companies require short term, medium term, and long term debt in order to carry on their day-to-day activities and undertake investments that could result in an increase in production. A company needs short-term loans in order to meet its working capital requirements. Working capital, which is defined as the difference between current assets and current liabilities, is needed for the following operations: making payments to suppliers, making do before receiving payments from buyers, paying wages and salaries, and so on. Medium and long term debt is required for investments such as: buying land and equipment, investing in research and development, and incurring other expenses which are usually capitalized.
Types of Bank Loans
Secured bank loans are backed by a collateral. Generally, the assets of a company function as the collateral. In case the business is unable to pay interest and principal payments on the borrowed sum, the bank has the right to seize the collateral. This kind of bank loan is common and easy to obtain.
Unsecured bank loans, as the name suggests, are not backed by any collateral. In this case, the goodwill and reputation of the company play an important role. In addition to these factors, the credit history of the borrower also assumes importance. Naturally, a start up might find it difficult to obtain an unsecured bank loan.
Pros and Cons of Bank Loans
The choice of whether to borrow money from the bank or raise money by issuing bonds depends on a number of factors.
Credit Quality of the Borrower
The credit quality of the borrower determines the type of debt preferred by the borrower or the kind of debt that can easily be accessed by the company. Borrowers with medium credit quality generally prefer bank loans. Bonds issued by such borrowers carry a higher rate of interest than the interest on loans issued by banks. This is because, the bondholder’s claim is subordinate to the bank’s claim. In case of default, the bank has prior claim on the assets of the company. A medium to poor credit quality ensures that the borrower turns to bank loans.
Line of Credit
Banks provide a line of credit to the borrower. The line of credit has a revolving credit card structure which means that the business firm is expected to pay off only the minimum interest that accrues on its loans. A line of credit is useful for the business to meet its working capital requirements. Generally, the collateral for the line of credit is the firm’s inventory or its receivables. Unlike the line of credit, a bond provides a lump sum amount to the issuer and the interest is charged on the entire amount sanctioned.
Emerging Market Country Premiums
It has been observed that interest rate on bonds includes a huge country risk premium for companies in emerging economies. This is because emerging economies are characterized by inflation and political and economic instability. Such companies generally issue junk bonds that carry a high rate of interest. Bank loans, on the other hand, are better for firms located in emerging economies because restructuring foreign bank loans is easier compared to restructuring bonds that have a long maturity period. In fact, liquidating a bank loan is also easier. Hence, banks generally charge a lower country risk premium than bondholders.
Covenants define the obligations and rights of the borrower. Any bond carries both positive and negative covenants. Positive covenants are the rights of the borrower, whereas negative covenants are the restrictions imposed upon him. The restrictions may be related to incurring additional debt or selling off certain assets. Banks, in general, impose greater restraints on a borrower’s actions. The borrower may also be forced to maintain the EPS (earnings per share) within a narrow range. Failure to abide by the covenants might result in a substantial increase in the interest rate on the loan.
Companies can issue convertible bonds to borrow money. Convertible bonds give the bondholder the option to convert his bonds into shares. This is an advantage of corporate bonds over bank loans since the creditor now becomes the owner and receives dividend instead of interest. A company is not obligated to pay dividends unlike interest which is mandatory. The interest on convertible bonds is tax deductible and is generally lower than the interest on a similar debt.
During periods of economic prosperity it is easier to raise money by issuing bonds. However, during times of crisis it has been observed that obtaining corporate bank loans is an easier task. The current recession has resulted in banks freezing their lines of credit. This has made loans less attractive. Ultimately the mode of raising capital is a decision that has to be made by the management after careful analysis of the prevailing situation and the needs of the company.