Debt Financing in Personal Financing

Debt financing is an approach used by individuals to raise funds while understanding that the borrowed amount must be repaid at a specified period given interest rate. This mode of financing is mostly applied by Companies to raise funds from investors (Campello 2006, P.136). Equity financing occurs when an investor is granted incomplete ownership based on the amount of funds contributed. In most incidences, this form of financing does not need to be repaid because an investor might have more interest in investing funds into the Company having confidence that the investment will be multiplied in future. Small businesses operated by individuals accept debt financing and the obligation of repaying the debt at a specified period provided by loaner. The interest rate given on various loans is directly proportional to the degree of risk undertaken by lender when providing the money. For instance, a lender can set a higher interest rate to a person taking loan for the first time and a lower interest to an already existing customer who has shown a certain degree of loyalty.

Currently, there are various options of debt-financing available for small personal businesses such as, industrial development loans, bonds, leveraged buyouts and convertible debentures. The most commonly recognized mode of debt financing is a standard loan. Standards loans that are extended for less than a year are identified as short-term loans while those granted for a period longer than a year are referred to as long-term loans. They can be supported by guarantors, the government or by collateral facilities. When applying a loan for personal use, most lenders demand to see a reliable credit history of more than one year in order to build more confidence and approve the loan. In conjunction, one is obligated to share the key objective plan of the money, reliable cash flows from other sources such as personal investments and the capability to acquire emergency loans from other lenders in case of default loan instances. The lender will therefore approve or disapprove the loan considering certain factors including the ability to repay the loan at the given period. The lender will also inquire the available sources of personal income such as basic salary and any other existing businesses.

 Personal financing is a mode of financial management whereby a person, friends or family members run a budget to spend, budget and save financial resources at a given period considering financial threats and future occurrences. Before deciding on personal financing products, an individual would consider different banking facilities such as savings account and consumer loans among others. Personal planning in debt financing requires critical re-evaluation and regular monitoring because it is a dynamic process Cole and Sokolyk (2018). Debt enables an individual to cater for emergency financial problems, business needs among other daily transaction requirements. Based on the context of personal financing, debt financing is important in the following ways;

i) Debt Financing is an efficient way of obtaining funds from a Company to initiate or run a small business

In most incidences, an individual can sell bonds to acquire funds needed to start and operate a business. The owners of small businesses can take advantage of these facilities bearing in mind that bank will take longer to build trust and extend credit facilities to them. In such circumstances, debt functions as an effective way of acquiring funds to start or run a small business. In the United Kingdom, most venture capitalists tend to look for stable Companies with a net value of over $1 billion in order to extend their loan facilities. For this reason, most small businesses are eliminated based on that criterion. Therefore, it necessitates individuals to apply for personal facilities in order to boost the existence of their businesses. Therefore, the significance of debt financing in personal finance is also applicable when initiating or running businesses as illustrated by the three starting businesses in table 1.1 below.

Business Finance and Personal Debt Financing

Source: Cole and Sokolyk (2018)

Table 1.1                         

Prospective Business

Capital Required

Personal Loan limit of Investor (A, B and C)

A

$50,000

$55,000

B

$21,900

$25,000

C

$36,000

$37,000

Based on the above financial information, it is evident that debt financing is significant in the context of personal financing because it can offer a quick and easy way of acquiring capital for potential small businesses. This loan can only be accessed by the individual investor as a personal facility and not business loan Cole and Sokolyk (2018).

ii) It can serve as a source of Income

In circumstances whereby an individual purchases bonds worth million dollars, the expected yield to maturity will be high. In this case, debt financing will become a regular source of income to an individual. For highly profitable Companies, debt financing will provide regular cash flows to an investor without utilizing the original equity contributed.

iii) It improves an individual’s credit score

Making instalment payments to the lender on a timely basis builds a strong reputation, lending confidence and facilitates advancement of your credit score. This becomes more possible when an investor funds financial Companies such as banks and other credit institutions. A personal credit score is an important factor that enables an individual to access even larger credit facilities in future. It determines the amount of money that the bank can advance to personal account at a specified period. The lenders use this metric to assess the degree of responsibility attached to a person based on transaction history recorded in their systems. Taking the accountability of making regular bank transactions enables an individual to construct personal creditworthiness and increased limits Cole and Sokolyk (2018). Accessibility to enhanced debt financing can enable a person to meet future financial requirements more effectively through debt.

iv) The interest rates charged on debt financing are tax deductible

The value of interest rate accumulated after obtaining personal financing facilities are tax deductible. According to section 4 of International Reporting Standards, all interests paid after taking personal financing activities are perceived as expenses. This deduction is applicable to all forms of personal loans and small business facilities. Deducting taxes is advantageous to an individual because it lowers the net interest accrued. This makes debt financing facilities more efficient and inexpensive to use especially when the loan is obtained for a sole proprietorship business (Isis 2018, p.350).

In the context of personal planning, managing a debt is influenced by various key economic factors. The economic influence in debt is associated with factors such as government policies, labour costs and taxes. Some factors such as labour costs and government regulations have a direct impact on individuals’ financial leverage. Financial leverage occurs when one uses the borrowed funds to acquire useful assets such as land and buildings with anticipation that the future economic benefits expected will be higher than the cost of borrowing. The key economic influences in debt are;

Taxes

In finance, taxes are considered to be deductible expenses when accounting at either corporate or personal finance level. For this reason, Companies with high tax obligations are required to offer more debt financing facilities in order to reduce the extend of their liabilities. High taxation influences a Company to take debts in order to offset the burden. On the other hand, low taxation rates can be disadvantageous especially to a company willing to finance its activities using debt. Also, high taxation reduces people morale to work hence affecting their savings negatively. Decreased ability to save funds influences debt repayment plan (Isis 2019, p.359). When the rates of taxation are low, an individual will be encouraged to work hence saving more funds to use in repaying a debt.

Government Policy

The government of the United Kingdom affects peoples’ ability to save through institution of monetary policies. Monetary policies are routes of action adopted by the government to regulate the interest rate and supply of money in the national economy. In most incidences, monetary policies are applied to enhance living standards of the citizens by influencing levels of inflation, interest rates and employment levels. The interest rates of an economy have a direct impact to the amount of loan that an individual can take within a specified period. When the lending interest rates provided by the central bank are high, an individual will find it expensive to rely on debt. Contrary, an individual will be encouraged to obtain a long in circumstances when the interest rates are low. When the interest rates set by the central are lower, the ripple impact is extended to the entire economy Tervo and Jokipii (2018). Consumer expenditure increases and it triggers the ability of people and Companies to borrow.

Costs of Labour

The cost of labour can be incurred on labour intensive machines or even the individual labourers working at a given Company. When the cost of labour in an economy is high, Companies’ tend to spend more on compensating workers and purchasing production machines. Incurring more expenditure on labour costs decreases the net revenues obtained by the Company hence affecting its capacity to settle loan facilities. When the cost of labour within an economy is cheap, the ability to access and repay loan within an economy is usually stable, therefore, instilling the confidence of debt financing to Companies who later extends these facilities to investors.

There are several types of debt financing that play a critical role in starting businesses, financing the existing firms and meeting personal financial requirements. These types include:

Trade Credit

This facility is extended by suppliers to businesses in exchange for goods sold on credit. To receive “trade credit”, the business must demonstrate a reputable record of creditworthiness by maintaining constant repayments of the agreed amount after the indicated period. For instance, when a learning institution needs to repaint its offices before commencement of the next academic year, the paints hardware store can supply the required quantity of paint and extend the repayment period to 120 days Liedong and Rajwani (2018). This type of debt financing occurs in a situation whereby the supplier does not request for immediate cash. The supplier can also allow discount to the customer when the amount due is paid earlier than the period indicated.

Overdraft facility

This type of debt financing is also known as ”overdraft lines of credit”. It is established between an individual and the bank. Under this provision, the lender sets a certain withdrawal limit that enables the business or an individual to access funds even when there are inadequate funds in the account. The interest rate charged on overdraft requires the business to repay the amount loaned together with the principal. In most incidences, the interest rates charged on overdraft facilities might be as high as the normal prime rate added 6 percent.

Factoring

In this category, the business is granted cash immediately after offering a certain amount of its accounts receivable to the financing institution or Company. The factoring Company then collects the specified accounts receivable from the customer to compensate its cash. However, the factoring is not absolutely responsible for the transaction especially when the customer fails to repay the loan. In such a case, the borrowing business is responsible for making a repayment plus interest rate to the factoring Company Liedong and Rajwani (2018).

Loan from friends and relatives

This type of debt financing occurs when business owner obtain funds from friends or relatives without granting them some shares to act as collateral. As an alternative, a formal contract is made by both parties stating flexible terms that will for the borrower to refund the loan. This form of debt financing does not require presence of traditional financial institutions such as banks. It is mostly used to secure small amounts of loans as compared to other debt financing modes such as factoring and trade credit.

Peer-to-peer provision

This facility offers a flexible way of debt financing as an alternative to borrowing from friends, relatives or bank loans. Unlike the traditional banking system, this service matches a potential borrower with a lending without essentially involving a banking institution. It may not be an effective way especially when you are cautious about sharing your banking transaction history with strangers through the internet. In some instances, websites will demand scanned copies of financial statements with bank stamps a move that some people might find challenging. Peer-to-peer facility differs with other types of debt financing because it does not involve face-to-face interaction or short –Term Cooperation with the lender.

Credit Card Financing

This category of debt financing is utilized mostly when an individual needs quick cash and this amount is advanced on the credit card. In most situations, this card is considered to be expensive because of the advance fees and relatively high interest rates. This makes most credit card users to avoid using this facility because it is relatively expensive. It offers an easy, quicker and flexible way of debt financing compared other types.

Home Equity Loans

This form of debt financing enables an individual to obtain a loan against the accrued home equity in order to meet personal or small business financial needs. This method is different from other categories because it provides lower interest rates such as factoring, credit cards and overdraft provisions. The demerit of this facility is that the lending institution can auction your home in the event of default repayment to compensate the principal amount loaned.  

Financial crisis occurs in various forms that range from fluctuations in the banking sector to external debts. Financial crisis is directly related to the value of debt owned by a Company. The causes of financial crisis might involve compound dynamics such as, regulatory failures, market and policies. To solve the issue of a financial crisis in a more effective and efficient manner, the Company should find appropriate ways to manage its debts.

Financial Data of Company A

Source: (Campello, 2006)

Table 1.2

Year

Name of Asset

Value

Returns obtained after investment

Financial Crisis (Yes/No)

Overall Debt

2016

Motor Vehicle

$543,600

$350,000

Yes

$600,000

2017

Production Machine

$234,980

$249,000

No

$240,000

2018

Building

$452,800

$201,900

Yes

$452,800

Total

$1,231,380

$800,900

$1,292,800

Based on the above financial assets data of Company A, the value of returns on investment obtained from Motor vehicle and Building is lower compared to the amount of debt obtained to leverage these assets. The financial crisis involved in this scenario is low liquidity rate of the assets purchased in the fiscal years 2016, 2017 and 2018. This predicament can be evident because the total overall debt is $1,292,800 and the Company is able to raise only $800,900. The variance, in this case, is 491,900 and this could lead Company A into a deep financial crisis marked by a huge debt payable (Campello 2006, p. 124).

The Financial crisis caused by negative impact of taxes and subsidies will have a comprehensive effect on debt of the Company. In United Kingdom, financial transaction taxes are introduced to motivate business owners to participate in long-term investments while ignoring short-term investments. In the long run, non-existence of short-term investments might lead to achievement of low cash flows and net revenues within the business. This impact will later on pose a financial crisis to a Company since the government is more into launching progressive capital gains tax in order to foster long-term investments. Eventually, missing short-term investments will subject the business into cash flow problems hence leading to a financial crisis.

References

Liedong, T.A. and Rajwani, T., 2018. The impact of managerial political ties on corporate governance and debt financing: Evidence from Ghana. Long Range Planning, 51(5), pp.666-679.

Isin, A.A., 2018. Tax avoidance and cost of debt: The case for loan-specific risk mitigation and public debt financing. Journal of Corporate Finance, 49, pp.344-378.

Campello, M., 2006. Debt financing: Does it boost or hurt firm performance in product markets?. Journal of Financial Economics, 82(1), pp.111-172.

Cole, R.A. and Sokolyk, T., 2018. Debt financing, survival, and growth of start-up firms. Journal of Corporate Finance, 50, pp.609-625.

Tervo, S. and Jokipii, A., 2018. The value of a voluntary audit in debt financing: evidence from small privately held companies. International Journal of Accounting, Auditing and Performance Evaluation, 14(4), pp.291-314.