DEBT FINANCE

Debt is borrowing; borrowing of money, goods and even services. For a layman, debt is trouble. It implies suffering; a symbol of misery. Debt is mostly a last resort. In contrast, however, debt is a symbol of hope in finance. Debt in an economy signifies the faith in the economy and in the days to come. It’s an indicator of the health of the economy. Companies often look at debt as a monetary tool to fund several of their ventures and investments. It’s an intriguing contrast. But companies prefer it. Why? How?

A firm resorts to debt financing when there is a need to raise money for the working capital or capital expenditures. It involves borrowing money and repaying it, accrued with interest, at a later point in time in specified intervals. Several companies use debt financing as part of their overall corporate finance strategy. However, debt financing doesn’t imply a shortage in funds as it might sound to a layman. In fact, issuing debt is a financial strategy that helps minimize the cost of capital of a firm and in turn maximize the value of a firm.

Typically, the cost of capital of a firm is the summation of the cost of equity and the cost of debt. When compared with equity issuance, the cost of raising funds and the annual return required to attract an investor is less in debt finance. Equity involves giving up a part of the ownership of the firm while debts don’t. It is preferred also because of the tax advantages a company enjoys on debt issuance. The interest paid here is regarded as the cost of doing business. This will consequently reduce the total taxable profit. However, this is true only till this addition of debt doesn’t increase the default risk or the credit risk of the company. An increase in the default risk means increase in the interest rate. At this point, issuing equity becomes cheaper. Hence, it becomes imperative for the management to find the right mix of financing in order to minimize the cost of capital involved.

Debt is generally used for financing working capital, capital expenditures and acquisitions. The two primary sources of debt are loans and bonds. Loans, short term or long term, are usually made for real estate purchases, equipment purchases, funding day-to-day operating needs and buying inventory. They are sourced from a wide spectrum of investors like angel investors, banks, the Government and other financial institutions. Some entrepreneurs also pool in their personal savings to add to the capital. This is especially the case in most start-up companies. Loans from friends and family are also used by start-ups. This is all the more attractive an option because of the no-interest, no strings attached benefit. Moreover, finding a creditor for start-up companies is a Herculean task.

Long term debt is one of those initial avenues a company should pursue. In a long term debt, the interest and the principal is paid in equal installments over the life of the loan. Commercial banks and private investors are a great source of long term loans. Government sponsors a few loan programs too, though only as long as the company meets the required criteria. Long term loans usually require collateral or in most cases a guarantor. Banks also evaluate the performance of the company in the preceding few years. Private investors, on the other hand, invest with the future prospects of the company in mind. Long term loans are usually used to fund acquisitions, real estate purchases and equipment purchases.

To fund day-to-day operating needs and to meet inventory requirements, a company could opt for a short term, line of credit loan. These loans provide funds for short term requirements and help maintain a positive cash flow. Most commercial banks offer a ‘revolving line of credit’ where a fixed amount of money is kept aside for the company to use. As funds are used, the ‘line of credit’ decreases. When the payments are made, the ‘line of credit’ increases accordingly. This helps maintain a constant cash flow. The best part about the whole program, however, is that the interest is not accrued until the cash is withdrawn and still the line of credit is immediately available for the company to use.

Issuing bonds is another alternative. A corporate bond is generally a long-term contract between bondholders (creditors) and the company. In return for money, a bond promises a creditor the payment of a series of interest, known as coupon payments, until the bond matures. At maturity, the bondholder will receive a specified principal sum, which is the nominal value of the bond. The time to maturity could take between 7 to 30 years. Bonds require collateral. Some bonds are issued as convertible bonds. This empowers the owner of the bond to convert the bond to a pre-specified number of shares of the company’s stock.

Angel investors and Governments could help a great deal if dealt with properly. In fact, the largest pool of high risk capital in the country is provided by angel investors. Angel investors are typically wealthy individuals who invest in a company in exchange for equity. Also, loans against assets, mortgage for instance, could help fund small businesses. Some life insurance companies allow borrowing of money, provided the premium made is for a lifetime of the individual. Funding opportunities are many. Just look around.

It’s not in this article’s confines to detail out every loan and every loan procedure or every funding option available. That is not the objective. This article only aims to present a general overview on debt as a financing tool in corporate finance strategy. Nevertheless, certain conclusions could be drawn. Given all the advantages of debt financing, companies would do better to issue it with caution. There are a few dangers associated with it as well. Creditors, more often than not claim some or all assets of the company in case of any non-compliance with the terms of the loan. This will inevitably lead to liquidation. Money borrowed must also correspond to the company’s estimated growth and earnings because payments must be made regardless of the company’s profits. Also, debt is limited to the total value of assets. Agreed, debt financing is a brilliant tool in minimizing cost of capital and boosting the value of a firm, but it is advisable to exercise caution when required.