Debt As A Source Of Corporate Financing

A public company, apart from the capital raised by offering shares on an exchange, is financed by another component: debt capital. It comes with an obligation to repay the amount borrowed plus interest at a later date. 

Why take on debt? Couldn't a company be content with equity? How is debt capital different from its equity counterpart? And what's the optimum debt-equity balance for an efficient capital structure? 

These are a few questions Benzinga will attempt to answer in this story. 

Debt Financing: Meaning And Types 

Debt financing is the process by which companies raise capital by offering debt instruments to individuals, institutional investors and others to fund working capital needs or capital expenditures.

Related Link: What To Do If Your Debt Is Sold

Types Of Debt Financing

Commercial paper: A short-term debt instrument issued by a company to finance short-term liabilities, accounts receivables and inventories. It is usually bought by money market funds or cash investors.

Corporate bonds: Bonds issued by a company for a period greater than one year that pay periodic interest. They are further classified as follows:

• By duration. Short-term, or less than three years; medium-term, or from four to 10 years; and long-term, or greater than 10 years.
• By risk. Investment grade, non-investment grade or junk bonds.
• By interest payment: Fixed rate or plain vanilla, with fixed periodic payments; floating rates, which are reset every six months on the basis of the prevailing rate; zero coupon bonds, which are interest payments deferred until maturity; and convertible bonds, which allows conversion to equity shares.

A bond can be a secured bond if the company pledges specific asset as collateral for the bond, or an unsecured bond — debenture — if the company has not pledged any collateral.

An unsecured bond can be a senior debenture or a junior (subordinated) debenture depending on the priority accorded to it for claims on the company's assets and cashflow.

Term loans: Loans provided to companies by banks that mandate regular repayment of both the principal amount and interest over a set period of time.

Revolving credit: It gives the flexibility of drawing down as well as repaying loans as often as a company needs within an overall agreed-upon loan limit during an agreed term —without having to pay an early repayment fee or reapply for a loan. 

Debt Vs. Equity Financing

• Debt financing does not dilute promoter's holdings, unlike equity financing, where shareholders can claim ownership of the business.
• Promoters need not share with the bondholders profits generated by business, as the latter is eligible to receive only the agreed-upon principal and the interest.
• Interest paid on debt is tax-deductible for the company, which lowers the cost of this mode of financing.
• Since principal and interest payments are known in advance, they can be used for financial budgeting and planning.

Equity financing is more attractive than debt by some criteria: 

• In case of a business failure, a company does not owe any amount to shareholders.
• Since the company is not saddled with the burden of repaying the loan along with interest, it can preserve cash flow and plow it back into the business.
• A high debt-equity ratio is considered risky by lenders as well as investors.

Unlike debt financing, which comes with some restrictive covenants that impact the flexibility and functioning of the company, equity financing lets the company to have a relatively free hand in making business and strategic decisions.

Both equity and debt financing options hold their own unique positives and negatives. Prudence calls for a mix of both debt and equity in the capital structure. What's the right mix?

Optimal Capital Structure

An optimal capital structure is an appropriate debt-equity mix that minimizes a company's cost of capital. Although debt vests the advantage of a lower cost of capital due to the tax advantage, it poses repayment risks.

A leverage ratio known as the debt-equity ratio is invariably used to determine whether a company is highly leveraged or underleveraged. It speaks to how dependent a company is on borrowed capital and its ability to meet its financial obligations. 

Mathematically, the debt-equity ratio equals total liabilities divided by shareholder equity.

A debt-equity ratio of 2 is often considered to be optimum, although asset-heavy companies can afford to be have a ratio above the norm.

See Also: What Is A Bond

Is US Heading Toward Corporate Debt Bubble?

One vice engendered by ultra-loose monetary policy is the  piling up of debt by companies as they take advantage of low interest rates.

Since 2008, the heat of the Great Recession, total outstanding non-financial U.S. corporate debt has climbed a staggering $2.5 trillion or 40 percent, according to Realinvestmentadvice.com.

Corporate debt as a percentage of GDP is now at all-time of high of 40 percent.

More disconcerting is the fact that companies are largely splurging the borrowed capital on shareholders in the form of share buybacks, dividends and M&A, rather than on reinvesting in growth projects and opportunities.

With monetary policy normalization well underway, the American corporate debt dynamic could change: if companies bogged down by heavy debt burdens default, a broader economic crisis could occur if and when the debt bubble bursts.