What is Debt:
Debt is obtaining loan for the purpose of running a business and to fulfill
business financing requirements. Debt is borrowing. Debt may
be secured debt or unsecured debt. Secured debt is obtaining
loan or borrowing against security of asset. This security may
be a capital asset called as mortgaging against property or
this security may be current asset like inventory or future
receivables called as hypothecation.
Need for debt:
Debt is required to run a business that is to maintain the growth of the business and also to improve and increase the turnover of the business. The need for investment in business depends on the customer demand for the product. The ownership has limitations with regard to the amount of capital or investment that it can bring into the business. So the business is compelled to go for debt against security of its assets to finance its capital or investment requirements. The amount of borrowing may be short term or long term debt. That is debt may be short term debt or long term debt.
Short term debt and long term debt:
Short term debit is obtained to meet the working capital requirements of the business that is to meet payments of purchases of raw materials, to pay staff salaries and to meet administrative expenses and marketing expenses.
Long term debt is obtained to finance capital investments like purchase of assets like machines, land and buildings, new factory etc.
Debt leveraging is a business strategy to obtain debt against net worth of the assets to finance the capital expansion of the business that is to increase the production capacity of the business or to acquire a competitor's business. As per banking norms, a healthy debt equity ratio is 2 is to 1. That is for every one dollar of equity available in the business, the business can go for 2 dollars of debt financing.
Why debt financing instead of equity financing:
1. Tax benefits
2. Debt is repayable
3. Equity financing is sharing of ownership
1. Tax benefits:
The main advantage of debt loan is tax benefits available in almost all countries. That is interest paid on debt loan is tax deductible expenditure, whereas dividend paid on equity is not tax deductible expenditure. To that extent the actual cash outflow is reduced by the available tax benefit. So in capital investment decisions, this aspect plays a critical part in arriving at a decision.
2. Debt is repayable:
Interest and principal portion is repayable as per the agreed term or period. This in turn depends on the future cash inflows of the business. Suppose a business goes for expansion of production capacity from 100000 tablets to 150000 tablets manufacturing capacity and goes for 1/3 portion to equity financing and 2/3 portion to debt financing. The cash inflow or margin obtained out of the 50000 extra tablets sold is utilized to repay the debt loan over a period of time.
3. Equity financing is sharing of ownership:
In the same example given above suppose the business goes for 100 percent equity financing and the investor demands some percentage allotment of equity instead of full repayment then the ownership is shared. That means the future profits and the present and future ownership is shared between the present equity ownership and the proposed equity ownership. This type is not usually preferred by the present owners who usually go for debt loans.
Also the advantage of debt leveraging is based on the present strength of the balance sheet and future cash flows, the business can obtain several multiples of debt particularly in case of buyouts. In the recent buyout of Corus Steel by Tata Steel, the turnover of Corus is 18 million TPA whereas the turnover of Tata Steel is 5 million TPA. But the Tata Steel margin is higher than Corus steel and the entire purchase price is funded by debt. Standard Chartered Bank and ABN AMRO bank are sharing the USD 1.80 billion debt being raised for this deal.
Also debt loan financing can take the form of prefential shares issue and debenture issue. Even in debentures it can be fully convertible or partly convertible or non-convertible type.
In India debt financing is provided by project financial
institutions also like:
1. INDUSTRIAL DEVELOPMENT BANK OF INDIA
3. INDUSTRIAL FINANCE CORPORATION OF INDIA
4. LIFE INSURANCE CORPORATION OF INDIA
5. COMMERCIAL BANKS
6. EXPORT IMPORT BANK OF INDIA
Also short term debt requirements for meeting working capital requirements are met by commercial banks against hypothecation of inventory, book debts and movable assets.
Also manufacturing companies float fixed deposit schemes that are they collect debt directly from small investors against their strength of balance sheet. This is governed by separate rules in several countries. Also they float commercial papers in the call money market.
But debt loan financing is not without risks. Debt loan against secured assets that is the creditors are called secured creditors is protected by the provisions of law but the business is under compulsion to repay them under any eventuality. That is they are a Damocles sword always. If the business is running profitably then repayment is not a problem. If the business is at a loss and there is negative cash flow then repayment is a problem. In a typical case, India cements company a big and growing cement manufacturing company is South India in the 1990s went for a huge scale acquisition of rival factories based in South India. This was done to augment its production capacity in the belief that the demand for cement will increase. But the demand for cement did not increase in the later years and also the price per bag of cement was stagnant for 3-4 years. Then the debt burden started to eat the substantial portion of its profits and the company was unable to pay dividend to its shareholders for few years. Also the company could not repay the debt and restructured its debt payment period with financial institutions.
Now a latest trend is stressed asset financing that is financing of sick industrial units. The recent case being OCM mills financed by a stressed asset financing firm based in USA.
There are many forms of debt financing that have evolved
over time like:
1. Mortgage finance
2. Mortgage refinance
3. home finance
4. credit cards
5. subordinated debts
Equated a monthly installment that is repayment of principal and interest over a period of time is one of the pioneering products in the world of finance which has changed the consumer purchase for ever. It has made the general public to aspire for better lifestyle commodities like cars, home, furniture, foreign travel, school education, credit card etc. The concept of credit multiplier in banking terminology is akeen to such debt spiral or EMI.
But one risk associated with growth in debt or consumer credit or home loan
market is USA is the existence of asset bubble. That is property
is overvalued in order to fund higher debt without evaluating
the credit worthiness and repaying capacity of borrower. Lenders
shall be very cautious in evaluation procedures in order to
protect their interest and capital.
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