When a business has a record of at least earning significant revenues (cash flowing in), or, better still, of earning profits, the firm can make a credible promise to pay interest. At that point it becomes possible for the firm to borrow money. Businesses have two main methods of borrowing: banks and bonds.

Borrowing from a Bank

A bank loan for a firm works in much the same way as a loan for an individual who is buying a car or a house. The business borrows an amount of money and then promises to repay it, including some rate of interest, over an agreed upon period of time. If the business fails to make its loan payments, the bank can often take the firm to court and require it to sell the collateral on the loan, assets such as buildings or equipment, to make the loan payments.

Issuing Bonds as Borrowing

Another source of financial capital is a bond. A bond is a financial contract where the borrower agrees to repay the amount that was borrowed and also a rate of interest over a period of time in the future. You already learned that the U.S. government issues bonds to fund government expenditures. In contrast, corporate bond is issued by companies. Cities can issue municipal bonds and U.S. states issue state bonds. A bond specifies an amount that will be borrowed, the interest rate that will be paid, and the time until repayment.

A large company, for example, might issue bonds for $10 million; the firm promises to make interest payments at an annual rate of 8 percent ($800,000 per year), and then, after ten years, it will repay the $10 million it originally borrowed. When a firm issues bonds, the total amount that is borrowed is divided up. A firm that seeks to borrow $50 million by issuing bonds might actually issue 10,000 bonds of $5,000 each. In this way, an individual investor could, in effect, loan the firm just $5,000, or any multiple of that amount. Anyone who owns a bond and receives the interest payments is called a bondholder.

If a firm issues bonds and fails to make the promised interest payments, the bondholders can take the firm to court and require it to pay, even if the firm needs to raise the money by selling buildings or equipment. However, there is no guarantee that the firm will have sufficient assets to pay off the bonds. The bondholders may get back only a portion of what they loaned the firm.

Bank Borrowing vs. Bonds

A significant disadvantage to bank debt versus bonds is restrictive debt covenants. A covenant is a rule in the loan agreement that places restrictions on what the business can do. Here are some examples of covenants that are designed to reduce the bank’s risk but limit the ability of the borrowing business to respond to changes in market conditions:^[1]

• The borrowing business cannot take on any more debt until the bank loan is paid off. This would limit the company’s ability to seek additional financial capital such as issuing bonds.
• The borrowing business cannot acquire any other companies until the bank loan is paid off. If, for example, the business became aware of a company that makes an app that would complement their existing product or services, this type of restriction would prevent the borrowing business from buying the other company.
• The interest rate on the loan automatically goes up if profits fall. This would limit the borrowing business from reinvesting profits because more would need to go towards interest payments.

Bank borrowing is more customized than issuing bonds, so it often works better for relatively small firms. The bank can get to know the firm extremely well; the bank can monitor sales and expenses quite accurately by looking at deposits and withdrawals. Relatively large and well-known firms often issue bonds instead. They use bonds to raise new financial capital that pays for investments, pay off old bonds, or to buy other firms. However, the idea that banks are usually used for relatively smaller loans and bonds for larger loans is not a universal rule.