Debt financing is considered one of the most feasible sources of finance. It’s on account of the following two reasons.
- Debt financing is cheaper than equity financing because interest payment on a loan is taxable. On the other hand, the payment of a dividend is not tax-deductible. Hence, debt is a cheaper source of finance due to tax deductions.
- Raising finance via loan does not lead to control dilution. On the contrary, raising finance via equity leads to ownership dilution.
Hence, raising finance via debt is a desirable and prominent source of finance. This article shall discuss major sources of long-term debt financing for most corporations.
The following sources are considered major sources of finance for major corporations.
- Bank loan/financing from financial institutions
- Issue of debentures
- Issue of bonds.
- Short terms borrowings
- Director loans
- Sale and leaseback
- Accounts payable
Let’s discuss detailed aspects of each of the financing methods.
Bank loan/financing from financial institutions
It’s a traditional method of financing. Most companies opt to enter into a loan agreement for the following reasons.
- The interest rate charged by the banks is comparatively lower than other financing sources. For instance, the interest rate charged on the bank loan is comparatively lower than overdraft and the rate charged by credit card companies. Generally, the interest rate on the bank loan falls from 8% to 10%. And the interest rate on overdraft is usually more than 15%. However, it’s important that overdraft is for a short period and used by companies to meet short-term obligations.
- The bank loan is flexible in terms of size and use. An application for a loan can be made for a small amount to moderate and massive depending on the need. Further, proceeds raised from a bank can be used for any business needs unless there is some covenant.
- The interest paid on loan is tax-deductible, as discussed above.
- The business does not need to dilute control to raise debt. It’s, in contrast, to raise of equity as discussed above.
Issue of debentures
Debentures are certificates issued by large corporations. Corporations issue these certificates against receipt of funds as a liability. Terms of the loan are pre-agreed between a corporation (borrower) and lender (public).
The debenture holder gets interested from the corporation on pre-agreed time, which may be monthly, quarterly, or annually. Sometimes, interest is paid at the time of redemption.
Further, there can be different types of debentures that include convertible and non-convertible. The convertible debentures lead to equity at the end of the day.
On the other hand, non-convertible debentures are settled in terms of interest and principal repayment in cash.
The debentures are classified under the liability section of the financial statement.
Issue of bonds
Bonds are financial instruments issued by corporations. These financial instruments are the same as debentures. However, the difference is that issue of the bonds are backed by some physical assets or some form of collateral.
Further, bonds are issued for a longer time than debentures. Likewise, the interest rate on the bonds is comparatively lower as these are backed by collateral.
Usually, companies issue bonds to finance some projects that can be given as collateral. It’s equally important to note that Government can issue bonds/debentures to finance some public projects.
Short term financing
Short-term financing is when the business has to repay proceeds within twelve months. It’s raised by businesses to meet financing needs for a short period.
It’s classified under the current liability section of the balance sheet. Examples of short-term financing include overdraft/running finance and another financing arrangement that the business needs to pay back within the next twelve months.
Other financing arrangements may include payables on credit cards, payday loans, refund anticipation loans, bridge loans, and even bank loans (payable in the next twelve months).
Generally, the process to raise short-term financing is quick and fast. However, interest cost is comparatively higher.
It’s a loan the company obtains from its Directors. Mostly, it’s an unsecured loan, and repayment terms are not usually defined.
So, it’s classified under current liabilities. Generally, this loan is quick, flexible, and easily accessible by the business. Further, details of such a loan should be disclosed in the notes to the financial statement.
Sale and leaseback
Sales and leaseback are financing arrangements where companies sell their equipment and raise funds. However, since the equipment is critical to the business, they lease it back from the customer. In this financing arrangement, the physical asset remains within the business.
However, ownership is transferred to the buyer, and the business has to pay lease rentals. The lease rental includes interest payment and the principal repayment.
Accounts payable refers to amounts payable to the suppliers against receipt of the goods/supplies. Although, it’s not perfect financing where cash is received against some contract. However, goods are received that can be sold in cash to enhance business liquidity.
Generally, no interest is payable on the accounts payable until a certain period. However, excess delay in payment might lead to impairment in supplier relations, penalties, and interest on the accounts payable.
Debt structure of some companies operating in different sectors
Let’s glance over some giant global corporations to understand their debt structure.
1) Unilever debt structure
The recent balance sheet of Unilever plc reflects that the company has raised loans through bonds issue amounting to €21,308 million.
And the second-highest financing is raised by trade payable and other current liabilities amounting to €14,861 million. We have covered both of these finance sources in the discussion above.
2) Airbus debt structure
The balance sheet of Airbus year ending 2021 reflects that the contract liability contributes the biggest liability. It’s a form of advance that the company has received against a promise to deliver aircraft, which amounts to €38,000 million.
This type of financing is rarely seen with much higher numbers. However, it seems to be due to the nature of the industry. The second highest liability contribution in the liability structure is made by long-term financing.
3) GSK debt structure
The recent balance sheet of GSK reflects that the liability structure is well diversified, and the highest contribution is made by medium-term USD term loan amounting to £20,780 million.
And second, the highest contribution is made by the accounts and other payable amounting to £15,840. Overall, different companies have different contributions in terms of liability, and most of the liabilities include long-term financing, advance, and accounts payable.
Debt financing is one of the most prominent sources of finance. It’s because it does not dilute control on the company’s ownership. Further, interest paid on loans is tax allowable, leading to reduced taxable income and a higher/increased business profit.
There can be different sources of finance that include long-term financing, bank loan, advance from a customer, accounts payable, sale and leaseback, issues of bonds, director’s loans, etc.
Frequently asked questions
What is the difference between secured and unsecured loans?
A secured loan is backed by physical assets/collateral. The borrower has to provide certain security to raise the finance. And in case of default, the lender can collect their funds by selling assets given as collateral.
What are the main sources of finance for the corporation?
Generally, companies raise finance through retained earnings, equity, and debt financing through three different sources.
Retained earnings are profits accumulated in the past accounting periods. This is the amount that has not been distributed as a dividend. It’s considered to be the cheapest source of finance.
Equity finance is raised by selling an ownership stake in the business. However, it leads to dilution in control. On the other hand, debt financing leads to a present obligation that needs to be settled in the future.
Why is retained earnings the safest source of financing?
Retained earnings do not require interest payment, do not lead to control dilution, and do not bring any covenant. Hence, it’s considered one of the safe sources of finance.