Debt Financing Flashcards
1
Q
What is debt finance?
A
Debt finance is when a business borrows money from a lender, which must be repaid with interest. The loan may be secured (backed by collateral - secured against an asset, such as property or equipment) or unsecured (no collateral required).
2
Q
What is the legal principle of debt finance?
A
Debt finance is governed primarily by contract law and, where secured, by the Companies Act 2006. Secured debts must be registered at Companies House within 21 days under s. 859A CA 2006. If the borrower defaults, secured lenders can enforce their rights over the collateral.
3
Q
What are the advantages of debt finance?
A
- Quick and flexible to arrange – Debt finance can usually be obtained faster than equity finance, especially if the borrower has a good credit rating or valuable collateral.
- Retains ownership and control – Borrowers do not have to sell shares or give up any control over the business, unlike equity finance. The lender has no say in how the company is run.
- Tax efficiency – Interest payments are tax-deductible, meaning they can be deducted from taxable income, reducing the overall tax liability. This makes debt a cost-effective option compared to equity.
4
Q
What are the disadvantages of debt finance?
A
- Cost of finance (Interest Payments):
Borrowers must pay interest on the loan, which increases financial obligations. The interest rate can be higher for unsecured loans since there is no collateral to reduce the lender’s risk. - Risk of losing assets (Secured Loans):
If the loan is secured and the borrower fails to repay, the lender can seize the collateral (e.g., property, machinery) to recover their money. This poses a serious risk to businesses that rely on key assets. - Repayment obligations:
Loan repayments must be made even if the company is not profitable. This can create cash flow problems, especially for businesses with irregular income.
