Characteristics of Debt Finance

·       It is a fixed return finance i.e. interest on debt is fixed regarding less of the profits made by the company.

·       Interest of debt finance is a legal obligation on the part of company to pay and failure to pay it may lead the company into receivership in the extreme.

·       It is usually given on conditions and restrictions except for overdrafts.

·       It carries a first claim on profits and assets before other finances.

·       It does not carry voting rights and as such it does not participate in the decision making process of the company.

·       Its use rises the company’s gearing level.

·       It is always refundable except for irredeemable debentures.

·       It is usually a secured type of finance

·       Interest on debt finance is a tax-allowable expense.

  Classifications of debt Finance.

Short-term finance

This ranges from 1 month up to 4 years and is given to customers known to the bank or to lenders. The agreement of this loan will mention both the repayment of principal and interest, and must identify whether it is simple or compound interest. For principal, it has to be paid over some time. This finance usually secured and the terms of the loan will be restrictive. Usually be invested in an area acceptable to the bank or lender. Usually this finance should be used to solve short-term liquidity problems.

Medium –term finance

This finance will be in the business for a period ranging between 4-7 years. This term is relative and will depend upon the nature of the business. This type of loan is used for investment purpose and is usually secured but the security should not be sensitive to the company’s operations. The finance obtained must be investigated while respecting the matching approach to financing i.e the term and payback period must be matched. This type of finance if the most popular of all debt financing because most of the businesses will need it both in their growing stages and also their mature stages of development;

Long-term finance

This is a rare finance and is only raised by financially strong companies. It will be in business for a period of 7 years and above. This finance is used to purchase fixed assets in particular during the early stages of a company’s development. It is always secured with a long-term fixed asset usually land or buildings. Its investment, however must obey the matching approach. In all, the companies needing such finance do not have to be known to the lenders.

Reasons why long term loans are difficult to raise/ limitations of using long-term debts.

·       This finance calls for long-term securities such as land and buildings which most businesses may not have.

·       There are no long term savings to back-up these loans due to low income of average business people and as much most of the savings are short-term and cannot be made available on long-term basis.

·       Most businesses are agro based and these are risky and as such lenders cannot avail their finance to such businesses of long-term.

·       The central bank has tended to stimulate the development of money markets than capital markets which have not been fully developed to avail such finance to meet the development needs of industry and commercial sectors of the economy.

 ·       Long-term loans are not usually profitable because interest and principal repayment are eroded by the by the impact of inflation and thus banks may be reluctant to give such.

·       The size of the businesses in Rwanda and other developing countries is small and such businesses are not going concerns so as to be able to attract this finance on long term basis.

·       A number of companies in Rwanda are multinational companies which obtain long term finances from parent companies abroad and this has limited the development of capital markets in Rwanda as demand by such companies is low.

·       There has been a tendency by the financial institutions to avail long term debt for building purposes and little attention has been paid to long-term finances for businesses.

·       This finance is given on conditions and restrictions to avail long-term debt for building purposes and little attention has been paid to long-term finances for businesses.

·       This finance is given on conditions and restrictions which make it less ideal for profitable ventures as such restriction may reduce profitability of companies concerned.

·       Long-term forecasts by commercial banks are inaccurate and filled with a lot of uncertainties thus the banks are very reluctant to shield such potential risks and prefer to lend short term finances which they can forecast with some degree of accuracy and certainty.

 Solutions to the above problems

The government should diversify the security such that the same asset acquired acts as its on security and also to allow guarantees as securities in particular personal guarantees

The government or individual commercial banks should undertake mass education campaigns to businessmen so as to induce them to save/keep their money in banks so as to avail such money of long –term lending.

The government should participate in the development of this capital market by;

Allowing some parastatals to go public i.e. to sell shares to the public

 Selling or purchasing long-term debt instrument or creating a market for these and allowing the forces of demand and supply for money to operate freely in Rwanda so as to determine the prices of securities in the financial market.

The government should introduce insurance schemes to cover agro-based industries so as to reduce their risk and so as to be open to long-term finance.

There should be diversification in the economy from over-dependence on agro-based industries to manufacturing which will create employment and thus boost the incomes of average Rwandans and thus saving which will be available for lending.

The government should stabilize the value of the Rwandan currency so as to attract foreign long-term investors and aim at exporting more as means of gaining foreign exchange which can be used to stimulate long-term growth through importation of more capital goods and less consumer goods.

 ·       General Limitations of Debt Financing

·       The economic life of the asset to be used a security act as an outer limit to debt financing both the terms of principal and the term.

·       If the balance of debt outstanding in the company’s capital structure is high it means that the company is highly geared and this cannot allow lenders to give further finance to such a company as it will be viewed as risky.

·       Debt financing may be expensive because it carries both implicit and explicit costs. These may out-weigh the returns from the investments.

·       Ordinary shareholders may limit the much a company can use in debt financing as the level of the gearing is influenced by this finance thus putting them at risk.

·       The size of the company may influence its ability to raise debt finance this size works better for quoted companies and unquoted companies usually find it difficult to raise such finance.

·       General economic conditions may limit the availability of debt finance because in recession it is quite dangerous to use large sums of debt finance as these may not be serviced under conditions of low profits and may lead to the company’s receivership in extreme.

·       The management for the company may also limit the availability of this finance either by virtue of its nature (if its integrity is questionable) or if it is conservative in the use of debt.

 Advantages of using an Overdraft

·       It can be used to bail the company out of short-term financial liquidity problems

·       Usually it is not secured as the company’s goodwill is all that matters in obtaining this finance as long as the company is known to lenders.

·       It is used without pre-conditions or restrictions which makes it a flexible source of finance,.

·       It can be raised fast thus very useful in emergency financing endeavors.

·       It is not expensive to raise i.e there are no costs paid to obtain it such as floatation costs. ‘

·       Its cost and financial constraints are short lived.

·       It can assist the company to meet its obligations in particular short term obligations thus sustaining the goodwill from creditors.

·       Overdraft finance does not increase the company’s gearing level, at least in the long run.

·       Overdraft finance is used without consent of shareholders thus it is flexible as it can be used as and when it is needed.

 Disadvantages of using Overdrafts

·       It is very expensive finance and its lending rate is usually 1-2 % higher than the usual lending rates.

·       Its constant use of a sign of bad/poor financial management policy and this may endanger the company’s ability to raise long-term finance as long-term lenders view constant use of overdrafts as a sign of lack of overdrafts as a sign of lack of cash forecasts and budgeting policies on the part of the economy.

·       It is not easily available to every business thus it is obtained by companies know better to the bankers.

·       In some cases this finance may be used in a manner flexible to the management which most cases may not be in the interest of shareholders it may be used in areas which may not directly benefit shareholders i.e.

·       It is only available is small quantities and as such may not be useful for bigger ventures.

·       The bank may recall this overdraft in part or in whole at any time and this may inconvenience the Company affected.

·       Overdraft finance may only be used to finance non-profitable operations e.g. working capital and cannot be used to finance fixed assets which are the most important ingredients in the company’s production and profitable operations.