Debt finance and leasing - Bank loans, bonds, and covenants

Learning Outcomes

After reading this article, you will be able to explain the primary forms of debt finance—bank loans, bonds, and leasing arrangements—and identify their core features and risks. You will understand key terms such as covenants and the difference between finance and operating leases, and appreciate the significance of covenants in managing financial risk. This knowledge is critical for the ACCA Financial Management exam.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand the sources of long-term finance and their features, as well as related risks and controls. Focus your revision on:

• The principal types and features of debt finance, including bank loans and bonds
• The core types of leasing arrangements: finance and operating leases
• The role and impact of covenants in debt agreements
• The advantages, disadvantages, and risks of debt financing compared to equity
• The evaluation of lease versus buy decisions

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following best describes a ‘covenant’ in a loan agreement?
   1. A promise to repay the loan on time
   2. A restriction or requirement imposed by the lender to manage risk
   3. A fixed interest rate on the loan
   4. The guarantee provided by a director
2. What is the primary difference between a finance lease and an operating lease?
   1. The lessee never uses the asset in a finance lease.
   2. Finance leases transfer most risks and rewards of ownership to the lessee; operating leases do not.
   3. Only finance leases require regular payments.
   4. Operating leases always last for the asset’s full economic life.

3. True or false? Bonds typically offer lower risk and lower returns to investors compared to equity shares.

4. Briefly explain why a company might choose leasing over a bank loan to acquire equipment.

Introduction

Debt finance enables organisations to raise funds without issuing new shares. Common forms include bank loans, bonds (debentures), and leasing. Selecting the right source depends on factors such as cost, flexibility, and control. Additionally, covenants—terms or conditions attached to debt—are often used by lenders to monitor and manage risk.

For ACCA Financial Management, it is essential to distinguish between types of debt finance, the nature of leasing arrangements, and the purpose of covenants in safeguarding both lender and borrower interests.

Key Term: debt finance
Borrowed funds that must be repaid with interest, usually within an agreed timeframe, including bank loans, bonds, and leasing liabilities.

BANK LOANS AND BONDS

Bank Loans

Bank loans are formal agreements where a company borrows a fixed amount from a bank for a specified period at an agreed interest rate. They may be secured (against assets) or unsecured. Terms commonly require regular payments of interest and, often, principal in instalments.

• Short-term loans: up to one year, mainly for working capital needs.
• Long-term loans: typically 1–10 years, used for capital expenditure.

Key Term: covenant
A clause in a loan or bond agreement that imposes specific conditions or restrictions on the borrower to protect the lender’s interests.

Typical covenants might limit further borrowing, require certain financial ratios (e.g., maintaining a minimum interest cover), or restrict asset disposals. Breaching a covenant may trigger penalties, higher interest, or even immediate loan repayment.

Key Term: bond
A tradable, long-term debt instrument issued by a company (or government), typically paying periodic interest and repaying principal at maturity.

Bonds (Debentures)

Bonds are issued to investors on capital markets. They promise fixed periodic interest (“coupon”) and repay principal after a set term.

• Secured bonds: backed by assets
• Unsecured bonds: no specific security

Bondholders have priority if the company is liquidated, but no voting rights. Bonds can be listed and traded, allowing investors to buy and sell before maturity.

Advantages and Disadvantages

Debt finance is usually cheaper than equity, as interest payments are tax-deductible and carry a lower risk for investors (compared to shares). However, debt increases financial risk; failure to make interest payments may lead to insolvency.

Revision Tip Always check whether debt finance will breach existing covenants or increase gearing to risky levels.

LEASING AS A SOURCE OF FINANCE

Leasing allows a company to use an asset without immediate purchase. Leases are classified as either finance leases or operating leases, each with different implications for risk, asset control, and financial reporting.

Key Term: finance lease
A lease transferring substantially all risks and rewards of asset ownership to the lessee, even if legal title remains with the lessor.

Key Term: operating lease
A lease that does not transfer significant risks and rewards of ownership; the asset is returned to the lessor at lease-end.

Finance Lease

• The lessee is responsible for most costs (maintenance, insurance).
• Lease spans most of the asset’s useful life.
• Recognised on the lessee’s statement of financial position as an asset and liability.

Operating Lease

• Shorter-term; does not run for the asset’s full economic life.
• The lessor is responsible for maintenance.
• Typically treated as off-balance-sheet finance, though recent accounting standards may require some recognition.

Sale and Leaseback

Key Term: sale and leaseback
An arrangement where a company sells an owned asset to a lessor and immediately leases it back, unlocking cash while retaining use.

Sale and leaseback provides immediate liquidity but may involve long-term rental costs and loss of asset appreciation.

Why Choose Leasing?

• Preserves cash flow compared to outright purchase.
• Fixed payments aid budgeting.
• No need to tie up capital or arrange a loan.
• May enable use of newer assets due to easier upgrades.

COVENANTS: RISK CONTROL IN DEBT AGREEMENTS

Covenants are a critical tool for lenders to limit risk. Common types include:

• Positive (affirmative) covenants: borrower must meet certain requirements (e.g., provide audited statements).
• Negative covenants: restrict certain actions (e.g., limit further debt, large dividends, asset sales).

Breach of covenant (“default”) can have immediate and substantial consequences, including loan recall or renegotiation of terms.

Worked Example 1.1

A company has a bank loan with a covenant requiring that interest cover must not fall below 4 times. The company's operating profit is $800,000 and annual interest expense is $200,000. Does the company comply with this covenant?

Answer:

Interest cover = Operating profit ÷ Interest expense = $800,000 ÷ $200,000 = 4 times.

The company meets the covenant, but any reduction in profit or increase in interest could cause a breach.

Worked Example 1.2

A manufacturer needs a new machine costing $120,000. The company can either:

1. Take a four-year bank loan at 8% per annum, or
2. Enter a finance lease with four annual payments of $35,000. Assume tax at 25% and interest is tax-deductible. Should the company prefer the loan or the lease (ignore residual values)?

Answer:

Compare after-tax cash outflows. Loan interest saves tax, lease payments may also be tax-deductible (depending on local rules). Calculate the net present value of both options using after-tax cash flows to determine the cheaper alternative.

Exam Warning

Do not confuse “interest cover” (a ratio set by covenants) with “interest payable”—interest cover measures the ability to meet payments, while interest payable is the actual amount required.

Summary

Debt finance includes bank loans (often with covenants), bonds (debentures), and leasing (finance and operating). Each source differs in cost, flexibility, and risk. Covenants in loan or bond agreements protect lenders but may restrict business decisions. Leasing, in particular, offers an alternative to borrowing for acquiring assets, with implications for cash flow and financial reporting.

Key Point Checklist

This article has covered the following key knowledge points:

• Define and distinguish bank loans, bonds, and leasing as sources of debt finance
• Explain the purpose of covenants in loan and bond agreements
• Identify the differences between finance and operating leases
• Discuss advantages and risks of debt finance versus leasing
• Describe sale and leaseback arrangements
• Illustrate the impact of covenants and lease classification with examples

Key Terms and Concepts

• debt finance
• covenant
• bond
• finance lease
• operating lease
• sale and leaseback