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As in my previous part, I already presented about financing source which derives from the shareholders of the company, and its relation towards equity items in the Balance Sheet. In this part, I will introduce the second method to raising finance. They are Debt financing sources.
Investopedia.com defined this term as they are used when a company or firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. They includes: bank loans, financial companies and investment funds. There are also a lot of different forms of these sources: debenture, loan, overdraft, lease and hire purchase.
First of all, it is debenture. Debentures are defined like amounts loaned to a company. Debentures have no collateral. Bond buyers generally purchase debentures based on the belief that the bond issuer is unlikely to default on the repayment. Both corporations and governments frequently issue this type of bond in order to secure capital. Like other types of bonds, debentures are documented in an indenture.
In particular to bank loan, when a business needs a substantial amount of finance, it is likely to apply for a bank loan. A bank loan is a monetary loan received from a commercial lender. Bank lends their money to business follow CAMPARI principles. It is normally secured on the assets and the interest rate may be variable or fixed.
Beside bank loan, overdraft is an available source. Overdraft financing is provided when a business makes payments from their business current account exceeding the available cash balance. This type is used like short-term financing. Therefore, it is useful for daily expenses.
The next financing type is hire purchase, when a business cannot afford to buy assets outright, such as vehicles, machinery and equipment, it could choose to lease or hire purchase them. Hire purchase is a form of borrowing whereby an individual or business purchases goods on credit and pays for them by installment. Its contract is arranged by the vendor of the goods but is usually between the customer and a finance company. In details, the supplier sells goods to the finance company, and then it delivers the goods to the customer who will eventually purchase them and the hire purchase arrangement exits between the finance company and the customer. When hire purchasing, a business must pay a deposit and monthly payments for the term of the agreement. At the end of the contract the business owns the assets. This is a choice in case company does not have enough money to afford brand new machine for next period’s growth plan.
Bank loans. When a business needs a substantial amount of finance, it is likely to apply for a bank loan. The loan may be existed risk because of the interest. Firstly, the company got a loan for a reason, and if it borrowed in right way, it borrowed such that the returns on the investment that it is going to use the loan for are higher than the loan costs, putting its ahead in the long run. This means that the borrower has risk: risk that the return on the investment will be too low and the costs of the loan too high, making business’s endeavor a financial failure. This is a form of interest risk. The biggest risk for a borrower, then, is that something will go wrong with the investment and he won't be able to pay back the loan. Therefore, it is able for company to become bankruptcy.
Beside, the legal of loan is very complicated. The legal of interest as well as conditions of a business to make a loan do not only depend on the bank and the borrowers but also law of government in this time. This is a system of law including a lot of contents and repaired contents every year. This means it is not easy for firm to make a bank loan. In the addition, it takes a quite long time to get a loan. This is also a disadvantage of this source.
In the opposite, Bank loan have a lot of advantage. First, the company pay the fixed amount loan plus because the interest set from the beginning. The interest rate of a loan is fixed so the company can calculate exactly the expense for loans to make financing as well as activities plan in a period’s time. In the other words, it helps company to control the working capital better than other financing method.
In the addition, there is no dilution of control when using this source. The lenders do not have any rights and authority in the business. All of control still belongs to the owner. They still are the persons who make business’ decisions.
Furthermore, according to law, interest of loan that the business must pay is a kind of expense. As the result, the cost of loan will reduce the profit of the business. Because of this, the corporate tax will be decreased.
So after financing, how is the debt look like in the Balance Sheet?
The debts raised will match to items of Liabilities section. For example, short term bank borrowing, long term bank borrowings, finance lease obligations, so on.
Both equity and debt financing have advantages and disadvantages. Company needs to use them wisely, in an appropriate ratio. If mainly using debt financing, company has to suffer lots of interest charge. Too much equity financing, you can lose your company. Be balance!
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