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.
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.
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
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?
- 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.
- 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
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.
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.