Borrowed funds, also referred to as debt capital, include the monies an enterprise borrows from outside sources and agrees to repay on a future date, usually with interest. Companies and businesses will often utilize borrowed funds to raise moneys for their operations, expand business activities, or fulfill working capital needs without issuing ownership through equity. Some of them have specific terms such as a fixed or floating interest rate and repayment period. Therefore, offering an alternative to raising money through owners’ equity.
What is Borrowed Fund?
Borrowed funds are the capital accessed by a firm by way of loan or debt rather than equity. Such a source of finance would enable a business to tap significant amounts of money, which could be used either to invest in growth opportunities or to manage short-term cash flow requirements. However, borrowed money results in a commitment by the business to repay the borrowed money with interest, and this forms a fixed financial obligation. Borrowed funds are very ideal for business enterprises expecting high growth. However, they come with risks as they impose extra burdens of interest payment and the timing of repayment.
Borrowed funds are integral components of the capital structure of a firm. The option between borrowing and equity capital has important long-term financial implications on cash generation, profitability, and stability in business operations.
Features of Borrowed Fund
There are several salient features of borrowed funds that tend to distinguish them from other sources of capital, most particularly owner’s funds. Firms are going to rely on these features when deciding how and when to borrow.
- Fixed Obligation: The borrowed money is consistently paid back regardless of the performance of the company in terms of profitability and cash.
- Interest Payment: Payback of money with interest is usually linked with periodical payment of interest, whose reimbursement may range from loan terms to market conditions.
- Need for Collateral: Most loans ensure that the borrower provides some form of security to the lender, usually in the form of pledging assets so as to protect the lenders against loss in case of default by the borrower.
- No Ownership Dilution: It does not cause ownership dilution, as is the case with equity financing.
- Fixed Repayment Terms: The whole amount to be repaid will consist of a fixed principal accompanied by an added interest and will be due at a particular point in time. Loans are borrowed for a specific period subsequent to which the principal with interest is to be paid.
Various Sources of Borrowed Funds
Businesses can secure borrowed funds from a variety of sources. Each source offers different terms, conditions, and suitability depending on the borrowing needs of the business.
Bank Loans
- Term Loans normally raise long-term capital for equipment, infrastructure, etc.
- Working Capital Loans utilize the trappings to manage short-term liquidity.
- The interest can be either fixed or floater, depending upon the market condition and the creditworthiness of the borrower.
Debentures
- Debentures are long-term borrowed funds. These are issued by the company to the public or institutional investors.
- They are an issue that provides fixed interest payments and has a stated maturity after which the company will return the principal.
- Debentures are normally either secured or unsecured.
Bonds
- Bonds, like debentures, are similar but are usually issued by larger corporations or the government.
- They are generally issues for long-term projects and tend to be much more stable with lower interest rates.
Trade Credit
Trade credit is a short-term borrowing method where suppliers allow businesses to purchase goods or services on credit, deferring payment for a set period.
Lease Financing
Leasing allows a company to use an asset, like equipment or real estate, without purchasing it outright, making lease payments over time.
Commercial Paper
- A short-term, unsecured loan generally made by large firms to finance payroll, accounts payable, or inventories
- It is issued at a discount and paid on its face value at maturity.
Difference Between Owners’ Funds and Borrowed Funds
It is essential in deciding on a financing structure to distinguish between owners’ funds and borrowed funds in a case since the two carry very different features regarding control, risk, and financial implications.
| Feature | Owners’ Funds | Borrowed Funds |
|---|---|---|
| Ownership | Represents the equity capital contributed by owners or shareholders. | Represents external capital from lenders with no ownership stake. |
| Repayment | No repayment is required; it represents permanent capital. | Requires periodic repayment of the principal along with interest. |
| Cost | Returns in the form of dividends; non-compulsory payment. | Interest payments must be made regularly. |
| Risk | No obligation to return in case of loss or liquidation. | Fixed obligation to repay, increasing financial risk in times of loss. |
| Control | Investors hold ownership and control rights. | Lenders have no control over business decisions. |
| Security | Does not require collateral. | Often secured against company assets. |
Conclusion
Borrowed funds become crucial in the financial strategy of the company and can help the company grow and remain operationally flexible without diluting ownership. However, access to and the ability of the business to assume the financial liabilities surrounding borrowed funds must be taken with great care. Though it throws open avenues for growth, repayment liability, and interest burden constitute a route to financial risk if not handled properly. With this, businesses can balance the borrowed amounts with the amounts of owners’ equity to optimize the structure of capital, hence enabling the fulfillment of short-term and long-term financial goals.
Borrowed Funds FAQs
What are borrowed funds?
Borrowed funds are financial resources obtained from external lenders with a commitment to repay them at a future date, typically with interest.
How do borrowed funds affect a company’s risk?
Borrowed funds increase a company’s financial obligations due to fixed interest payments and the need for principal repayment, thereby raising its financial risk.
What is the difference between owners’ funds and borrowed funds?
Owners’ funds represent the equity of the business, while borrowed funds are external loans. Owners’ funds don’t require repayment, whereas borrowed funds must be repaid with interest.
Are borrowed funds always secured?
Not always. Some loans, like debentures, can be unsecured, while others may require collateral depending on the lender’s terms.
What is the significance of collateral in borrowed funds?
Collateral provides security to the lender, ensuring that they can recover their loan in case of default by selling the pledged assets.
