Debt financing occurs when a company borrows money to be paid back at a future date with interest. Debt finance can take many forms including loans and debt securities. Companies may use debt finance for working capital, capital expenditures or to replace equity. In return for lending money, lenders and investors will become creditors in a company.
In this article we will be covering:
- What are debt securities?
- Types of debt securities
- What are the advantages of debt financing?
- What are the disadvantages of debt financing?
- Debt financing vs equity financing: a comparison
- Methods of raising debt finance
- Process for issuing debt securities
- Process for bank loans
- Advantages of debt securities
- Advantages of loans
What are debt securities?
Debt securities are financial instruments representing a debt from an issuer to an investor. They contain a promise for the issuer (the company) to repay a defined amount to an investor (the holder of the debt security). The obligation is usually to pay on or by a specified date.
Most debt securities are transferable, meaning that they can be bought or sold by an investor on a debt capital market.
Types of debt securities
Debt securities are grouped according to the characteristics they display. This may include the way interest is paid, the type of investors or the time allowed until repayment.
The following is a non-exhaustive list of some of the different types of debt securities that exist:
- Bonds and eurobonds
- Medium-term notes (MTN) and euro medium-term notes (EMTN)
- Commercial paper
- Convertible bonds
- Credit-linked notes
- Exchangeable bonds
- Green bonds
- High yield bonds
- Project bonds
- Asset-backed securities (ABS)
What are the advantages of debt financing?
The major advantages of debt financing are control, tax and predictability.
One advantage of debt finance is that the debt is temporary. After a period of time, the relationship between the borrower and the lender will cease. The lender will also not typically have any say over how a borrower runs its business and will not be able to vote in shareholder meetings.
The interest paid under debt finance is tax deductible. A company can deduct the cost of interest payments from its tax bill whereas it cannot deduct the cost of dividends paid to shareholders.
The timing of debt repayments and interest are stated in advance. These payments are predictable, and a company can prepare for these payments as part of its cash flow planning.
What are the disadvantages of debt financing?
The major disadvantages of debt financing are the need for a credit rating, fixed payments and collateral.
- Credit rating
A company will have to have an acceptable credit rating to qualify for many forms of debt finance. If a company does not have the required credit rating then debt finance will not be available.
- Fixed payments
Debt finance payments must be made on specified dates. Businesses do not have the flexibility to postpone payments if their cash flow declines. Failure to pay will also trigger adverse consequences for a company.
Many lenders will require companies to hold certain assets of the company as collateral for a loan. The collateral ensures that the lender has recourse to assets if a company is unable to repay a loan. If a company does not have enough collateral it may not be able to obtain debt financing.
Debt financing vs equity financing: a comparison
The fundamental difference between debt and equity financing is one of ownership. In equity financing, the owners of a business give up part or all of their ownership in a company. By contrast, in debt financing the owners of a business do not change but the company becomes indebted to investors.
Despite the difference between equity finance and debt finance, both may involve securities. In equity finance, securities normally take the form of shares whereas bonds and notes are common forms of securities in debt finance.
Investors who acquire shares in a company will be entitled to the rights of a shareholder. These rights can include the right to receive a dividend and the right to vote in shareholder meetings. By contrast, debt investors are not entitled to vote in shareholder meetings nor are they entitled to share in a company’s dividends. Debt securities are commonly time limited and only entitle investors to receive payments for a limited period of time. Shareholders on the other hand remain entitled to vote and dividends for as long as they hold shares in a company.
Methods of raising debt finance
Debt finance can be broadly divided into two types:
- Issuing debt securities
- Taking out a bank loan
We’ll look at each of these in more detail below.
Process for issuing debt securities
The process for listing debt securities in London is similar to that of an equity listing. The process involves:
- Admission to the UK Listing Authority’s (UKLA’s) Official List
- Admission to trading
To obtain a listing, securities must be first admitted to the UKLA’s Official List. To be admitted, a company must first submit a prospectus to the UKLA for review and approval, together with any supporting documents.
A prospectus is a document setting out details of the offering and information (known as disclosures) about the company.
Process for bank loans
Obtaining a bank loan on the other hand doesn’t require a prospectus and is largely a private matter between a company and its lender. A borrowing company may obtain a loan from a single bank (a bilateral loan) or from a group of banks (a syndicated loan). Bank loans may take many forms, including:
- An overdraft
- A term loan
- A revolving facility
For an introduction to the different types of corporate bank loans, read our advice post, Corporate Loans: the Basics.
Advantages of debt securities
The advantages of debt securities include:
- A broad investor base
- Fewer covenants
- Flexible interest rates
- Securities are tradeable
- Limited disclosure
Advantages of loans
The advantages of a syndicated loan include:
- Available for smaller companies
- Flexibility in the amount to borrow
- Flexibility in repayments
- Multi-currency options