask for security on a loan. If a borrower business defaults on a secured loan, the lender will have the right to seize a particular asset to satisfy payment of the debt. Examples of security include a personal guarantee, equipment, savings accounts, inventory and insurance policies.

•    Bonds (Debentures)

Bonds (debentures) are negotiable instruments. Hong Kong law uses the word “debentures” but the common term used by most people is “bonds”. Unlike a loan contract, bonds can be transferred to any seller with protection of negotiability. Bonds are instruments representing the bond issuers’ promise to repay the principal and make accrued interest payments to the bondholders.  Generally, bonds are secured. Thus, if the issuer fails to make timely payment of interest and principal, bondholders will have a claim on the issuers’ assets named as collateral, thus enabling repayment.[3] The exact rights conveyed to the holder of a bond (debenture) will be expressed in the instrument associated with their issue.

Debt Financing Over Equity Financing

•    Retain Control

Businesses can utilise debt financing to meet their short-term needs. Unlike shares, debts do not dilute ownership because generally lenders are only entitled to principal repayment and interest. They have no say in how the businesses conduct their management.

•    Leverage

Because the repayment obligations incurred for debt financing are fixed and no control rights are relinquished, if a company grows very rapidly with debt financing, the members of the company will retain the lion’s share of profit from that growth while retaining their control of the enterprise.

•    Tax Advantage

The interests paid to bondholders may be tax deductible for income tax purposes.

•    Fixed Claims

A significant disadvantage of debt financing arrangements is that a borrower has no choice about repaying principal and interest. If a company finances itself with shares, it may choose not to distribute dividends to conserve resources, but this option will not be available with debt, which can drive a company quickly into insolvency.

•    Better Planning

Businesses know in advance the principal and interest they need to pay back each month. This makes it easier to budget and make financial plans.

Limitations of Debt Financing

•    Qualification Requirements

Businesses need to have a good enough credit rating to borrow. Thus the availability of loans, in particular loans from banks and sizeable lending institutions, is often limited to established businesses. Startup businesses often have difficulty obtaining loans of any size.

•    Discipline

Businesses need to have the financial discipline to make repayments on time. Most lenders provide harsh penalties for late or missed payments such as late fees, taking possession of collateral, calling the loan due early, or forcing the company into winding up. This is particularly relevant to startup businesses that may struggle to make regular payments due to unstable cash flow. Also, businesses must exercise good judgment in deciding when to use debt. Potential investors may consider a business heavily reliant on debts to be a high-risk investment. This can limit future access to equity financing.

•    Security

By agreeing to provide collateral or security to the lenders, businesses put some of their assets at potential risk. If the loan agreement requires the owner to personally guarantee the loan, the owner also puts his personal assets at risk.

Given the limitations, this article suggests that in deciding whether to raise funds through debt financing, a business should consider the following questions.

Is Debt Financing Suitable for Your Business? Consider – Is it important for you to retain full control of the business?Is it important for you to know precisely how much your business will owe in monthly payments?Is your business capable of meeting regular monthly payments?Does your business have a good credit rating? How is its credit history?Are you comfortable with using the business’ assets as collateral or security?  

[1] ‘Debt Financing’, Entrepreneur, <https://www.entrepreneur.com/encyclopedia/debt-financing&gt;

[2] ‘Debt Financing’, Entrepreneur, <https://www.entrepreneur.com/encyclopedia/debt-financing&gt;

[3] Thomas Kenny, ‘Secured Bonds vs. Unsecured Bonds’ http://bonds.about.com/od/bonds101/a/Secured-Bonds-Vs-Unsecured-Bonds.htm

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