Debt Sources of Finance

8/3/2019 Debt Sources of Finance

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DEBT SOURCES OFFINANCE

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What is debt financing?

n Debt – borrowing money from an outside source withthe promise to return the principal, in addition to anagreed-upon level of interest.

n Debt is also referred to as „leverage“ in finance.n In contrast – equity financing does not have to berepaid.n The interest rate reflects the level of risk that the

lender undertakes by providing the money. Debtfinancing entails less risk than equity financing, thus itis usually cheaper.






Debt financing - prosn Maintained ownership – allows the founders to retain

ownership and control of the company (in contrast to equityfinancing)

n Greater degree of financial freedom – provides business witha greater degree of financial freedom than equity financing asdebt obligations are limited to the loan repayment period, afterwhich the lender has no further claim on the business

n Easy to administer – lacks the complex reporting requirementsaccompanying some forms of equity financing

n Tax deductions – interest payments can be deducted frombusiness income taxes (lower interest rate)

n Less expensive – tends to be less expensive over the longterm than equity financing






Debt finanicng - consn Repayment – shortages in CF may make regular payments

difficult (incl. penalties, taking possession of collateral etc.)n High rates – interest rates vary with macroeconomic conditions,

the borrower´s history with banks, business credit rating,personal credit history

n Impacts borrower´s credit rating – debt increases leverage,failure to make payments adversely affects business creditrating and its ability to obtain further financing

n Cash and collateral – necessary to make sure the business willbe generating sufficient CF, it is asked to put up collateral on theloan

n Availability limited to established businesses – it can bedifficult for unproven businesses to obtain loans, the amount of

money SMEs may be able to obtain via debt financing is likely tobe limited, so they may need to use other sources of financingas well






Bank loan – factors influencinginterest ratesn Factors influencing the price of the loan:- Macroeconomic factors : the level of inflation; the volume of M2

money supply and higher monetary aggregates and politics ofmoney supply regulation; velocity of money circulation; level ofGDP and its growth rate; level of investments and rate ofsavings; discount rate of the National Bank

- Microeconomic factors: - creditor´s costs of obtaining funds; level of risk of the financed

project; period of a loan (maturity); relation between short-termloan sources and long-term sources; amount of a loan; backingof a loan; individual rate of profit (project, business, industry);NPV of investment project






The loan processn Documents necessary to submit:- loan application,- business plan,- financial statements,- documents of legal capacity (trading certificate,

extract of companies´ register),- other documents may be required.n After submitting the loan application and the

accompanying documents – the employee of thebank loan department prepares the loan proposal,

particularly evaluates creditworthiness of the client –containing evaluation of personal and objectivecreditworthiness






Collateral

n C. – an item that is pledged to guaranteerepayment of a loan; comes into play when abusiness needs to make a secured loan

n

The nature of collateral acceptable dependson the type of a loan, structure, tenor,amount, etc.






Types of collateral

n Real estate – land, buildings are used (especially formedium to long-term loans and revolving loans ofsignificant size)

n Principles of this agreement:-

banks accept real estate as a whole (not parts),- it is necessary to limit the possibility to sell realestate,

- insurance benefits for events of damage have to bepledged for account of the bank,

- banks usually require the present market value ofpledged real estate to exceed the amount of the loanby 20 -30 %






Types of collateral (continued)n Tangible assets – called „lombard“n „Lombard loan“ – usually means only loans secured by short-

term securitiesn This type of collateral – risky – banks usually require their value

to be twice the loan amount at leastn

Intangible assets – very rarely used as collateral, only in thecase of short-term loans of large companies (technology, know-how, trademarks, software, accounts receivable)

n Guarantor (the third party) – an aval, may enter the loanrelation between the bank and the client, may be a specializedbank (SZRB in Slovakia) or another guarantor (legal or physicalentity)- if the client does not repay the loan, the guarantor has to takeon his obligations






Long-term and medium-term debtsources of financen financial loans,n supplier loans,n bonds (alternative sources– characterized in the

following chapter ),n special debt forms (alternative sources -

leasing, franchising, forfeiting– characterized in the

following chapter ).






Short-term debt sources of finance

n trade credit,n permanent and semi-permanent accruals,n bank loans (overdrafts, short-term specific

loans, lombard loans, paper loans, specificcredit services),n advance payments,n factoring(alternative source -characterized in following chapter ),

n commercial papers(alternative source –characterized in following chapter) .






Long-term debt sources of finance






Financial loans – term loans

n based on a contract requiring the borrower tomake periodic payments of interest andprincipal to the lender

n the commonest form – loan financing thedevelopment needs (also called „investmentloan“), also can be used to finance operatingneeds beyond one year

n resources to repay it – generated by thefinanced project, therefore creditors assesspotential profitability of projects






Financial loans – term loans(continued)n The creditors generally:- require backing by first-class personal or property

guarantee,- limit the amount of the loan (debtor shares in

financing the project – at least 30 to 50%),- try to agree as short maturity as possible (according

to the character and limits of the financed project),- analyse in detail financial and overall economic

situation of the applicant incl. expected income, long-term projections of financial situation.






Financial loans – term loans(continued)Characteristics:- 1 – 10 or 15 years maturity,- repaid regularly by regular instalment payments using

several types of term-loan amortization schedules,- they are secured by different types of collateral,- the interest rate fixed or floating; the longer maturity,

the more often the floating rate is used,- financing large projects – the bank consortia to

diversify risks.






Financial loans – mortgage loansn Mortgage – a form of loan that is normally secured on freehold

property; maturity 15 – 30 years, provides a business with anopportunity to purchase, build, reconstruct and maintain real estate;

n provided by specialized banks (mortgage banks) or commercial bankshaving the license to provide them;

n in Slovakia – 9 banks:ČSOB, Dexia Banka, Istrobanka, OTP BankaSlovensko, Slovenská sporiteľňa, Tatrabanka, UniCreditBank,

Volksbank, VÚBn in case of not fulfilling obligations – the bank can sell pledged realestate

n funds through mortgage bondsn limits – percentage of the value of mortgage collateral to which banks

may grant mortgage loans (up to 60% market value of pledged realestate)

n borrower pays interest and periodically repays principaln SR – particularly house building






Revolving credit line

n intermediate source (2-3 years); short-termloan is repaid by another short-term loan –„revolving“

n determined maximum amount that can beborrowed over a period, may be collateralized

n rather risky (liquidity), expensive






Export loans; supplier loans

n Export loan – special form of advancepayment to exporter granted by banks

n

Supplier loan – medium- to long-term loansgranted by suppliers of equity, interestincluded in price






Short-term debt sources of finance






Trade credit

n typical short-term loan associated with agreeddelayed payments for goods/services; spontaneous –generated by day-to-day operation; not financial loan(form of goods/services paid for later)

n

readily available to most businesses, payment termsmay differ between suppliersn the oldest loan form, simplifies salesn interest included in price, when promptly paid –

discount (2/10 net 30)n secured: open account up to agreed limit; written

debenture; bill of exchange






Trade credit (continued)

n Advantages:- convenient / informal / cheap,- available to companies of any size.

Factors determining terms of trade credit:- tradition within industry,- bargaining position of the two parties.






Permanent and semi-permanentaccrualsn Accrual – an expense that has been incurred

but has not yet been paid – (1) accruedwages and salaries, (2) accrued taxes

n Represent spontaneous financial source






Bank overdrafts

n Enable to take more money out of a bankaccount that it contains, granted by banks onoverdraft account, combine current and loanaccounts; credit, zero or debit balance

n Debit balance should not be below agreedloan limit






Bank overdrafts – pros and cons

n Advantages:- flexibility up to agreed limit- interest paid for really drawn moned for real

period of loann Disadvantages:- bank´s right to withdraw facility at short

notice,

- issue of security,- more expensive than special loans






Short-term special loans; lombard loan

Short-term special loansn granted by banks for special agreed purposesn finance short-term operational needs (seasonal

stocks, seasonal costs, temporary shortage of fundsetc.)

n usually repaid with one payment including principaland interestLombard loann granted against the pledged securities (or accepted

bills of exchange, accounts receivable, stocks,bullions); used to bridge personal or businessfinancial shortfalls; lombard loan equates topercentage of pledged assets market value






Advance payments

n currently used in some industries (shipbuilding, manufacturing of large equipment,house building etc.)

n the part (or the whole) of contractually duesum paid in advance by buyers to suppliers

n limited use in highly competitive industries




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