Debt financing is the process where companies raise capital to their cash flow by selling debt securities to individuals or institutional lenders. In many cases, the corporations might even borrow the money from these financiers at a specific rate of interest. In return, the companies promise to repay the principal and the interest payable on their debts to the lenders within a certain period. Subsequently, the lenders remain the companies’ creditors in the financial records until they are able to clear their outstanding debts. It is a convenient way for companies to obtain the necessary funds to run their businesses without having to forgo an ownership stake.
Kavan Choksi – Why do companies opt for debt financing?
Kavan Choksi is a businessman with an interest in modern technology, photography, and business finance. According to him, companies often have to depend on external sources to obtain money to boost their cash flow position. In this situation, these corporate enterprises have two options open to them. In the first instance, the companies can issue and sell equity shares to individuals who are willing to buy the financial instruments. These investors can then stake a claim to the ownership of the corporations and the future after-tax profits they generate. They even participate in the decision-making process at the companies’ annual general meetings.
Most companies are unwilling to forgo a stake in ownership and control of their businesses to raise capital. Moreover, corporations find issuing shares to investors is both time-consuming and expensive. Corporate enterprises prefer to choose the second option of debt financing to obtain funds. It involves selling debt securities in the form of bonds or debentures to institutional lenders at competitive prices.
In return, the corporate enterprises receive capital from the financiers. The lenders become the companies’ creditors and receive payment in accordance with a legally-binding debt financing agreement. Another form of debt financing arrangement involves the companies taking out a loan for a certain period from the institutional lenders.
The corporations need to fulfill the following stringent conditions to obtain business loans from institutional lenders:
- Offer to submit documents certifying the good credit scores of the companies and their directors,
- Provide copies of financial statements show their businesses are generating adequate revenue,
- Submit copies of bank statements to indicate their existing business cash flow position, and
- Pledge to provide suitable business assets as collateral security for availing loan funds,
The advantages of selling debt securities to or taking out a loan from institutional lenders for companies are as follows:
- Helps the corporations to improve their business credit score,
- Enables the companies to claim a tax deduction on the principal and interest payments, and
- The cost of raising capital via debt financing is cheaper than issuing shares.
According to Kavan Choksi, debt financing is a convenient and cost-effective way for companies to procure capital. However, corporate enterprises should consider the following factors when approaching institutional lenders to sanction their loans. Financiers they consult should have a good market reputation and sound knowledge of the nature of the companies’ business. Moreover, the companies should accept the terms, tenure, interest chargeable, principal payment, and collateral conditions of the loan agreement.