There are four basic activities that companies usually show as the sources of generation and use of cash. They are – the income from operations, cash generated by selling assets and /investments (if any), capital generated by issuing new shares and finally the cash flow due to debt. Most of the companies generate cash flows by using all these 4 mediums. But, few differ from, heavily relying on any particular one and less on the others.
As a part of expansion /fastening the growth, companies mostly rely either on debt or issue equity, either to the public or private players to accumulate the required capital. In the case of debt, interest cost adds-up to the borrowed capital. The result is that there is a negative cash-flow number on the balance-sheet. So, the borrowed funds need to be utilized efficiently, to make the overall cash flow a positive good number. Lets discuss about it in detail.
What is ‘Debt’
Whether it is an individual or a company, when the current finances don’t allow to make large purchases /harnessing the business activities, the most preferred alternative is making debt /borrowing the amount required, from the lender. This happens under an agreement that, the borrower will pay back the borrowed amount, later in the future, usually with along with an interest and that too at an agreed rate.
Hence, debt can be defined as the process of borrowing, a certain amount of capital, by one party (either by an individual or a company) for the purpose of financing the current needs, from an another party, usually called, the lender, under an agreement that, the borrowed party repays the borrowed amount called the debt, along with an agreed rate of interest, later in the future.
In the case of businesses, debt is a good alternative method of making the business a successful one, if utilized properly for its growth.
Types of Debt
Credit Card Debt, Mortgages, Auto Loan and personal Loan fall in this category. Here the banks are the lenders /creditors, and the investors are the borrowers.
This type of debt is done by the companies rather than the individuals. Companies when they need funds, issue Bond and Commercial Papers. Through bonds and commercial papers they collect the required funds and utilize the same for the growth of their businesses. This type of debt facility is particularly in the corporate sector and not available to the individuals. Here, investors are the lenders /creditors and companies are the borrowers.
Types of Corporate Debt
Bonds are a type of debt instruments, that allows companies to collect funds in a very amicable manner from the investors. Here investors may be either individual /institutional investors. Once the bonds are issued by the company, they are available to the public as well as institutional investment firms through banks and other financial investment channels.
A bond is a written agreement between the issuer company and the investor. Through bonds companies sell a ‘promise of repayment’ in the future. This repayment includes an interest rate called Coupon and the original amount received. The coupon rate is decided by the company at the time of issuance itself.
Each bond has its face value and the coupon rate. The purchaser of the bond receives the basic amount that’s invested at the end of the maturity period. And, the Coupon Rate, periodically at an intervals fixed at the time of issuance /at the end of the maturity period.
When companies are in scarcity of funds to pay off the accounts receivable, inventories and to meet all the short-term liabilities, they usually issue commercial papers. During 1985 – 1990 there, the world economy witnessed a trend called the liberalization. This was the background push for the introduction short-term monetary instruments called the commercial papers in the Indian Money Market. An effective reform to avail the funds for short-term obligations by the corporate companies. This can be considered as an innovation in the financial system of India. These are the most short-term instruments in Indian Money Market since 1990 onwards.
Prior to injection of commercial paper in Indian money market, that is before 1990, the corporate companies had to borrow the working capital from the commercial banks. Under this traditional process, companies were pledging the inventory as a collateral security. The introduction of commercial paper in the Indian money market avoided, all the hassles of borrowing the working capital, from the commercial banks. But, because of not backed by any form of collateral, here there are chances of default risk by the companies. This is usually called the corporate default problem. That’s the risk associated with these monetary instruments.
Role of Credit Rating Agencies
Credit Rating Agencies rate the companies depending on their secured credit. Hence it is always desirable to invest in commercial papers of companies with high credit ratings. That’s a company with high credit rating has, less chances of default risk. Others are riskier.
Companies with high credit rating has the advantage of finding buyers without discount to their cost. Whereas low credit companies need to offer a substantial discount (higher cost) for their debt.
In India, the maturity period of commercial papers ranges from 15 days to 1 year. Whereas in the United States, it’s no longer than 270 days.
A debenture is just like a bond, but not not backed by any collateral. The credit and faithfulness of the issuer company are its underlying security. Debentures are issued to raise the short-term capital. Companies when they are expected to pay for future expenses or for expansion plans, they raise the capital through the issuance of debentures.
In corporate finance, a Debenture is a medium to long-term debt instrument, used by large companies to borrow money, at a fixed rate of interest.
In other words, a debenture is a movable property, issued by a company in the form of indebtedness, specifying the dates of redemption, repayment of principal and interest. Debentures may or may not create a charge on the assets of the company.[/fusion_text][/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]