Maneuvering through available financial products to determine the right instrument is a task in itself. In an economic milieu that is dynamic, debt puts itself as a quick way to not only finance one’s immediate needs but also make one resilient for the future and fulfill one’s business aspirations.
Thus, we shall understand the meaning of the term ‘Debt Financing’ and understand the products being offered under its ambit.
What is Debt Financing?
Debt Financing, or Debt funding is a process of raising capital by borrowing. A corporate body or a company can choose to access capital for its short-term and long-term needs by issuing debt instruments (like bonds or notes) that must be repaid at a later date.
In juxtaposition to raising capital through equity, debt financing doesn’t dilute the shareholders’ equity. It keeps the ownership structure intact with the relationship with the financier only limited to debt conditions.
Debt financing includes various methods to access capital by borrowing, some of which include-
1. Debentures/Bonds
A company could issue debentures or bonds at a specified interest rate allowing them to raise money from the market. Both debentures and bonds are traded on exchanges that ensures high liquidity.
2. Commercial Paper
It is a short-term debt instrument issued by corporations and other entities to fund their immediate financial requirements. Commercial Paper is an unsecured instrument and has a minimum and maximum maturity of 15 days and 1 year, respectively.
It is issued in the denomination of INR 5 lakhs or its multiples.
3. Business Loan
A business loan is simply a loan taken by a business for its short-term or long-term financial requirements. A business loan is sanctioned by either a bank or an NBFC.
A short-term business loan, usually called a Working Capital Loan, has a maximum maturity of 12 months. On the other hand, a loan with a maturity beyond 12 months is simply called a business loan.
A business loan could either be secured or unsecured.
4. Invoice Discounting
Invoice Discounting is the process through which a company discounts its outstanding invoices with a lender to access funds for the short term. The lender sanctions a loan against the proof of outstanding invoices of the firm which must be paid within 90 days.
Invoice Discounting is an unsecured form of loan.
5. Overdraft Facility/Line of Credit
An Overdraft Facility and Line of Credit are products offered by Banks/NBFCs to take loans for payments as and when the need arises. The rate of interest on such loans is usually pre-determined. They could either be secured or unsecured.
How does Debt Financing work?
A debt-financing model entails borrowing money to take care of an enterprise’s financial requirements. In general, an enterprise in need of funds borrows money using a financial instrument and repays the borrowed amount according to the stipulations of that instrument.
The exact working of debt financing depends upon the financial instrument used. Let us understand how debt financing works if one uses the aforementioned instruments-
1. Debentures/Bonds
The process of debt financing through Debentures or Bonds is as follows-
- An enterprise issues bonds/debentures with an interest rate (or a coupon rate) and a maturity period that assures the lender of a fixed income for that period.
- Bonds/Debentures are issued in the primary market, which can later be traded on the secondary market (exchanges).
- Once a bond/debenture reaches its maturity, the enterprise buys back the instruments from the public at the issue price, paying back the principal amount. Some bonds however do not have any maturity period, like an Additional Tier-1 bond. At the same time, some debentures may not be bought back and instead be converted into equity- called convertible debentures.
2. Commercial Paper
An enterprise issues a Commercial Paper (a promissory note) in the money market to raise capital for its short-term needs. Since a CP is unsecured, only an enterprise with a good credit rating can issue it.
The enterprise must have at least INR 4 crores worth of tangible assets, have its working capital limit sanctioned by a financial institution, and its borrowing account be labeled as Standard Asset by a financial institution (FIs).
- An enterprise first selects an IPA (Issuing and Paying Agent) for the issuance of Commercial Paper (CP). An IPA is usually a bank that ensures that the issuing enterprise meets the credit rating requirements.
- The financial condition of the issuer is communicated to the potential investors.
- The CP is then issued at a discount to the face value in the money market.
- Upon CP’s maturity, it is bought back by the enterprise at face value.
3. Business Loan
A business loan functions as any other loan.
- An enterprise approaches a bank for either a short-term or long-term loan. The lender asks for relevant documents to determine whether the enterprise is eligible for a loan from the institution.
- The credit score of the enterprise, as well as its promoters is checked.
- Once the criteria for a business loan is fulfilled, the FI (Financial Institution) sanctions a loan on a specified interest rate and a fixed tenure.
- The interest obligations are borne by the borrower along with the principal amount repayment within the specified tenure.
4. Invoice Discounting
The process of Invoice discounting is as follows-
- An enterprise approaches a lender with their outstanding invoices to borrow a sum of money for the short term.
- The lender gives an advance after checking the authenticity of the invoice.
- Once the borrower receives the payment from its client, they repay the lender.
5. Overdraft Facility/Line of Credit
An enterprise opts for an Overdraft Facility or a Line of Credit to take care of its short-term finances.
- An enterprise first approaches a lender for an overdraft facility/line of credit.
- The lender opens an overdraft/line of credit account for the enterprise with a fixed limit and a specified interest rate. It usually charges a fee for providing such a facility.
- The enterprise can borrow money within the limit to make payments and repay the amount as and when they have the capacity to.
- The borrower pays interest on the amount utilised by them with interest levied on a daily basis.
When should you go for Debt Financing?
A debt-financing model is especially attractive for those enterprises that have a consistent or non-sporadic income. Since you must make regular interest payments for debt, it is essential that the enterprise has sufficient resources for income generation.
It is suitable for enterprises that do not wish to change their ownership structure to raise capital. Since the lender has no say in the enterprise’s management and the relationship usually terminates when the debt is repaid, it ensures that the management or ownership of the enterprise is unaffected.
Debt Financing concretises its place as an attractive method to raise capital because the interest paid on debt is tax-deductible. At the same time, you may want to avoid opting for the debt financing model if you already have existent debt with high interest payments to keep your debt ratios in a healthy range.
Debt financing also isn’t suitable for start-ups or new businesses with limited assets and resources, since the obligations of debt may be higher for these enterprises considering the risk involved.
Conclusion
The decision to go for financing through equity dilution or by debt depends upon the nature of the assets an enterprise has and the resources at its disposal. With each method having its pros and cons, one must keep in mind the nature of business while opting for a route. While Debt financing may make sense when the income is consistent, equity financing is better suited for start-ups and new ventures that do not have the assets to generate income or show substantial results in the short-term.
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FAQs
1. What is equity financing and debt financing?
Equity Financing means capital raised through the issuance of shares, while debt financing means capital raised through debt.
2. What are the two types of debt in Finance?
The debt instruments can be classified into two categories based on its tenure and collateral requirements.
The two types of debt are secured and unsecured debt. While an asset is pledged as an asset in secured debt, no such requirement exists for unsecured debt.
The debt could also be classified as short-term or long-term. While a short-term loan is for a tenure of less than 12 months, a long-term loan is for a tenure of more than 12 months.
3. What are the risks of debt financing?
Debt financing includes the risk of default. If a company fails to meet its debt obligations, it could hamper its credit score and deteriorate a company’s goodwill; further making it harder to raise capital either by debt or equity.
4. What is a good debt-to-equity ratio?
A healthy debt-to-equity ratio depends upon the nature of the industry. However, in general, a debt-to-equity ratio below 2.5 is considered good.
5. How much money can be raised by commercial paper?
According to the RBI guidelines, the aggregate amount to be raised by Commercial Paper shall adhere to the guidelines of Credit Rating Agencies regarding the maximum amount that can be raised by entities having the specified credit rating, or the limit approved by the company’s Board of Directors (whichever is lower). However, the rules for Financial Institutions (FIs) or banks raising money through Commercial Paper differ.
