• Aditya Battu

Debt Capital : Explained

Updated: Jul 4, 2020

In the previous post, we have covered in brief, the two broad ways in which companies raise money, namely :

  1. Debt Capital

  2. Equity Capital

In this post we look at the various debt capital options available for the companies to raise money through debt in more detail

What are the two broad ways in which a company can raise debt capital?

  1. Bank loan

  2. Debt instruments

A bank loan here for company is similar to loans that we take from banks?

Yes, it is similar. The same way we take loans to fulfill our needs companies also take loans from banks to fulfill their expansion needs

Okay clear. Now what is a debt instrument?

It is similar to a loan agreement. It allows the debt instrument holder, a promise from company to pay monthly interest, and the principal amount borrowed when matured. Here debt instrument holder is like the bank who lends money

So, if XYZ company issues a debt instrument to raise money, it must pay monthly interest and also pay back total money borrowed at the end of the maturity period to the debt instrument holders

Both bank loans and debt instruments seem to be similar. But how are they different?

  1. A bank loan can have a variable interest rate over time based on market conditions, but a debt instrument usually has a fixed interest rate. That is why they are also known as fixed income securities

  2. Debt instruments can be traded. The person who bought the debt instrument can sell it to another person. This is not possible with bank loans

Okay got it! But we see different types of debt instruments in the market. How are they different from each other?

We generally observe 4 types of debt instruments:

  1. Bonds

  2. Notes

  3. Non-convertible debentures ( NCD's )

  4. Commercial papers

Bonds: These are debt instruments backed by security hence safe. If the company is not able to pay back the amount, its assets can be sold to pay back your money. Can be issued by government and central bank as well, in that case they are called treasury bonds/bills

Notes: They are similar to bonds but with a shorter duration than bonds, usually 1-2 years

Non-convertible debentures ( NCD's ): They are similar to bonds but not backed by any security except company’s promise to pay you back the money. There is no guarantee that your money will be paid back if the company is bankrupt, so they usually pay higher interest rate than bonds

Commercial papers: These are extremely short-term notes with a duration of 9 months or less. These are generally issued by companies to buy inventory or to stabilize cash flow fluctuations

I hope the debt instruments are clear now and you won’t be boggled by these terms when they appear in the news :)

In the next series on debt and equity capital, we look at various ways of raising equity capital in detail. Do drop in your comments and suggestions, if any

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