4 Debt
4.1 Introduction
All firms lend and borrow. For example, the firm is a lender if it has a bank ac-
count in credit, and a borrower if its bank account is overdrawn. The firm is a
creditor if buyers pay for the firm’s products after delivery, and a debtor if it uses
trade credit as a source of funding. Banks base their business on lending, borrow-
ing, and buying and selling debt. Typically, most of the debt finance for small and
medium-sized enterprises is provided by the banking sector. Firms might borrow
to finance business expansion, meet day-to-day expenses, or to ease short-term
cash flow problems.
Advantages and disadvantages of debt. The use of debt can bring the borrower
many benefits: (a) In perfect capital markets, debt would be cheaper than share-
holders’ capital, because debts must be repaid. (b) Debt is flexible. The firm can
usually repay the debt when it no longer needs the funds. (c) The cost of the bor-
rowing might be tax deductible. (d) Debt belongs to traditional corporate govern-
ance tools, because it gives the firm an incentive to be effective. In addition, debt
does not dilute existing share ownership. (e) In addition, return can be increased
by gearing.
On the other hand, there may be some drawbacks: (a) Debt appears on the bal-
ance sheet, and too much debt will have an adverse effect on the firm’s debt-to-
equity ratio. (b) A very high gearing increases the risk of business failure and can
make it more difficult for the firm to survive in the long term.^1 (c) Generally, a
higher gearing and a higher debt-to-equity ratio can: signal an increase in credit
risk for banks, suppliers, and other providers of debt; lead to a lower credit rating;
decrease the availability of debt; and increase its cost. (d) Although debt can be
flexible, the formal and de facto powers of lenders may restrict managerial free-
dom and prevent the firm from taking important business decisions without credi-
tors’ consent.
Types of debt. The firm can borrow money in various ways. (a) It can borrow
money from banks and other financial institutions under loan facilities. There are
various kinds of loan facilities and loan instruments. The terms of bank lending
(^1) The fate of Long-Term Capital Management is an example of the effect of very high
gearing on potential return and risk. Lowenstein R, When Genius Failed. The Rise and
Fall of Long-Term Capital Management. Fourth Estate, London (2001): “For four years,
the brain trust in Greenwich had made money faster than anyone else. Now, like a movie
that reveals an unsuspected horror on rewind, they were losing it incomparably faster.”
P. Mäntysaari, The Law of Corporate Finance: General Principles and EU Law,
DOI 10.1007/ 978-3-642-03058-1_4, © Springer-Verlag Berlin Heidelberg 2010