Debt finance is a fixed return finance as the cost (interest) is fixed on the par value (face value of debt). It is ideal to use if there’s a strong equity base. It is raised from external sources to qualifying companies and is available in limited quantities. It is limited to:
- Value of security.
- Liquidity situation in a given country. It is ideal for companies where gearing allows them to raise more debt and thus gearing level.
Loan finance – this is a common type of debt and is available in different terms usually short term. Medium term loans vary from 2 – 5 years. Long-term loans vary from 6 years and above The terms are relative and depend on the borrower. This finance is used on the basis of Matching approach i.e. matching the economic life of the project to the term of the loan. It is prudent to use short-term loans for short-term ventures i.e. if a venture is to last 4 years generating returns, it is prudent to raise a loan of 4
years maturity period.
- When the company’s gearing level is low (the level of outstanding loans is low.
- The company’s future cash flows (inflows and their stability) must be assured. The company must be able to repay the principal and the interest.
- Economic conditions prevailing. The company must have a long-term forecast of the prevailing economic condition. Boom conditions are ideal for debt.
- When the company’s market share guarantees stable sales.
- When the company’s anticipated future expansion programs, justify such borrowing.
Requirements for Raising Loan
- History of the company and its subsidiaries.
- Names, ages, and qualifications of the company’s directors.
- The names of major shareholders – 51% plus i.e. owner who must give consent.
- Nature of the products and product lines.
- Publicity of the product.
- Nature of the loan – either secured, floating or unsecured.
- Cash flow forecast.
Reasons Why Commercial Banks Prefer To Lend Short Term Loans
- Long-term forecasts are not only difficult but also vague as uncertainties tend to jeopardise planning e.g. political and economic factors.
- Commercial banks are limited by the Central Bank of Kenya in their long term lending due to liquidity considerations.
- Short-term loans are profitable. This is because interest is high as in overdrafts.
- Long term finance loses value with time due to inflation.
- Cost of finance – in the long term, the cost of finance may increase and yet they cannot pass such a cost to borrowers since the interest rate is fixed.
- Commercial banks do credit analysis that is limited to short term situations.
- Usually security market favours short term loans because there are very few long term securities and as such commercial banks prefer to lend short term due to security problems.
Advantages of Using Debt Finance
- Interest on debt is a tax allowable expense and as such it is reduced by the tax allowance.
- It is a conditional finance i.e. it is not invested without the approval of lender.
- Debt finance, if used in excess may interrupt the companies decision making process when gearing level is high, creditors will demand a say in the company i.e. and demand representation in the BOD.
- It is dangerous to use in a recession as such a condition may force the company into receivership through lack of funds to service the loan.
- It calls for securities which are highly negotiable or marketable thus limiting its availability.
- It is only available for specific ventures and for a short term, which reduces its investment in strategic ventures.
- The use of debt finance may lower the value of a share if used excessively. It increases financial risk and required rate of return by shareholders thus reduce the value of shares.