Financial Management · Sources of finance and their relative costs

Debt Finance, Bonds and Loan Notes for ACCA Financial Management

Updated 11 October 2026 · Fact-checked

Debt finance is money a company borrows and must repay with interest. It includes bank loans, bonds, debentures and loan notes. In FM you compare debt by security, repayment (redeemable or irredeemable), interest basis (fixed or floating) and covenants, then judge which suits the company's situation.

Understand Debt Finance, Bonds and Loan Notes

Debt finance means borrowing. The lender is not an owner. The company must pay interest and repay the capital on the agreed terms. If it fails, the lender can take legal action. This is why debt is riskier for the company than equity, but usually cheaper.

There are two main routes. A bank loan is a private deal with one lender, often with flexible terms and quick to arrange. A bond (also called a loan note) is a long-term borrowing split into many small units, sold to many investors. Large bonds are often traded on a stock exchange. In exam use, debenture normally means a bond backed by a charge over assets, though some countries use the word more loosely. Loan notes are usually a smaller or less formal issue. Read the question wording before assuming a difference.

Secured debt gives the lender a charge over assets. A fixed charge is over a specific asset, such as property. A floating charge is over a class of changing assets, such as inventory, and becomes fixed if the company defaults. Because the lender has security, the interest rate is lower. Unsecured debt has no charge, so the lender bears more risk and asks for a higher rate.

Debt can be redeemable, repaid on a set date, or irredeemable, where only interest is paid and the capital is never repaid. Redeemable debt may be repaid at par, at a premium, or be converted into shares. Interest can be fixed or floating. Fixed rates give certainty. Floating rates move with a base rate. They are good if rates fall and risky if rates rise.

Lenders protect themselves with covenants. These are promises in the loan agreement. Examples are limits on total borrowing, a minimum interest cover or current ratio, and limits on dividends or on selling assets. Breaching a covenant can make the debt repayable at once. Covenants reduce the company's freedom, which is a cost of borrowing.

Key rules to remember

Gearing (debt to equity): Debt ÷ Equity; Use the definition the question gives. Another common form is Debt ÷ (Debt + Equity).
Interest cover: Profit before interest and tax ÷ Interest; A common covenant measure. A low result signals risk to lenders.
Annual interest on a bond: Nominal value × Coupon rate; Interest is paid on nominal (par) value, not market value.
Value of irredeemable debt: Market value = Annual interest ÷ Required return; Treats the interest as a perpetuity.
Tax shield on interest: Interest × Tax rate; Interest is tax deductible, so the after-tax cost of debt is lower.

How to solve Debt Finance, Bonds and Loan Notes questions

Use this method for any question that asks you to describe, compare or recommend a type of debt.

1Identify the company's situation: size, assets available, cash flow stability, current gearing and the purpose and length of the funding.
2List the debt options: bank loan, bond, debenture or loan note, and note whether each is secured or unsecured.
3Decide on repayment: redeemable or irredeemable, the redemption date, and whether there is a premium or conversion option.
4Decide on the interest basis: fixed or floating. Link the choice to the company's view on rate movements and its ability to bear risk.
5Check covenants and security. State what restrictions the lender may impose and what assets may be charged.
6Apply numbers if given: calculate annual interest, gearing or interest cover, and test them against any covenant.
7Give a clear recommendation and a reason tied to the scenario. Add one risk of your choice.

Quickest way: The four-label shortcut

When to use it: Use this on Section A and OT case questions where you must match a description to a type of debt.

Label the security: secured or unsecured.
Label the repayment: redeemable or irredeemable.
Label the rate: fixed or floating.
Spot any covenant words such as 'must maintain', 'may not exceed' or 'restricts'.
Match your four labels to the option. Eliminate any option that contradicts one label.

Common mistakes in Debt Finance, Bonds and Loan Notes

Calculating bond interest on market value instead of nominal value.
Students see a market price and use it automatically.
Fix: Interest = nominal value × coupon rate. Market value matters only for valuation and cost of debt.
Saying secured debt is always cheaper for the company in every sense.
Students stop at the lower interest rate.
Fix: Mention the cost too: assets are tied up, which limits future borrowing, and default allows the lender to seize them.
Confusing a fixed charge with a floating charge.
Both are described as 'security'.
Fix: Fixed is over a specific asset and restricts its sale. Floating is over a changing pool of assets and crystallises on default.
Treating covenants as only a benefit to the company.
Students link them to lower rates and stop there.
Fix: Covenants protect the lender and limit management's freedom. A breach can make the debt repayable immediately.
Recommending floating rate debt because rates are 'low now'.
Students ignore future movements.
Fix: Floating suits a company expecting rates to fall or able to absorb rises. Fixed suits tight budgeting and rate rise fears. Always tie the choice to the scenario.
Writing generic lists with no link to the company.
Students recall features and write them all out.
Fix: Pick the two or three features that matter for this company and explain why.

Worked examples

Example 1

Pyre Co has ₹10,00,000 of 8% bonds, nominal value ₹100 each, redeemable at par in 5 years. The covenant requires interest cover of at least 4 times. Profit before interest and tax is ₹4,00,000. Bond interest is the only interest. Does Pyre Co meet the covenant?

Show the solution

Annual interest = ₹10,00,000 × 8% = ₹80,000.
Interest cover = ₹4,00,000 ÷ ₹80,000 = 5 times.
Compare with the covenant: 5 times is above the minimum of 4 times.

Answer: Yes. Interest cover is 5 times, above the required 4 times, so the covenant is met.

Example 2

Kora Co needs a 10-year loan and expects interest rates to rise. It has large freehold property and stable cash flows. Advise on the type of debt.

Show the solution

Security: the freehold property can be a fixed charge, so secured debt is available at a lower rate.
Term: a 10-year need suits a redeemable bond or term loan, not short-term overdraft finance.
Rate: rates are expected to rise, so a fixed rate protects Kora from higher interest costs and gives certain cash flows.
Covenants: expect limits such as maximum gearing or interest cover. Stable cash flows make these easier to meet.
Risk: if rates actually fall, Kora is locked into a higher rate and may face a penalty for early repayment.

Answer: Kora should raise secured, redeemable, fixed rate debt, such as a bond or term loan secured on its property. This gives a lower rate and certain interest costs, but it accepts covenants and the risk that rates fall.

Exam tips

In OT questions, read every option fully. A single word such as 'floating' or 'irredeemable' often decides the answer.
Always use nominal value for interest and market value for valuation. Check which one the question gives.
For written questions, tie every advantage or disadvantage to the scenario. Generic lists score poorly.
Learn the typical covenants: gearing limit, interest cover, dividend limit and restriction on asset sales.
If a question asks you to compare debt with equity, mention tax deductibility of interest, fixed obligation and loss of no control.

Practice questions from Sources of finance and their relative costs

Debt Finance, Bonds and Loan Notes in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Debt Finance, Bonds and Loan Notes: frequently asked questions

What is the difference between debentures and loan notes?

Both are long-term borrowing issued as units. A debenture normally carries a charge over company assets. A loan note may be unsecured or less formal. Wording varies by country, so follow the definition in the question.

What are covenants in debt finance?

They are conditions in the loan agreement that protect the lender. Examples are a maximum gearing level, minimum interest cover or limits on dividends. Breaching them can make the debt repayable at once.

What is the difference between redeemable and irredeemable debt?

Redeemable debt is repaid on a set date, sometimes at a premium or by conversion into shares. Irredeemable debt is never repaid, and the company pays interest indefinitely. Irredeemable debt is rare.

What are the advantages of fixed rate over floating rate debt?

Fixed rate debt gives certain interest costs, which helps budgeting and protects against rate rises. Its downside is that you pay more if rates fall. Floating rate debt gains from falls but exposes you to rises.