Function of debt financing in business

National Bank of Rwanda. / File

A company may use various kinds of debt to finance its operations as a part of its overall corporate finance strategy.

A term loan is the simplest form of corporate debt. It consists of an agreement to lend a fixed amount of money, called the principal sum or principal, for a fixed period of time, with this amount to be repaid by a certain date.

In commercial loans interest, calculated as a percentage of the principal sum per year, will also have to be paid by that date, or may be paid periodically in the interval, such as annually or monthly.

Such loans are also colloquially called “bullet loans”, particularly if there is only a single payment at the end – the “bullet” – without a “stream” of interest payments during the life of the loan.

Syndicated loan

A syndicated loan is a loan that is granted to companies that wish to borrow more money than any single lender is prepared to risk in a single loan.

A syndicated loan is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banks or investment banks known as arrangers.

Loan syndication is a risk management tool that allows the lead banks underwriting the debt to reduce their risk and free up lending capacity.

Bonds

A company may also issue bonds, which are debt securities. Bonds have a fixed lifetime, usually a number of years; with long-term bonds, lasting over 30 years, being less common. At the end of the bond’s life the money should be repaid in full.

Interest may be added to the last payment, or can be paid in regular installments (known as coupons) during the life of the bond.

Letter of credit

A letter of credit or LC can also be the source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another.

They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, storm-water ponds, etc.) will be built.

The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client.

Almost all letters of credit are irrevocable; they cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and traveler’s check.

Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and a document proving the shipment was insured against loss or damage in transit.

However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.

Companies also use debt in many ways to leverage the investment made in their assets, “leveraging” the return on their equity. This leverage, the proportion of debt to equity, is considered important in determining the riskiness of an investment; the more debt per equity, the riskier.

Governments-Treasury bonds

Governments issue debt to pay for ongoing expenses as well as major capital projects. Government debt may be issued by sovereign states as well as by local governments, sometimes known as municipalities.

The overall level of indebtedness by a government is typically shown as a ratio of debt-to-GDP. This ratio helps to assess the speed of changes in government indebtedness and the size of the debt due.

Assessment of Credit worthiness: The debt service coverage ratio is the ratio of income available to the amount of debt service due (including both interest and principal amortization, if any).

The higher the debt service coverage ratio, the more income is available to pay debt service, and the easier and lower-cost it will be for a borrower to obtain financing.

Different debt markets have somewhat different conventions in terminology and calculations for income-related measurements.

For example, in mortgage lending in the United States, a debt-to-income ratio typically includes the cost of mortgage payments as well as insurance and property tax, divided by a consumer’s monthly income.

A “front-end ratio” of 28 per cent or below, together with a “back-end ratio” (including required payments on non-housing debt as well) of 36 per cent or below is also required to be eligible for a conforming loan.

Value metrics

The loan-to-value ratio is the ratio of the total amount of the loan to the total value of the collateral securing the loan.

For example, in mortgage lending, the loan-to-value concept is most commonly expressed as a “down payment.”

A 20 per cent down payment is equivalent to an 80 per cent loan to value. With home purchases, value may be assessed using the agreed-upon purchase price, and/or an appraisal.

Collateral and recourse

A debt obligation is considered secured if creditors have recourse to specific collateral. Collateral may include claims on tax receipts (in the case of a government), specific assets (in the case of a company) or a home (in the case of a consumer).

Unsecured debt comprises financial obligations for which creditors do not have recourse to the assets of the borrower to satisfy their claims.

Role of rating agencies

Debts owed by governments and private corporations may be rated by rating agencies, such as Moody’s, Standard & Poor’s, Fitch Ratings, and A. M. Best.

The government or company itself will also be given its own separate rating. These agencies assess the ability of the debtor to honor his obligations and accordingly give him or her a credit rating. Moody’s uses the letters Aaa Aa A Baa Ba B Caa Ca C, where ratings Aa-Caa are qualified by numbers 1-3. S&P and other rating agencies have slightly different systems using capital letters and +/- qualifiers. Thus a government or corporation with a high rating would have Aaa rating.

A change in ratings can strongly affect a company, since its cost of refinancing depends on its creditworthiness. Bonds below Baa/BBB (Moody’s/S&P) are considered junk or high-risk bonds.

Their high risk of default (approximately 1.6 percent for Ba) is compensated by higher interest payments. Bad Debt is a loan that cannot (partially or fully) be repaid by the debtor. The debtor is said to default on his debt. These types of debt are frequently repackaged and sold below face value. Buying junk bonds is seen as a risky but potentially profitable investment.

Debt markets

Bonds are debt securities, tradeable on a bond market. A country’s regulatory structure determines what qualifies as a security.

For example, in North America, each security is uniquely identified by a CUSIP for trading and settlement purposes.

In contrast, loans are not securities and do not have CUSIPs (or the equivalent). Loans may be sold or acquired in certain circumstances, as when a bank syndicates a loan.

Loans can be turned into securities through the securitisation process. In a securitisation, a company sells a pool of assets to a securitization trust, and the securitization trust finances its purchase of the assets by selling securities to the market. For example, a trust may own a pool of home mortgages, and be financed by residential mortgage-backed securities. In this case, the asset-backed trust is a debt issuer of residential mortgage-backed securities.

Role of central banks

Central banks play a key role in the debt markets. Debt is normally denominated in a particular currency, and so changes in the valuation of that currency can change the effective size of the debt. This can happen due to inflation or deflation, so it can happen even though the borrower and the lender are using the same currency.

Dangers of debt

Some argue against debt as an instrument and institution, on a personal, family, social, corporate and governmental level. In hard times, the cost of servicing debt can grow beyond the debtor’s ability to pay, due to either external events (income loss) or internal difficulties (poor management of resources).

Debt with an associated interest rate will increase through time if it is not repaid faster than it grows through interest. This effect may be termed usury, while the term “usury” in other contexts refers only to an excessive rate of interest, in excess of a reasonable profit for the risk accepted.

In international legal thought, odious debt is debt that is incurred by a regime for purposes that do not serve the interest of the state. Such debts are thus considered by this doctrine to be personal debts of the regime that incurred them and not debts of the state.

At one time, International Third World debt had reached the scale that many economists were convinced that debt relief or debt cancellation was the only way to restore global equity in relations with the developing nations.

Excessive debt accumulation [has been blamed for exacerbating economic problems.  At the household level, debts can also have detrimental effects — particularly when households make spending decisions assuming income will increase, or remain stable, in years to come.

When households take on credit based on this assumption, life events can easily change indebtedness into over-indebtedness.

Such life events include unexpected unemployment, relationship break-up, leaving the parental home, business failure, illness, or home repairs.

Over-indebtedness has severe social consequences, such as financial hardship, poor physical and mental health, family stress, stigma, difficulty obtaining employment, exclusion from basic financial services

Traditions in some cultures demand that debt be forgiven on a regular (often annual) basis, in order to prevent systemic inequities between groups in society, or anyone becoming a specialist in holding debt and coercing repayment. An example is the Biblical Jubilee year, described in the Book of Leviticus.

The writer is Vice Chancellor, ALU Rwanda.