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Hi, I'm Jeff. And in this lesson, we'll learn about some of the options for long-term debt financing. So let's get started. First of all, what is debt financing?
This is an arrangement in financing, where a company takes a loan and agrees to pay the loan back at a specific point in time. There are two types of long-term debt financing that we'll discuss, loans and bonds.
While large businesses use both loans and bonds, often small businesses will rely only on loans. In either case, businesses use these borrowed funds as financial leverage to grow the business and increase the return on owner's equity. As long as the earnings from a business are higher than the interest paid to service the loan or bonds, the business and the owners can benefit. Here is an example.
As you can see, if the earnings are not solid, then the business can fail if the debt load is too high. Long-term loans are often offered through banks, credit unions, or savings, and loan associations. These loans are almost always secured by collateral. Manufacturers and suppliers may also offer long-term credit for longer than one year, which would function identically to a long-term loan.
If a business obtains a loan for more than one year, then there must be a term loan agreement, which is a promissory note that details the repayment criteria and process. Here is an example of such a promissory note. As you can see, the language within the promissory note is intended to be clear and to protect both the lender and the lendee.
Another method to finance long-term debt is through corporate bonds. A bond is a financial instrument where the organization, a company or the government offers an IOU to the holder of the bond, where the organization promises to repay the IOU with specified interest by a specific date. The maturity date is the final payment due date for a loan or other monetary instrument, such as a bond.
All of the legal information about a bond is detailed in a bond indenture. And the corporation will appoint a person or an independent firm as a trustee to be the representative for the bond owners. The independent firm is often a bank. And they will be responsible for communications between the corporation and the bond owners.
Some of the different types of corporate bonds are debenture bonds, which is an unsecured bond. That means no collateral supports the bond. Only a financially strong company may use this type of bond, since it is the company's reputation that supports it. No one would buy unsecured bonds from a company that is not credit worthy.
And mortgage bonds, these are bonds that use a pool of property mortgage loans as the collateral. By using a pool, the bond is better protected from economic shifts. Now let's run through some of the differences between bonds and loans.
First, these are the elements of long-term loans. There are a limited number of parties involved, no public disclosure of financial information. They can be arranged quickly. Usually, it's three to seven years to repay the long-term loan. And they usually have a 6% to 12% interest rate.
Bonds, on the other hand, can take a while to arrange, have maturity dates of 10 to 30 years have a higher cost to sell and administer, and usually have a 5% to 10% interest rate. OK, good job. In this lesson, we learned about secured long-term financing with loans and bonds. We talked about the use of long-term loans and the use of corporate bonds. And we reviewed the difference between loans and bonds. Thanks for your time, and have a great day.
