Requirements a Company must meet before raising Debt Finance.

·       The company must provide a summary of history of the business and its nature. This is used to assess the risk of the company’s business line.

·       Details of management – names, ages, qualification and experience of managers and directors. If these are of questionable integrity, such as a company may not get debt finance.

·       To produce five years audited accounts which will reflect the company‘s financial ability to service debt finance.

·       The purpose of the loan must be; within the lender’s priority and within the government areas of priority for development purposes.

·       Furnish lenders with cash flow forecast and proposed trend of repayment.

·       Major shareholders of the company must give consent to the loan.

 Reasons why Commercial Banks prefer to lend short-term

·       Majority of deposits with these banks are subject to withdrawal on demand and short-term notice these cannot be lent long term. The violation of this principle leads to the downfall of a number of financial institutions.

·       Commercial banks are subject to sudden credit squeeze imposed by the central Bank and as such they have to keep their investments in short-term investments to meet the requirements of the central bank.

·       Short-term forecasts are usually accurate and also short-term investments are less risky which is thus preferable to commercial banks.

·       Short-term investments are usually more profitable to the banks e.g overdrafts which carry higher rates of interest than long-term loans.

·       Usually short-term investments are not secured e.g. overdrafts and thus are easier ad more flexible go give.

 Limitations of debt finance/ disadvantages of using debt finance to the company.

·       Interest is a legal obligation and failure to pay it may lead the company into receivership and consequently liquidation.

·       Using debt finance entails conditions and restrictions to its use and this makes it non-flexible finance which can only be invested in those ventures approved by the lenders.

·       Its use on large scale increases the company’s gearing level which exposes the company to incidences of receivership and thus liquidation.

·       It is not usually long-term finance and the payment of principal leaves the company in financial strain and may cause liquidity problems to the company.

·       The use of excessive debt finance i.e. beyond 67% level puts the company at the mercy of the lenders because they can come in to control their interests which dilute the control of owners and this may lead to lower share prices.

·       Moreover, this finance calls for a security i.e. it is usually secured against a collateral security which may be rare or lenders may be rare or lenders may restrict the use of such asset thus reducing the company’s operations and thus its profit.

·       The lenders usually insist that the security be compressively insured which will compound the cost of this finance as it will entail an implicit cost to the company.

·       This finance is available only in big businesses which are known to lenders and as such small companies will not be able to raise it easily as they are assumed to be risky and are in most cases unknown to lenders.

 Advantages of using Debt Financing

·       Most debt financing is short-term and as such it will not burden the company‘s cost of financing for long i.e. cost is short-lived.

·       Interest on debt is a tax-allowable expense and thus the effective/real cost of debt will be equal to interest less tax on interest i.e. interest is less by the much of tax on it. (refer to cost of finance)

·       The principal is later reduced in real monetary values by much of inflation on it i.e the company pays less on long- term loans by virtue of inflation reducing the real monetary value of the principal and interest.

 ·       The use of debt finance does not necessarily entail dilution of control to existing shareholders are these shareholders may only lose the control if the company has used 67% of debt finance in its financing i.e in its total capital employed.

·       It is usually invested in viable ventures whose return is higher than its cost, thus it is used with a good investment policy

·       This finance does not call for a lot of formalities in its use in as much as it does not involve a lot of floatation costs.

 Circumstances under which a company should use short-term debt finance.

Under situations when the company has identified a venture which calls for finance on short-term notice and will pay back early enough to facilitate repayment of the loan.

Under situations where the company’s venture promises higher returns that the cost of debt finances.

Under high debtor’s turnover where the company wants to boost sales through further investment in stock.

Under boom conditions when the company’s cost of debt is relatively lower as profits will increase relatively and the company can be able to service debt finance. This will raise the earning per share of the company’s shares.