Borrowed Sources of Finance — Debentures, Institutional Loans and Public Deposits

Borrowed sources of finance are funds raised from outsiders who are not owners of the business but who lend money to it for a specified period, in return for a fixed rate of interest and a promise of repayment. Because these amounts must be repaid with interest regardless of whether the company earns a profit, borrowed sources increase the financial risk of a business, but they also let a company raise large sums without diluting the ownership or control of its existing shareholders. The principal long- and medium-term borrowed sources are debentures, loans from commercial banks and financial institutions, and public deposits.

A debenture (sometimes called a bond) is a certificate acknowledging a loan taken by a company from the public or from institutional investors. A debenture holder is a creditor of the company, not an owner, and therefore has no voting rights and no share in the company's profits beyond the fixed rate of interest promised on the debenture. This interest must be paid whether or not the company makes a profit, and the principal amount must be repaid on the date of redemption specified at the time of issue. Debentures may be secured, meaning they are backed by a charge on the company's assets which the debenture holder can claim if the company defaults, or unsecured, meaning they carry no such specific backing. Debentures are an attractive means of raising long-term capital without diluting ownership, and the interest paid on them is a deductible business expense, but they add a fixed financial burden that a company must be confident of meeting even in a lean year.

Loans from commercial banks and specialised financial institutions are another important source of finance, especially for the medium and long term. Banks and institutions extend both working-capital finance — such as cash credit and overdraft facilities to meet short-term needs — and term loans for the purchase of fixed assets or for expansion. Such loans are usually granted against some security, either of the assets being financed or of other assets of the business, and carry an interest rate that depends on the borrower's creditworthiness and the current lending rates. Institutional loans allow even a business that cannot access the public capital market, perhaps because it is not yet a large public company, to raise substantial finance, and the terms of repayment can often be structured to match the pattern of the business's own cash flows. …