Debt Instruments Meaning
Debt instruments are the instruments that are used by the companies to provide finance (short term as well as long term) for their growth, investments and future planning and comes with an agreement to repay the same within the stipulated time period. Long-term instruments include debentures, bonds, long-term loans from the financial institutions, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans from financial instruments.
Types of Debt Instruments
There are two types of debts instruments, which are as follows:
- Long-term
- Medium & Short-term
Let us now explain these in detail.
#1 – Long-Term Debt Instruments
The company uses these instruments for their growth, heavy investments, future planning. These are those instrument which generally have a period of financing of more than 5 years. These instruments have a charge on the companies assets and also bears an interest payment regularly.
#1 – Debentures
A debenture is the most used and most accepted source of long-term financing by a company. These carry a fixed Interest Rate on the finance raised by the company through this mode of the debt instrument. These are raised for a minimum period of 5 years. Debenture forms part of the capital structure of the company but is not clubbed with calculate share capital in the balance sheet.
#2 – Bonds
Bonds are just like the debentures, but the main difference is that bonds are used by government, central bank & large companies, and also these are backed by securities, which means these have a charge over the company’s assets. These also have a fixed interest rate, and the minimum period is also at least 5 years.
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#3 – Long-Term Loans
It is another method which is used by companies to get loans from banks, financial institutions. It is not as much a favorable option method of financing as the companies have to mortgage its assets to banks or financial institutions. And also, the Interest rates are too high as compared to Debentures.
#4 – Mortgage
Under this option, the company can raise funds by mortgaging their assets with anyone either from other companies, individuals, banks, financial institutions. These have a higher rate of interest in funding the companies. The interest of the party providing funds is secured as they have a charge over the asset being mortgaged.
#2 – Medium & Short-Term Debt Instruments
These are those instruments which generally used by the companies for their day to day activities and working capital requirements of the companies. The period of financing in this case of Instruments are generally less than 2-5 years. They don’t have any charge over the companies assets and also don’t have a high-interest liability on the companies. Examples are as follows:-
#1 – Working Capital Loans
Working capital loans are the loans which are used by the companies for their day to day activities like clearing of creditors outstanding, payment for the rent of the premises, purchase of raw material, repairs of machinery. These have interest charges on the monthly limit used by the company during the month from the limit allowed by financial institutions.
#2 – Short-Term Loans
Banks and financial institutions also finance these, but they do not charge interest monthly; they have a fixed rate of interest, but the period for funds transferred is for less than 5 years.
#3 – Treasury Bills
Treasury Bills are the short-term debt instruments that mature within 12 months. They are redeemed at the maturity in full, and if sold before maturity, then they can be sold at a discounted price. The interest on these T-bills is covered in the issue price as they issued at a premium and redeemed at par value.
Advantages
- Tax Benefit for Interest Paid:- In debt financing, the companies get the benefit of interest deduction from the profit before calculation of tax liability.
- Ownership of Company:- One of the major advantages of debt financing is that the company does not lose its ownership to the new shareholders as the debenture does not form part of the share capital.
- Flexibility in Raising Funds:- Funds can be raised from debts instruments more easily as compared to equity funding as there is a fixed rate of interest payment to the debt holder at regular intervals
- Easier Planning for Cashflows:- The companies know the payment schedule of the funds raised from debt instruments such as there is an annual payment of interest and a fixed time period for redemption of these instruments, which helps companies to plan well in advance regarding its cashflow/funds flow status.
- Periodic Meetings of Companies:- The companies raising funds from such instruments are not required to sent notices, mails to debt holders for the regular meetings, as in the case of equity holders. Only those meeting which affects the interest of the debt holders would be sent to them.
Disadvantages
- Repayment:- They come with a repayment tag on them. Once funds are raised from debt instruments, these are to be repaid on their maturity.
- Interest Burden:- These instrument carries an interest payment at a regular interval, which needs to be met for which the company needs to maintain sufficient cash flow. Interest payment reduces the company profit by a significant amount.
- Cashflow Requirement:- The company needs to pay interest as well as the principal amount for the company has kept the cashflows for making these payments well in time.
- Debt-Equity Ratio:- The companies having a larger debt-equity Ratio are considered risky by the lenders and investors. It should be used up to such amount, which does not fall below that risky debt financing.
- Charge Over the Assets:- It has a charge over the companies assets, many of which require the company to pledge/mortgage their assets in order to keep their interest/funds safe for redemption.
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