Complete guide to debt financing

Published in DARE Magazine Issue February, 2008

Debt is a good option to raise money to grow your business without giving up the freedom to operate Mohd Haroon is a happy man. Last year, this founder and managing director of Noida-based auto parts company Aglow Engineers wanted to grow his business, for which he needed to buy more sophisticated machinery. Haroon looked around for options to raise money and finally zeroed in on J&K Bank. He took a loan of Rs 35 lakh at 11.5% interest, to be repaid in five years. Haroon has had a good working relationship with the bank, from which he has been taking working capital loans to meet his companys day-to-day needs. Since the amount needed by Haroon was low, he did not even consider the option of going in for equity financing. Now he is targeting a turnover of Rs 8-9 crore in the next five years, as against Rs 2 crore at present. Every business, no matter how big or small, needs money to meet its short-term, medium-term and longterm capital requirements. While short-term requirements are aimed at meeting daily expenses, those relating to medium- and long-term are aimed at scaling up the business to increase the value of the company. While for working capital loans companies look up to banks, when it comes to making big investments, they have to take a tough decisioneither go for pure debt, pure equity or mixed financing. It is widely believed that companies prefer to bootstrap first, which means relying on their internal resources such as savings, family and friends. If that falls short of requirement, they go in for debt, and lastly, they opt for equity. The equity option for small and medium businesses is in the form of angel funding or venture capital, while the same for large businesses is raising money from financial markets, which involves launching an IPO. Debt options are in the form of bank loans and bonds.

What is debt financing? Debt financing refers to borrowing money from a source outside the company under certain terms and conditions relating to interest rate and the period of return of the principal amount. Most entrepreneurs prefer to start their operations with the money borrowed from banks and financial institutions. But this does not mean that large corporates are averse to taking loans. In fact, most big businesses have a debt component in their balance sheets, the reasons for which could vary from tax breaks, low interest funding or big acquisitions. But the option of debt financing may not be open to some sectors at all. For instance, startup technology companies. This is because they have no assets to offer as collaterals. According to Jayant Tewari of Outsourced CFO and Business Advisory Services, in the technology space, debt is fundamentally not available. This is because there is no asset base that can be securitized as most firms operate out of rented premises. The only asset they can lay claim to is hardware. Thus debt as an avenue of funding is not available. However, to some extent, they can do a little bit of leasing on their hardware, which is negligible, This too does not apply to startup firms, he adds.

But for large corporates, sometimes, equity is more attractive that debt and it is also easy to come by based on their reputation. If you are an Infosys or a Wipro, then you are giving equity at par. Take the case of Reliance Power IPO priced at Rs 450. You are giving 10 rupees share to get Rs 450. Thus Rs 440 comes without any cost. In this case, equity becomes ideal. This is because you manage to sell equity based on your image in the market, says S Padmanabhan, Director, Padmaja Financial Services. Pros and cons of debt financing Pros Autonomy: This is a big reason why going in for debt is considered to be a better option vis--vis sharing a part of your company with the lender during equity financing. Raising a loan leaves you with the freedom to run the company the way you want to, without any interference from the lender, as long as you meet your re-payment requirements. Tax benefits: Interest payments on loans are deducted from the companys income before calculating taxable income. This reduces the tax burden, thus making debt a favorable option for both small and big firms. Discipline: Some experts believe that managers of firms that have no debt and generate high income tend to become complacent. This may lead to inefficiency. On the other hand, managers who work with companies that have a debt burden have to be on their toes to ensure that enough income is generated to service the debt. Cons Repayment: One needs sufficient cash-flow to keep servicing debt. Failure to do so may result in lenders taking legal recourse to recover their money. This could even result in bankruptcy. The lender is not concerned whether your business succeeds or fails, as long as you are making repayments on time. Even if your business collapses, loans have to be repaid to avoid getting into legal hassles. A company should look at its own cash-flow situation, based on which it should take a decision on debt financing. Pankaj Jain Director and CEO Finman Ventures Consulting

Interest rates: The rate of interest may vary depending on the source of financing and your companys credit rating. So it is important to look for a good deal. Companies with poor credit rating are offered to pay higher interest rate, compared to those with a good credit rating. Higher the debt on your balance sheet, greater the difficulty in getting a good credit rating. Collaterals and guarantees: Most loans come with riders. You have to provide collaterals, which could be the ownership papers of your company. At times, you may need someone to guarantee the return of loan amount on your behalf. These may act as dampeners, as you see a part of your company lying with the lender.

However, Pankaj Jain, Director and CEO, Finman Venture Consulting believes that the advantages and disadvantages of debt financing may vary for different companies. It all depends on the requirements of the company, which may be short-, medium- or long-term. A company should look at its own cash-flow situation, based on which it should take a decision on debt financing, he says. Types of debt financing Working Capital Loan: This is the most popular short-term financing option. It is meant to fund the purchase of raw material, payment of wages and other administrative expenses, financing inventories, managing internal cash-flows, supporting supply chains, funding production and marketing operations. Most banks provide these as secured loans, ie, against collaterals. For instance, State Bank of India, the countrys largest bank, offers working capital loans that are tailored to suit the precise requirements of the client or structured as a combination of cash credit, demand loan, bill financing and non-funded facilities. These loans are extended for tenures of up to one year. The loans normally carry a floating interest rate linked to the SBI prime lending rate for working capital finance. Certain self-liquidating short-term loans are also linked to the banks Short Term Advance Rate (SBSTAR). Everybody takes working capital loans. It is meant for running the business. Even large corporations take such loans, says Padmanabhan. Overdraft: The other short-term debt option is the overdraft facility, by way of which a company opens a current account with a bank and can overdraw money up to an agreed limit. In this case, you pay interest only for the time you use the money. For example, HSBC India offers overdraft against RBI Bonds and Debt Mutual Fund units. Factoring: In this case, the bank buys the customers account receivables in domestic and international trade, assuming the responsibility of collecting them from the party that owes money. Commercial Papers (CPs): It is a short-term money market debt instrument issued by companies at a discount on the face value. Banks, individuals and mutual funds usually buy commercial papers. Of late, there has been a rise in the amount of commercial papers issued by companies. As of October 2007, the total amount of outstanding CPs issued by companies rose by about 80% to Rs 42,183 crore, compared to Rs 23,521 crore during the same time last year. Term loans: Most popular loans. These are mostly taken to buy assets and grow business. These loans are tenure based, which may vary from three to ten years. The amount, the tenure and interest rates may vary depending upon the risk profile of the company. In the case of State Bank of India, the SSI unit that takes the loan should not have any history of defaults in payment of interest or installments of the principal. The unit should have a strong performance record and a respectable credit rating as per the banks own credit assessment scales (in case of loan above Rs 25 lakh).

Term loans are either asset-backed or cash-flow backed. In the case of asset-backed term loans, lender institutions seek assets of the company as collaterals while issuing loans. In the case of cash-flow backed loans, banks carefully scrutinize the balance sheets of a company to study its cash-flow capability. The lenders want to be assured that the borrowers financial situation is good enough to make debt repayments. Due to high popularity, most banks have now devised tailor-made term loans targeted at women entrepreneurs, and specific sectors, such as textiles, jewelry, pharmaceuticals, construction and tourism. Syndicated loans: Syndicated loans are large capital loans raised by big corporations from a group of banks. These are aimed at acquiring domestic or international companies. In this case, one bank acts as a lead bank. According to consulting firm Dealogic, Indian companies raised over $35 billion in syndicated loans in 2007. The loans were spread over 112 deals. Project Finance: Large and long-term infrastructure projects require huge amounts amount of funding both in the form of debt and equity. In project financing, lenders (banks) rely on the assets created for the project as security and the cash-flow generated by the project as source of funds for repaying their dues. These projects include building of roads, dams, ports etc are sensitive to regulatory and political policies and tariffs. Debentures: This is a long-term debt instrument issued by a company with the acknowledgement that it would repay the money at a certain rate of interest to the buyer. These are not shares, thus the buyer can stake no claim in the share of the company. Inter-corporate deposits: This is a short-term help provided by one corporate with surplus funds to another in need of funds. These deposits could be both securitized and unsecuritized. The major disadvantage to lenders is that the money is locked in for the certain period of time. Personal loans: Of late, several entrepreneurs have been taking personal loans from banks and financial institutions to fund their projects. Most banks these days offer such loans of up to Rs 3 lakh for small business ventures. The interest rate may vary from 17% to 24%. These are mostly unsecured loans and are easily sanctioned. This is making personal loans popular among self-employed entrepreneurs. Deciding on debt or equity Whether to go for pure debt, pure equity or mixed financing depends on three major factorscapital requirement, which may be short-term to long-term; repaying capacity in case of debt; and money-raising capabilities. A promoters thought process on ownership also matters. If a promoter does not want to part with the ownership of the company at all, raising debt is the best option. A good decision can be taken after carefully studying the companys cash-flow analysis and determining the debt equity ratio. Cash-flow represents the flow of money to and from the business. A close look at receivables, inventory, payables, etc, helps determine the financial health of a company. It represents a record of the companys income and expenses. To carry out a meticulous cash-flow analysis, a business needs to identify clearly its major expenses in the future, and also major investments.

In the case of our clients, we take at least a five-year time frame. We then estimate their entire fund requirement at different stages of growth. Then we assess their cash-flow situation. Based on which, we advise on the amount of debt and equity to be taken, says Jain of Finman Venture Consulting. Experts believe that a companys management should spend considerable time, effort and money to obtain a correct cash-flow data. It is important to recheck the information received from various departments such as accounts, production, and marketing to arrive at an accurate figure. Debt-equity ratio of the company also plays a major role in deciding on the debt option and also affects the lenders decision to give money.

Debt-equity ratio is calculated by dividing the total liability of the company by shareholders equity. Debt-equity ratio may vary from 2:1 to 4: 1. Normally it is 2:1, says Padmanabhan. A high debt-equity ratio represents a high-risk business and a diminishing capability of a firm to repay debt.

What do lenders look for? Any lender, be it a bank or a financial institution, would want to reassure itself that the borrower would repay the loan on time, without hassles. That is why banks and FIs offer securitized loans, ie, seek collaterals. Besides, they would want to get maximum information about the borrower company. This information may include that related to its audited balance sheets, income tax returns, number of employees, list of customers, etc. In the case of listed companies seeking to raise debt, banks would also want to know about the shareholders and full-time directors. But in the end, the onus is on you to prove that you have the capability to repay debt on time. Security can be of two types. In the case of term loans, primary security refers to the assets acquired using term loans. This is a form of hypothecation, ie, the assets you buy with the money taken as loan remain with the lender till the time you pay back the debt. The secondary or collateral security refers to the companys current and future assets, which are secured by the bank while issuing loans. To protect themselves further, some banks impose restrictive covenants, generally referred to as terms of loans. This may make it mandatory for the borrower to keep the lender informed about the financial health of its business by furbishing the financial statements of the company. In the case of asset-related covenants, banks would like to see the company maintain its minimum asset base, and not sell any assets without the approval of the lender. Liability-related covenants may restrain the firm from incurring any additional debt. In some cases, a lender may impose cash-flow related covenants which would restrain the firms cash outflow by restricting capital expenditures, salaries and perks of managerial staff.