Question

1. Discuss the purpose of an entity borrowing money and discuss several ways they can take on this debt. (elaborate on each method..big point question)

Answer 1

The main purpose of entity borrowing money is as follows:

-- To fund working capital. The entity requires an investment in receivables and inventories before they can generate and collect revenues from clients. An entity uses the working capital loans to cover operational expenditure incurred during the sales cycles and production and afterwards use proceeds from the collection cycle to pay down the borrowed amount.

-- Growth: When entity grow faster compared to it's sustainable growth rate, they requires external sources to fund the excess growth.

-- Business Expansion: The entity come across opportunities to expand in jumps thus requires investment in land, new plant and equipment, real estate, warehouses etc.

-- Improve credit score: When an entity borrow loans and make timely credit payments it significantly boosts the credit score for business.

-- Expense Deductions: IRS permits an entity to deduct necessary and reasonable expenses related to the operations. Thus can deduct the interest paid on business loans from their federal income tax return. It is beneficial for start-ups that require an entity to reinvest all profits back into the business

-- Reduce personal risk: With borrowed funds it can reduce the personal risk of the assets.

The main financial sources on the basis of period are:

--Long-term sources: Funds needed for a period exceeding five year are termed Long-term sources; and the main sources are long-term borrowings, shares and debentures, and loans from financial institutions. These are mainly for the procurement of fixed assets such as machinery, plant, equipment, etc.

An entity may raise funds with issuance of shares and debentures. Debentures are a loan capital of an entity and the debentures holders are the creditors; and they receive a fixed charged funds that carry a fixed interest rate. It can also raise funds with the issuance of equity and preference shares.

2) Medium-term sources: Funds needed for a period but less than five years are termed medium-term sources; and the main sources are lease financing, commercial banks, public deposits, and loans from financial institutions

A finance lease allows the finance company to be the legal owner of the asset for the lease duration, thus holds the right to asset usage against periodical payments. An entity may raise revenue by inviting the public for depositing their savings in the entity. The commercial banks and financial institutions are also financing the medium term loans.

3) Short-term sources: Funds needed for a period not exceeding one year are termed short-term sources; and the main sources are loans from commercial banks, trade credit, and commercial papers.

Commercial bank acts as financial intermediaries who accept public deposits and lend them in the form of short-term loan to business entity. Trade credit is the credit provided by the supplier to entity when it allows it to buy now and pay later. Commercial paper is an unsecured, short-term debt instrument which is issued by an entity especially for the financing of inventories and accounts payable and meeting short-term liabilities.