By Business Team Last updated on July 1, 2019

By far, you should have a clear distinction between debt and equity in mind. Debt financing both creates a fixed duty to make cash flow payments and provides the lender with prior claims if the company declares bankruptcy. There are three basic categories of debt:

Bank Debt

The main source of borrowed money for all private enterprises and many publicly traded companies were banks, with debt interest rates based on the borrower’s perceived risk. Bank debt provides some benefits for the borrower. First, it can be used to borrow small amounts of money; bond issues, on the other hand, based on economies of scale, with larger issues having lower costs. Second, if the company is not popular, bank debt provides a convenient method for transmitting information to the lender that will assist in both pricing and loan evaluation,

Bonds

The issue of bonds is an alternative to bank debt for larger, publicly traded companies. In general, bond issues provide these companies with some benefits. The first is that bonds typically have more favorable financial terms, largely because the risk is shared by more financial market investors than equivalent bank debt. Second, bond issues may give the issuer the opportunity to add special characteristics to the bank debt that could not be added. For example, there are convertible bonds that can be converted into common stock.

When issuing bonds, firms make a range of choices, including maturity (short-term or long-term) and type of interest rates (fixed and floating rates).

Leases

A company often borrows money to finance its operations by acquiring an asset needed. An alternative approach that could achieve the same objective is to rent the asset. In a lease, the firm undertakes to make fixed payments for the rights to use the asset to the owner of the asset. Depending on how the lease is categorized for accounting purposes, these fixed payments are either fully or partially tax-deductible. Initially, failure to make lease payments results in the loss of the leased asset but may also result in bankruptcy, although the lessors ‘ claims (owners of the leased assets) may sometimes be subordinated to the company’s claims by other lenders.