‘A small debt produces a debtor; a large one, an enemy.’
Publilius Syrus, former slave, writer
In a nutshell
Companies raise finance in one of two ways: debt or equity. Debt finance involves borrowing money that must be repaid with interest. The repayment date of the original amount borrowed (the principal) is normally fixed at the time of borrowing.
The borrower and the lender will agree upon:
- ■the interest rate
- ■the frequency and timing of payments
- ■whether or not interest can be ‘rolled up’ and repaid together with the principal sum.
Debt finance is typically obtained from banks, either in the form of an unsecured or secured loan. A secured loan (debenture) is an agreement that gives the lender security over the borrower’s assets. Once agreed in writing between the parties, it is registered at Companies House.
Debt finance is a cheaper form of finance than equity. This is because debt:
- ■provides an agreed level of return for debt holders, unlike equity which has no guarantee of return
- ■can be secured against the assets of the company, reducing the risk of loss to lenders
- ■ranks higher on insolvency, providing greater protection to debtholders (see Chapter 25 Insolvency and going concern risk)
- ■carries tax advantages to the company because interest is tax-deductible.
However, highly indebted (geared) businesses carry a higher financial risk of default because of the interest expense commitment that must be repaid (see Chapter 26 Long-term solvency performance measures).
Need to know 
Why is this important? 
Deciding how to finance a company is a critical decision for most businesses and can affect a company’s chances of survival or prosperity.
Debt finance is often seen as more attractive to business owners than equity finance (see Chapter 29 Equity finance) for a number of reasons including:
| Certain return | Debtholders receive an agreed (and contracted) level of return at an agreed frequency. Shareholders have no guarantee of any return. |
| No ownership | Debtholders have no automatic right to be involved in the business. A business that borrows money enters a commercial relationship that ends when the amounts borrowed are repaid, unlike equity finance, where control and ownership remain with the owners throughout. From an existing ownership and management perspective, this is highly attractive as it avoids interference in the running of business. |
| Security and ranking | Debt finance is generally cheaper than equity because loans may be secured against the assets of the business. In the situation of insolvency, lenders rank higher than shareholders in the ‘pecking order’ for repayment. They are therefore more likely to recover some, or all, of the amounts invested, as companies are required to maintain capital reserves to protect creditors’ interests (see Chapter 15 Capital and reserves). |
| Tax advantages | Interest is a deductible expense for tax purposes, unlike dividends. In the UK (which had a corporation tax rate of 19% in 2021), this means that for every £100 interest paid, the company reduces its tax liability by £19. In effect, the Exchequer contributes £19 of every £100 paid in interest by companies. |
Businesses may raise debt finance to reduce their overall cost of capital (see Chapter 35 Investment appraisal). Lowering the cost of capital will increase the viability of projects and contribute to higher profitability.
Debt finance carries drawbacks, however. Debt increases financial risk (see Chapter 26 Long-term solvency performance measures) because it commits the company to paying interest and (repaying) the amounts borrowed. Interest commitments mean that operating profits must first be used to service debt obligations, rather than be reinvested in the growth of the business. Where debts are secured against a company’s assets, any failure to pay interest (a default) could result in the company being forced to sell assets, which would reduce operating capability or even threaten survival (see Chapter 25 Insolvency and going concern risk).
In practice 
While debt is cheaper than equity, it is not a realistic option for every business.
New or small companies are often unable to secure debt finance, either because the business does not generate sufficient cash to pay interest or because the business does not have sufficient assets to offer as security. Equity finance is often, therefore, the only financing option available to small businesses (see Chapter 29 Equity finance).
Established companies generating recurring revenues with positive cash flows are more easily able to raise debt finance and many choose debt over equity in order to finance their growth, because this reduces their overall cost of capital (see Chapter 35 Investment appraisal).
A company’s operating cost structure should be a consideration in its choice of finance. Companies operating with high fixed costs for example should avoid debt finance, as even a small decline in revenues can have a significant adverse effect on operating profits, thus increasing the risk of interest payment default (see Chapter 33 Profit planning).
In practice, most businesses carry a mixture of both debt and equity finance. A debt–equity mix enables a company to benefit from some of the advantages of debt while managing the drawbacks, i.e. gaining tax benefits while keeping the financial commitments within an acceptable level.
Getting the optimal mix of debt and equity is part of a company’s financing strategy (see Chapter 26 Long-term solvency performance measures). From a practical standpoint, the ability to obtain debt will depend on the company’s credit standing. Lenders look at credit ratings, previous performance, availability of security, cash flow forecasts, business plans, etc. when deciding whether and how much to lend.
Low interest rates during the 21st century have made debt a more attractive form of finance for business. This has not, however, translated into a growth in debt financing. This is in large part because smaller companies, in particular, continue to find it difficult to borrow.
Nice to know 
The cost of borrowing
Finance costs (interest rates) charged depend on the level of risk or creditworthiness of the company. The higher the risk, the greater the reward required by lenders as compensation. A company will be charged a higher interest rate whenever there is a higher risk of default.
Covenants
Debt finance invariably comes with ‘strings attached’. A company is typically required to adhere to covenants. These are financial performance limits or targets that must be met (or not breached) and will be included in loan agreements, such as debentures. Typically, interest cover and gearing ratio covenants will be imposed to prevent a company from taking on additional, excessive debt. Covenants provide a degree of assurance to lenders about the borrower’s continued solvency (see Chapter 26 Long-term solvency performance measures).
Covenants may also require a debtholder to provide frequent and regular financial information. In practice, therefore, providers of debt finance may receive more financial information than shareholders.
Sources of long-term debt finance
- ■Long-term loans: Money is borrowed from banks or other financial institutions on a secured or unsecured basis. Loans have a fixed term (e.g. ten years), requiring repayment of the principal at the end of the term. Interest payments are made monthly, quarterly or annually until the principal has been fully repaid.
- ■Bonds: Larger entities may issue bonds to finance the business over the long term. A bond is a debt liability that typically requires the company to pay regular (for example annual or six monthly) interest payments to bond holders and to pay back the principal when the bond matures. One distinctive feature of bonds is that they can be bought and sold by bond holders although, like shares, their price may fluctuate because of factors such as demand and supply, credit ratings, analysts’ opinions, state of the economy, etc.
- ■Debentures: A debenture is typically a long-term loan secured over the borrower’s assets. A debenture, once agreed in writing between the parties, is registered at Companies House (see Chapter 21 Information in the public domain).
- ■Convertible bonds: Long-term bonds that give holders the additional right to convert debt to equity (shares) in a company. If the company performs well the lender has the option to convert bonds to shares at a pre-determined rate and benefit from any share price increase of the company. If the bondholder chooses not to convert, the company still has to pay interest on the bond and repay the principal when the term of the bond expires.
- ■Crowdlending or peer-to-peer (P2P) lending: Crowdlending facilitates loans to small and medium-sized businesses for the long term, on a secured or unsecured basis. Crowdlending uses online platforms similar to crowdfunding (see Chapter 29 Equity finance) and the terms are often used interchangeably. A crowdlending platform acts as a marketplace that matches the funding needs of borrowers with the investment appetite of investors. Because all activity is online, lenders operate with lower overheads, enabling borrowers to obtain funds more cheaply than might otherwise be available.
Funding Circle is one example of a marketplace business lender and was the first online platform in the UK, set up during the financial crisis in 2010. While the average loan amount raised is £60,000, it is possible to borrow up to £1 million in secured loans and £500,000 in unsecured loans (see below).
Sources of short-term debt finance
- ■Asset-based finance: Businesses, especially smaller companies, can be significantly affected when customers delay paying amounts due. To help with short-term financing requirements, asset-based finance schemes can help a business to unlock working capital to focus on generating growth in sales (see Chapter 24 Working capital and liquidity management).
A typical example of asset-based finance is invoice finance (IF). This involves factoring organisations (known as ‘factors’) providing upfront cash against the value of specific unpaid invoices in a company’s ledger. The factoring organisations make money by retaining a percentage of the debt as fees, while the business gets cash up front to manage their working capital.
- ■Overdraft: Overdrafts are the most common form of short-term financing and are typically secured on the assets of a business. While they are an obvious source of finance for many businesses, overdrafts are an expensive form of debt financing (see Chapter 24 Working capital and liquidity management).
Optional detail 
Secured versus unsecured debt
Debt finance is typically ‘secured’ on one or more assets, giving debtholders security over their lending. The legal mechanism by which this is achieved is known as a ‘charge’.
Fixed charge
A fixed charge is created on specific assets. A mortgage is the most common example of a fixed legal charge on specific property (land and/or buildings).
Fixed charges secure debt lending against particular assets. Where a company fails to meet its debt obligations a charge legally limits what the company can do with the assets charged. While fixed charges do not give lenders any ownership rights over the assets, they give the right to dispose of the asset in a situation of default to recover amounts owed. In the UK, fixed charges are registered at Companies House (and in the case of land and buildings registered also at the Land Registry) (see Chapter 21 Information in the public domain).
Floating charge
A floating charge is ‘unsecured’, i.e. it is not secured against particular assets. Lenders may resort to seeking a floating charge where a company does not have fixed assets, typically freehold land and buildings, or where its assets have already been secured with existing debt finance.
A floating charge can crystallise into a fixed charge if a company falls into financial difficulty. This typically happens when a receiver is appointed (see Chapter 25 Insolvency and going concern risk).
Floating charges provide less security to a lender than fixed charges and therefore loans secured with a floating charge normally have a higher rate of interest. The exact status of a floating charge in a winding up remains contentious legally, as the rights of lenders continue to be shaped by case law.
Credit ratings and the cost of borrowing
A company’s credit rating can have a significant impact on the price of its debt securities, typically bonds. Companies (and even countries!) carry credit ratings from rating agencies such as Fitch, Moody’s and Standard & Poor. For a company wanting to raise debt finance through issuing bonds, for example, the effect of a poor rating or rating downgrade can increase the interest rate (yield) on the bond, to reflect the higher level of risk of lending to that company.
Credit rating agencies use their own terminology for rating although notations are very similar. The highest rating of AAA (used by Fitch and Standard & Poor) or Aaa (used by Moody’s) indicates the highest level of creditworthiness.
In October 2020, Moody’s lowered the UK's sovereign debt rating by one notch to Aa3 from Aa2, citing government struggles to contain a second wave of coronavirus and pressure to sanction extra spending to protect businesses and jobs. A rating of Aa3, while below Moody’s highest rating (Aaa), nevertheless indicates a very high investment grade (with the borrower described as high quality, low risk with an acceptable ability to repay short-term debt obligations).
Reflect and embed your understanding 
- 1Why might having a mix of debt and equity finance be preferable to equity only financed businesses?
- 2It is argued that debt finance is preferable to equity finance as the latter means giving up ‘control’ to outside investors. Do you agree?
- 3What effect does a rating downgrade by a credit rating agency have on a company and its ability to obtain finance?
- 4Review several crowdlending/crowdfunding platforms (Funding Circle, Indiegogo) to gain a better understanding of this route to raising debt finance.
For the authors’ reflections on these questions, please go to financebook.co.uk
Where to spot in company accounts 
Debt is a liability of the company. Debt finance is long-term debt and is included within non-current liabilities.
Extract from Greggs plc Annual Report and Accounts 2020 (p. 41)
Actions to ensure liquidity
In March 2020 Greggs’ shops were closed in response to the first national lockdown and it was clear that access to additional liquidity would be required in order to support the business through a significant period of closure. Actions were taken to preserve cash, including the furloughing of most employees with support from the Government’s Coronavirus Job Retention Scheme (CJRS), cancellation of the previously-declared final dividend for 2019 and halting capital projects.
In April 2020 the Company established its eligibility to draw on the Bank of England’s Coronavirus Corporate Financing Facility (CCFF) and issued £150 million of commercial paper to ensure that it maintained a strong financial position in the face of what was then an uncertain period of closure. In December 2020 the Company put in place a £100 million revolving credit facility with a syndicate of commercial banks. This gave us confidence to redeem the CCFF commercial paper and, along with a net cash balance at the end of the year, has put us in a strong financial position going into 2021.
Consolidate and apply
To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 426.
Watch out for in practice 
- →‘Fine print’ in debt agreements. Lenders charge severe penalties for late or missed payments. Missing payments can lead to repossession of assets or cancellation of loan facilities.
- →Debt covenants in debt agreements. Breaches can lead to loan cancellation, repossession of property or penalties.
- →Credit history. A failure to make payments on time adversely affects credit ratings and reduces the ability to obtain financing in future.
- →Personal guarantees. Lenders often require guarantees from owners, particularly in smaller businesses where the company has insufficient assets available as security. While a company may be a ‘separate legal entity’, personal guarantees blur that distinction.
- →Year-on-year growth/change in debt financing.
- →Gearing levels (see Chapter 26 Long-term solvency performance measures).
- →Interest cover (see Chapter 26 Long-term solvency performance measures).
- →Security of debt (e.g. unsecured/secured).
- →Maturity dates for existing debt.