Characteristics of the Debt Finance Essay Example

Debt financing is financing a company by selling the bonds, notes or mortgages held by the business. Basically it is borrowing money to keep your business running. Long term debt financing is typically associated with larger assets such as buildings, equipment, land, and large machinery.

The schedule for repayment for long term debt financing expands for more than a year. Short term debt financing is mostly associated with operations of the business such as inventory purchasing, payroll, and supplies. The repayment of short term debt financing happens in less than a year. With debt financing, your business does not have give up future profits or ownership in the company like with equity financing. Debt financing is more commonly known as selling bonds or debentures.

Debentures are tools used by large companies to raise capital for their projects and operations.

This is known as a debt offering since the company literally goes into debt to the investors until the price of the debenture is paid back, plus interest, or until it is converted into stock. The company must record this debt in their balance sheet.

If bankruptcy occurs, the debenture holders are considered creditors and must be paid back by the company’s remaining assets. Debentures are a way for companies to raise capital without having to use their assets or give up ownership in their company. This leaves their assets free to do other things to generate capital for the business. Long term Long term debt financing is done, when the repayment schedule of the loan and the approximated useful life that the purchased assets have is expected to go beyond one year.

These assets can be machineries, computers, shelving, land and other such things.

The long term loans are usually secured initially up to 65 percent by the purchased assets and then, the remaining 35 percent by the unburdened physical assets. If both these things fail, then the services are availed of guarantors and shareholders. Characteristics of the Long Term Loans of Debt : The principal amount is repaid over a time period that is in direct relation to the utilitarian life of assets such as buildings and land up to 30 years and computers for 3 years. The long term loan of debt carries the repayment provisions of both the principal as well as the interest in a repayment schedule that is preset. The repayment that is done before time is penalty bound, on account of the non-planning of the alternative investments regarding the same by the lenders.

The percentage of the interest rate usually remains steady for the entire loan term. Every payment of the original amount reduces the balance in it and subsequently, the interest is computed on the reducing balance of the amount. 

The Evaluation and Approach of the Loans

 The long term loan evaluation is a very sophisticated and rigorous process, than the evaluation of mortgage loans. The lenders of such loans are in fact evaluating the management teams ability, seeing the situations commercial viability and the collateral security attached for supporting the loan application, as mentioned in the financial submissions. The evaluation of the long term loans requires a plan that is in the format of a bound presentation and provides all the detailed information about the companys management or the project or individuals.

The loans concerning the business requires the exact history of it, the production methods of its products, the operations of the business, its market position, the purpose of taking the loan with the intimate details, the securities given for the loan approval and the extensive projections and financial information regarding the business. 

Most of the people approach the field of money borrowing with some apprehension. In fact, the borrowing of money from financial institutions has not to be viewed as begging. Rather, it has to be viewed as giving an opportunity to the commercial loan institute for doing business. The money is borrowed from the people, who aid in soliciting the business of the individuals taking the loan. Loans are in fact a commodity on the shelves of the retailers.

The aspirants of the loans are actually helping the lenders in doing business. Short Term CF Short Term Debt financing usually applies to money needed for the day-to-day operations of the business, such as purchasing inventory, supplies, or paying the wages of employees.

Short term financing is referred to as an operating loan or short term loan because scheduled repayment takes place in less than one year. A line of credit is an example of short term debt financing. 

Generally speaking, a loan is nonperforming when it is not making income for the lender. According to the “Financial Times,” the point when a loan is classified as nonperforming by a lender and when it becomes a bad debt depends on local regulations. There is no global standard to define non-performing loans at the practical level.

Variations exist in terms of the classification system, the scope, and contents. Such problem potentially adds to disorder and uncertainty in the NPL issues. For example, as described by Se-Hark Park (2003), during 1990s, there were three different methods of defining non-performing loans in Japan: the 1993 method based on banking laws; the “Bank’s Self-Valuation” in March 1996; and the “Financial Revival Laws-Based Debt Disclosure” in 1999. These measurements have gradually broadened the scope and scales of the risk-management method. 

Similar to the trend in Japan, more countries, regulators, and banks are moving towards adopting and adapting better and more consensus practices. For example, in the U.S., federal regulated banks are required to use the five-tier non-performing loan classification system according to BIS: Pass, Special Mention, Substandard, Doubtful, and Loss.

Presently, the five-tier system is the most popular risk classification method, or, in some cases, a dual system of reporting according to their domestic policy guidelines as well as the five-tier system. According to BIS, the standard loan classifications are defined as follows:

1. Passed: Solvent loans; 
2. Special Mention: Loans to enterprises which may pose some collection difficulties, for instance, because of continuing business losses;
3. Substandard: Loans whose interest or principal payments are longer than three months in arrears of lending conditions are eased. The banks make 10% provision for the unsecured portion of the loans classified as substandard; 
4. Doubtful: Full liquidation of outstanding debts appears doubtful and the accounts suggest that there will be a loss, the exact amount of which cannot be determined as yet. Banks make 50% provision for doubtful loans; 
5. Virtual Loss and Loss (Unrecoverable): Outstanding debts are regarded as not collectable, usually loans to firms which applied for legal resolution and protection under bankruptcy laws.

   Banks make 100% provision for loss loans. 

Non-performing loans comprise the loans in the latter three categories, and are further differentiated according to the degree of collection difficulties. In addition to the standardised system, efforts have been made to improve the classification of loans. For example, more countries are shortening the period when unpaid loans become past due, intending to put loans on lenders’ timetable sooner and require them to address these loans before losses start to escalate. The International Accounting Standard 39 revised in 2003 focuses on recognition and measurement of financial instruments and, most importantly, defines and establishes the measurement and evaluation of impaired loans. As lenders usually make little or no loss provision for impaired loans, they are at risk to be suddenly forced to reclassify such loans as a loss and take a full write-down if the borrowers go bankrupt. 

The initiation of this standard is to prevent lenders from being caught off-guard.

In addition, many global economists, rating agencies, and organisations such as the World Bank and the Asian Development Bank have begun to evaluate the effects of NPLs on GDP growth. They reduce growth estimates to reflect the time and cost of resolving large non-performing loan issues. 

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