Credit Financing: Definition, Types & Example
Companies cannot always finance running costs and surprising claims entirely from their own resources. Then they use credit financing as a classic case of debt financing. Companies can take out long-term bank loans as well as short-term loans such as Lombard loans. Alternatively, companies can also do factoring or take out customer and supplier loans.
Definition: what is loan finance?
Loan financing primarily means taking out loans. It is therefore a measure of external financing and can also be assigned to the area of external financing.
With the loan financing, the company receives outside capital. The investor, the financing bank, but not the shareholders of the company. However, the lender is entitled to interest and repayment of the borrowed funds. If the company goes bankrupt, the bank is even entitled to part of the bankruptcy estate. In contrast, the lender (= creditor) has neither a say nor is he liable for the actions of the borrower (company). Of course, the loan funds are only made available to the company for a limited period of time within the term. The capital is to be repaid in different forms in one amount or in installments.
What types of loan financing are there?
In the case of loan financing, the different types are differentiated in particular according to the terms. Short-term loan financing includes:
- Current account credit (also called overdraft or overdraft facility): The bank grants the company overdrafts of one or more bank accounts up to a predetermined limit. This is the so-called credit limit. Current account credits are flexible in terms of amount and term, but also have higher interest rates than regular loans and can cause considerable costs.
- Lombard loan : With this loan, movable property or assets that can be easily and quickly sold (securities, bills of exchange) are deposited as collateral (lien).
- Discount credit : The loan is based on a bill of exchange (promise to pay) which is loaned. That is why the loan is also called “bill of exchange”.
- Acceptance credit : In this case, the bank does not pay out credit money, but guarantees its own creditworthiness towards a third party by means of a bill of exchange. In this way, it is a loan.
- Guarantee credit : It is typical here that a bank makes a promise to pay for its own customer to a third party. The bank receives an interest (guarantee interest) or a fee (guarantee commission) for this.
The long-term variant of loan financing is typically the bank loan. These are loans that have a term of at least four to five years and can be concluded for up to a maximum of 30 years. As a rule, they are agreed with an initial rate fixation, but can also be subject to variable interest rates. With this long-term loan financing, the company primarily wants to finance investments in, for example, property, plant and equipment. Refinancing is also a common reason. Long-term loans can differ in particular according to the type of agreed repayment:
- Annuity loan : Annual installment payments in the same amount throughout until the end of the term.
- Repayment or repayment loans : With repayment rates remaining constant annually, however, the interest payments gradually decrease as the term increases.
- Final or fixed loan : Here, a one-time repayment (repayment) takes place at the end of the loan term. Until then, only interest is payable in installments.
Short-term vs. long-term loan financing
Short-term loan financing is of great importance to the company: If financial shortages arise only for a short time, they can be bridged in this way. This avoids temporary liquidity bottlenecks. The company remains able to act and can repay its short-term liabilities with the next incoming payments. Short-term financing therefore makes a decisive contribution to a company’s financial flexibility.
Long-term loan financing , on the other hand, is particularly suitable for very cost-intensive investments. This results in a very high capital requirement that can only be covered by external third parties. However, this also creates a certain dependency on the financing bank. On the other hand, small and medium-sized companies can finance larger investments as part of a loan. Otherwise, due to the strict credit rating requirements, they are usually denied alternative financing options for the promissory note loan or the issue of bonds.
Calculation and comparison of loan financing (practical example)
A company in the food industry needs a new packaging machine. It not only saves material and energy costs, but also has to replace the old machine due to increasing downtimes. Therefore short-term funds are necessary for the investment of 500,000 dollars. Nor can they be raised in this volume from reserves or other available funds. Therefore, debt capital in the form of loan financing is required in this amount.
Discussions have now been held with the company’s bank. After the negotiations are concluded, loan financing is agreed for the purchase of the packaging machine. The company uses this to calculate the following costs and key data:
|Credit amount:||500,000 dollars|
|Credit fees:||1,500 dollars|
|Total interest payments:||50,000 dollars|
|Short-term commitment interest:||500 dollars|
|Total cost of credit:||50,000 dollars|
However, if the required loan amounts are not so high, the self-employed, small business owners or freelancers can use conventional banking offers to finance loans.
What needs to be considered when financing loans?
If loan financing is to be carried out, the company must usually submit these documents to the bank for review before granting a loan:
- the last complete annual accounts included
- the profit and loss account (G + V)
- the business plans (earnings planning, business plan)
These documents are also desirable for self-employed persons and certain types of business:
- Business evaluation (BWA) from current and past business year
- Advance sales tax returns
- Credit overviews (other lenders)
- Proof of income (private)
- List of investments (securities holdings, interest and dividend income)
In addition, a lending bank will take a close look at certain key financial figures for the company. However, it is best to find out in advance of a loan financing what the bank attaches particular importance to and which key figures are of great importance.
Credit financing costs
At the same time, the cost of loan financing is an essential point for the company. Because banks calculate their loan interest as compensation and remuneration for the capital provided. They are the main component of the cost of a loan and are usually influenced by the following factors:
- the creditworthiness (creditworthiness) of the company, which results from
- the bank ‘s own credit or default risk from lending and
- this gives the bank’s equity with which it must hedge the loan
- the agreed time limit for the loan
- the internal loan processing effort
- the respective interest rate level on the money and capital markets when procuring the borrowed funds (refinancing)
- the credit bank’s profit targets
It is therefore in the interest of the company to take these influences on the amount of the credit costs into account when planning a loan financing.
What are the alternatives to loan financing?
As alternatives to loan financing, companies can use these classic ways of sometimes very short-term capital raising:
- Supplier loans : Short-term supplier loans through a more generous payment term.
- Customer loans: With agreed down payments or partial payments, money is left without interest.
- Mezzanine capital: For example in the form of subordinated loans and silent participations, without capital providers demanding a say or collateral.
- Factoring: Sale of the existing trade receivables to a factoring company (factor) at a discount. These claims no longer have to be collected in a protracted manner and the company receives money from the factor immediately.
- Private equity: An outside investor provides financial resources. These are added to equity. Because the investor now bears the entrepreneurial risk, for which he has a say.
- Leasing: As a rule, mobile commodities such as cars, cars, technical equipment or machines are financed and provided by third parties. Monthly leasing installments are payable for this.
Leasing vs. Loan financing
In contrast to leasing, the company usually becomes the owner of the purchased property in the case of loan financing. When leasing, the company pays the agreed installments only for one use of the movable property. But they don’t belong to him. At the end of the term, they must therefore be returned to the leasing company. In contrast, the company can benefit from tax that the leasing installments are completely deductible as operating expenses. With ongoing loan financing, only the interest portion of the monthly loan installment is tax-deductible.