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Companies and financial accounting
Companies and financial accounting

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2.3 Loan finance (debt capital or loan capital)

Companies can obtain debt capital in several ways, such as obtaining a loan from a bank, or issuing debentures (or bonds) or other debt instruments.

A debenture is evidenced by a formal document issued by the company which acknowledges its indebtedness, and will generally set out the terms of the loan, for example, rates of interest, dates the interest is payable (usually every six months), repayment of capital, etc.

Debentures may be issued by two methods:

  • public offer
  • private placement (where the offer is being made to a select group of persons).

While public companies can issue debentures using either method, private companies may only issue debentures using the private placement method.

It is common for a debenture to be secured or charged on a company’s assets, but it need not be. A prudent lender may insist on securing the loan on one or more assets of the company because a secured creditor has the right to be paid before unsecured creditors in the event that a company is liquidated.

As mentioned above, it is common for loans and debentures to be secured on a company’s asset(s). There are two types of charges:

  • fixed charges
  • floating charges.

Fixed charges

A fixed charge is when a loan or debenture is secured on a specific, identified asset (often land and/or buildings). The effect is that the company cannot sell the asset without the chargee’s agreement until the period of the charge comes to an end.

Floating charges

A floating charge attaches to a particular class of assets, which would typically change frequently during a normal trading cycle, for example bulk goods. It is a useful device for obtaining security over a company’s current assets, as it allows a company to deal freely with such assets, and provides a wider range of assets that can be charged.

A floating charge does not attach to any particular asset until crystallisation occurs. Crystallisation means that an event specified in the debenture document occurs which causes the charge to attach, such as the company being unable to pay its debts, especially the debenture interest. The company ceasing to trade or going into liquidation will also cause a floating charge to crystallise. A floating charge also has lower priority than any fixed charge.

Priority and registration of charges

The priority of a charge for repayment depends on the type of charge and whether or not it has been registered with the Registrar of Companies, which must be done within 21 days of creation of the charge. If the charge is not registered, if created within 12 months of winding-up, a liquidator may ignore it. Non-registration also results in the company and all officers in default being fined and makes the money borrowed repayable at once.

Activity 5 Comparing loan and share capital

Timing: Allow about 15 minutes

The purpose of this activity is to understand advantages and disadvantages of loan capital when compared to share capital.

Think of advantages and disadvantages of debt capital over share capital. What advantages and disadvantages can you think of?

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Advantages:

  • Debentures are usually cheaper to issue and may be issued at a discount.
  • There are fewer restrictions on redemption, and they do not ‘dilute’ control of the company as they do not carry voting rights.
  • The board does not usually need authorisation from the shareholders to issue debentures.
  • The interest payable is an allowable deduction from profits for corporate tax purposes.

Disadvantages:

  • Companies in financial difficulty may find it difficult to pay the required interest, so failure to pay may compel lenders to instigate liquidation and/or administration procedures, if the debentures are secured.
  • Also, if companies have a high level of debentures (and/or other loans) in comparison with share capital, they are said to have high gearing, and this adversely affects the market price of public company shares.

Activity 6 Sources of finance for small and medium-sized businesses

Timing: Allow about 15 minutes

The purpose of this activity is to learn about the different sources of company finance for small and medium-sized companies.

To remind you of the different sources of financing watch the video on sources of finance for small and medium-sized companies, and take notes on the sources of financing to which you had not yet been introduced.

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NARRATOR
In this presentation, we'll show the variety of sources of finance for a business as it matures. The different types and amounts of finance comprise the overall capital structure. The choice about capital structure, in particular the amount of equity versus debt, is a strategic decision. this involves a consideration of the risk-return trade off of each source of finance in the context of what type of business it is, its activities, and its environment.
On incorporation at startup, equity funds the newly formed company. The owners-- in other words, the shareholders-- contribute cash in return for a share of the business. Each shareholder is given a share certificate.
The return to shareholders is a dividend, which is paid at the discretion of the directors and any capital gain or increase in the value of their shares. The risk for shareholders is that there is no obligation for the business to repay them if the company becomes bankrupt. This means that shareholders can lose the amount they originally invested in the business.
Another source of finance available to a business at startup is from its suppliers. This is shown in trade payables on the balance sheet. This is a short term source of finance shown in current liabilities. If suppliers are happy with the company's ability to pay cash in the future, they may offer credit terms. This would allow a business to defer payment for a set period, commonly 30 days. Careful management of trade payables can result in suppliers funding the business in the short term.
After startup, a business uses its existing cash to support future growth by increasing its investment in non-current assets. Further sources of finance may be necessary to supplement equity finance. This process increases the size of a company's balance sheet.
Debt borrowing comes in an array of forms, primarily bonds issued by the company and bank loans. Bonds and bank loans are structured around investors depositing money with a company for a fixed period of time. It's a contractual arrangement enforced by law and receiving interest payments, which can be fixed or variable.
At the end of a loan period, a business pays back the original sum that was lent to it. Returns for the investor or lender are contractual and must be met by a business. Debt borrowing can be secured on business assets. In the case of default, the company's assets can be taken by the debt holder, converted to cash, and used to settle any amounts that are outstanding.
A variety of equity finance may appear on the balance sheet as the business continues to develop and grow. There are different types of equity capital.
The shares issued to shareholders at startup are typically ordinary shares. Preference shares are another type of equity and are issued in the form of a tradable share certificate. Preference shares have some of the characteristics of debt.
Preference shares pay a set return-- for example, 5%-- which is calculated on the original investment. Holders of preference shares receive dividends before ordinary shareholders, hence the name preference shares.
In the case of bankruptcy, the same preference applies to the preference share capital that has been invested. Any cash available for shareholders will go to the preference shareholders before the ordinary shareholders. Preference shares can be redeemable, that is repaid is set time, or irredeemable, which means that the investment is permanent. Ordinary shares are typically irredeemable.
Leasing gives rise to both leased assets and lease liabilities. Leasing transactions involve the company paying periodic fixed amounts, usually monthly, in order to use an asset or set of assets, for example, of furniture and equipment for a set period. The terms in a leasing contract determine whether leased assets and lease liabilities are shown in a company's balance sheet.
For a financed lease, the leased asset and the associated financing commitment as shown on the balance sheet. This occurs where the terms of the contract-- for example, the price and the length of the lease period-- mean that, in effect, the company is purchasing the asset to use as part of its business operation.
The other type of lease contract, called an operating lease, results in no additions or change to the balance sheet. Included in the current liabilities is an overdraft, which is a short term form of bank borrowing. A business may need to use an overdraft to plug a short term gap in cash resources.
However, using an overdraft as a form of financing can be risky as the lender can demand that the overdraft is repaid at any time. It can also be expensive for a business as a higher rate is charged by the lender. This is to compensate the lender for making funds available on tap and as a result, losing investment opportunities.
Convertible loans stock is a form of financing issued as a loan. It typically has a fixed return and a fixed period, which at a future date decided by the issuer is converted into ordinary shares. So the loan, in other words, the debt finance becomes equity.
Convertible debt is issued when there may be a lack of investor appetite for the business. Structuring the debt as a loan initially ensures some degree of security for investors with the promise of enhanced gains in the future after the loan has been converted to equity. You've now reached the end of this presentation.
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The video discussed equity and debt finance, which you learned about earlier, but also about trade credit and leasing as means through which small and medium-sized business finance their operations. Accounting for leasing is an advanced topic, so it is outside the scope of this course.