Regardless of a corporation's size or line of business, there are two fundamental ways to finance its operations. Either the owners can put up equity or the business can borrow money. Debt financing is a broad term that encompasses all possible ways of borrowing funds.
Bank loans are the first tool many consider in the context of corporate debt. In case of multinational giants, a consortium of banks may lend hundreds of millions of dollars, while the bank loan to a local grocery store may be much smaller. Bank loans usually require some type of collateral, an asset that the bank can confiscate and sell if the borrower fails to make timely payments. Real estate, such as land, office buildings and stores, are the most common types of collateral.
Bonds are financial instruments that promise a specific periodic payment to the rightful owner of the bond at the time of payment. For example, a bond might promise its holder a payment of $1,000 on June 1 every year for the next 10 years. The bond holder can sell the bond at any time. To obtain this privilege the bondholder will make a lump-sum payment when purchasing the bond. Interest rates on bonds are generally lower than bank loans, but bank loans often can be accessed faster in times of need.
Payables to Suppliers
Very few businesses purchase everything with immediate cash payments. Even the most affluent companies have some outstanding payables to suppliers of raw materials, utilities and even labor. Retailers can obtain payment terms of several months, then turn around and sell some of the products for cash long before the bill comes due. In such cases, loans to suppliers can turn into a key financing tool and reduce the amount that must be put up by shareholders to sustain operations. However, being too reliant on supplier loans could carry hidden costs. Some suppliers may be unwilling to provide the best-selling items or make hefty discounts available to retailers who enjoy very long payment terms.
Uncommon Debt Instruments
Some loans, as well as bonds, carry special provisions that give them properties of both debt and equity. These are sometimes called hybrid instruments. Convertible bonds can be exchanged for shares after a certain date. In addition, bank loans may carry provisions that allow the bank to become a shareholder if the borrowing business falls into financial hardship. This allows the lender to have a say in how the distressed business is run, thereby enhancing the probability that the business will emerge intact and profitable.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.