CFM11030 - Understanding corporate finance: raising finance: debt finance

Debtors and creditors

Where funding is raised in the form of debt, the lender of any person who subsequently becomes entitled to receive payments under the debt is referred to as a creditor and the borrower or a person otherwise subject to obligations under a debt security is known as the debtor.

These terms are picked up in the loan relationships legislation (CFM30000+) where a ‘debtor loan relationship’ is the debtor’s relationship with a money debt (a liability), and a ‘creditor loan relationship’ is a creditor’s relationship with such a debt (an asset).

Sources of borrowing

A company that wishes to raise its finance in the form of debt rather than equity may be able to borrow from a number of sources. A small family company will probably borrow from banks, finance companies or from people or companies it comes into contact with.

A medium sized company may use the services of a broker who, in return for a commission, finds a lender to match the needs of the borrower in the domestic money markets.

Larger companies will be able to attract other lenders. For short term finance, in addition to overdraft facilities and short-term loans, they may, for example be able to issue commercial paper (see CFM11050).

For medium to longer term funding, they might issue debt securities such as corporate bonds into a market where the debt can be bought. CFM11060 looks at corporate bonds in more detail.

Ranking of debt

Some forms of debt rank above others. Where the terms of the debt require it to be repaid ahead of other debt in the event of bankruptcy or other insolvency scenarios, it is described as senior debt. Subordinated, or junior, debt has a lower priority, is often unsecured (that is, not backed by collateral), and in a bankruptcy, subordinated debtholders receive payment only after senior debt claims are paid in full.

Risk and reward

Whether or not a company is able to raise funds by borrowing, and on what terms, will depend on factors such as the nature of the company’s business, its creditworthiness, the sort of security it is able to offer for the borrowing and the state of the money and bond markets. A lender will require a return for the use of the funds borrowed, commonly in the form of interest. CFM11080 describes some of the more common forms of return from debt.

In addition to a return from the use of the money lent, the lender will want its principal repaid by a specific date or according to a defined schedule.

Some businesses are so risky, and some forms of debt may be so deeply subordinated (that is, ranking after all other creditors) that the lender has no certainty about getting their money back. From the investor’s perspective, where there is little prospect that debt will be repaid it may in effect share the characteristics of equity finance, and the investor will look for a correspondingly higher return to compensate for the higher risk of losing its investment.

Senior debt is debt that provide the holder with the first claim to repayment and recourse to secured assets in the event of insolvency. Less secure ‘mezzanine finance’ is debt which is either unsecured or, more likely secured, but ranking behind senior debt. The risk to the holder of such debt is higher than that of senior debt; so, correspondingly, the return to the investor in terms of interest would be expected to be higher.