Question

What are the most common sources of debt financing and what are their pros and cons?

Answer 1

Major sources of debt financing:

• Loans: this is considered to be the most popular source of debt finance for the businesses. The businesses borrow money against a security. The main advantage of loans is that they are a secured form of debt financing because banks are recognized financial institutions in the country & the procedures are also not that difficult to get a loan. The drawback of this source is that the companies have to pay regular interest for the debt that is borrowed by them.
• Trade credit: this is an arrangement where a business can purchase goods & pay for them later. This is a short term source of debt financing. The main advantage of this is that it can reduce the capital requirement & it also does not require any agreement. The drawback is that it is very costly if payment not made on time & it is also very challenging for a new business.
• Instalment purchase: this includes buying an asset & making payment in pre determined instalments. The buyer needs to mortgage his asset until the payment is made fully. But the benefit is that a business that has a good credit rating need not have to mortgage any of its assets. Banks & other financial institutions offer this facility of instalment purchase.
• Asset based lenders: these are financial companies that can lend money to the businesses for purchasing its assets. The main advantage of this form of debt financing is that it is very useful for businesses that has high inventory, accounts receivable, real estate or any other assets that can be pledged. The main drawback is that businesses will have to pledge their assets like inventory, accounts receivable to get the financing.
• Bonds: these are long term sources of debt financing. These are debt capital for businesses that are well established. The main pros of bonds are that prices of bonds fluctuate less & they also provide income stability. Drawback is that they provide lower long term returns when compared with stocks. Also prices of bonds fall when interest rates goes up.
• Factoring: under this factor purchases accounts receivables of the companies. The main advantage is that businesses would get timely flow of funds & need not have to wait for the customers’ payments. The drawback is that business will have to pay a fee or commission in return for this debt financing. The business can avail this facility based on their requirement which can be recourse or non recourse factoring.
• Insurance companies: Insurance companies act as a major source of finance for small companies. They provide two types of loans to the businesses namely; mortgage loan and policy loan. A mortgage loan can be availed by mortgaging any asset of the company. On the other hand, policy loan is based on the amount of money that is paid in the form of a premium on the insurance policy.