Complete guide to debt financingPublished in DARE Magazine Issue February, 2008Debt is a good option to raise money to grow your business without giving up the freedom to operateMohd Haroon is a happy man. Last year, this founder and managing director of Noida-based auto partscompany Aglow Engineers wanted to grow his business, for which he needed to buy more sophisticatedmachinery.Haroon looked around for options to raise money and finally zeroed in on J&K Bank. He took a loan of Rs 35lakh 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 company’s day-to-day needs. Since theamount needed by Haroon was low, he did not even consider the option of going in for equity financing. Nowhe 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 long-term capital requirements. While short-term requirements are aimed at meeting daily expenses, thoserelating to medium- and long-term are aimed at scaling up the business to increase the value of thecompany.While for working capital loans companies look up to banks, when it comes to making big investments, theyhave to take a tough decision—either go for pure debt, pure equity or mixed financing. It is widely believedthat 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. Theequity option for small and medium businesses is in the form of angel funding or venture capital, while thesame for large businesses is raising money from financial markets, which involves launching an IPO. Debtoptions 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 undercertain terms and conditions relating to interest rate and the period of return of theprincipal amount. Most entrepreneurs prefer to start their operations with the moneyborrowed from banks and financial institutions. But this does not mean that largecorporates are averse to taking loans. In fact, most big businesses have a debt componentin their balance sheets, the reasons for which could vary from tax breaks, low interest funding or bigacquisitions.But the option of debt financing may not be open to some sectors at all. For instance, startup technologycompanies. This is because they have no assets to offer as collaterals. According to Jayant Tewari ofOutsourced CFO and Business Advisory Services, “in the technology space, debt is fundamentally notavailable. This is because there is no asset base that can be securitized as most firms operate out of rentedpremises. The only asset they can lay claim to is hardware. Thus debt as an avenue of funding is notavailable.” 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 basedon their reputation. “If you are an Infosys or a Wipro, then you are giving equity at par. Take the case ofReliance Power IPO priced at Rs 450. You are giving 10 rupees share to get Rs 450. Thus Rs 440 comeswithout any cost. In this case, equity becomes ideal. This is because you manage to sell equity based onyour image in the market,” says S Padmanabhan, Director, Padmaja Financial Services.Pros and cons of debt financingPros• Autonomy: This is a big reason why going in for debt is considered to be a better option vis-à-vis sharinga part of your company with the lender during equity financing. Raising a loan leaves you with the freedomto run the company the way you want to, without any interference from the lender, as long as you meet yourre-payment requirements.• Tax benefits: Interest payments on loans are deducted from the company’sincome before calculating taxable income. This reduces the tax burden, thusmaking debt a favorable option for both small and big firms.• Discipline: Some experts believe that managers of firms that have no debtand generate high income tend to become complacent. This may lead toinefficiency. On the other hand, managers who work with companies thathave a debt burden have to be on their toes to ensure that enough income isgenerated to service the debt.Cons A company should look at its own cash-flow situation,• Repayment: One needs sufficient cash-flow to keep servicing debt. Failure based on which it shouldto do so may result in lenders taking legal recourse to recover their money. take a decision on debtThis could even result in bankruptcy. The lender is not concerned whether financing.your business succeeds or fails, as long as you are making repayments on — Pankaj Jaintime. Even if your business collapses, loans have to be repaid to avoid getting Director and CEO Finmaninto legal hassles. Ventures Consulting• Interest rates: The rate of interest may vary depending on the source of financing and your company’scredit rating. So it is important to look for a good deal. Companies with poor credit rating are offered to payhigher 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 bethe ownership papers of your company. At times, you may need someone to guarantee the return of loanamount on your behalf. These may act as dampeners, as you see a part of your company lying with thelender.
However, Pankaj Jain, Director and CEO, Finman Venture Consulting believes that the advantagesand disadvantages of debt financing may vary for different companies. It all depends on therequirements of the company, which may be short-, medium- or long-term. “A company should lookat 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 assecured loans, ie, against collaterals.For instance, State Bank of India, the country’s largest bank, offers working capital loans that are “tailored tosuit 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 loansnormally carry a floating interest rate linked to the SBI prime lending rate for working capital finance. Certainself-liquidating short-term loans are also linked to the bank’s Short Term Advance Rate (SBSTAR).“Everybody takes working capital loans. It is meant for running the business. Even large corporations takesuch loans,” says Padmanabhan.Overdraft: The other short-term debt option is the overdraft facility, by way of which a company opens acurrent account with a bank and can overdraw money up to an agreed limit. In this case, you pay interestonly for the time you use the money. For example, HSBC India offers overdraft against RBI Bonds and DebtMutual Fund units.Factoring: In this case, the bank buys the customer’s account receivables in domestic and internationaltrade, 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 adiscount 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, thetotal amount of outstanding CPs issued by companies rose by about 80% to Rs 42,183 crore, compared toRs 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 aretenure based, which may vary from three to ten years. The amount, the tenure and interest rates may varydepending upon the risk profile of the company. In the case of State Bank of India, the SSI unit that takesthe loan should not have any history of defaults in payment of interest or installments of the principal. Theunit should have a strong performance record and a respectable credit rating as per the bank’s own creditassessment 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, lenderinstitutions seek assets of the company as collaterals while issuing loans. In the case of cash-flow backedloans, banks carefully scrutinize the balance sheets of a company to study its cash-flow capability. Thelenders want to be assured that the borrower’s financial situation is good enough to make debt repayments.Due to high popularity, most banks have now devised tailor-made term loans targeted at womenentrepreneurs, 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 ofbanks. These are aimed at acquiring domestic or international companies. In this case, one bank acts as alead bank. According to consulting firm Dealogic, Indian companies raised over $35 billion in syndicatedloans in 2007. The loans were spread over 112 deals.Project Finance: Large and long-term infrastructure projects require huge amounts amount of funding bothin the form of debt and equity. In project financing, lenders (banks) rely on the assets created for the projectas security and the cash-flow generated by the project as source of funds for repaying their dues. Theseprojects 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 itwould repay the money at a certain rate of interest to the buyer. These are not shares, thus the buyer canstake 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 anotherin need of funds. These deposits could be both securitized and unsecuritized. The major disadvantage tolenders 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 financialinstitutions to fund their projects. Most banks these days offer such loans of up to Rs 3 lakh for smallbusiness ventures. The interest rate may vary from 17% to 24%. These are mostly unsecured loans and areeasily sanctioned. This is making personal loans popular among self-employed entrepreneurs.Deciding on debt or equityWhether to go for pure debt, pure equity or mixed financing depends on three major factors—capitalrequirement, which may be short-term to long-term; repaying capacity in case of debt; and money-raisingcapabilities. A promoter’s thought process on ownership also matters. If a promoter does not want to partwith the ownership of the company at all, raising debt is the best option. A good decision can be taken aftercarefully studying the company’s 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 company’sincome and expenses. To carry out a meticulous cash-flow analysis, a business needs to identify clearly itsmajor 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 fundrequirement at different stages of growth. Then we assess their cash-flow situation. Based on which, weadvise on the amount of debt and equity to be taken,” says Jain of Finman Venture Consulting. Expertsbelieve that a company’s management should spend considerable time, effort and money to obtain a correctcash-flow data. It is important to recheck the information received from various departments such asaccounts, 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 affect’s thelender’s decision to give money.Debt-equity ratio is calculated by dividing the total liability of the company by shareholder’sequity. “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 afirm 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 repaythe 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 mayinclude that related to its audited balance sheets, income tax returns, number of employees, list ofcustomers, etc. In the case of listed companies seeking to raise debt, banks would also want to know aboutthe shareholders and full-time directors. But in the end, the onus is on you to prove that you have thecapability to repay debt on time.Security can be of two types. In the case of term loans, primary security refers to the assets acquired usingterm loans. This is a form of hypothecation, ie, the assets you buy with the money taken as loan remain withthe lender till the time you pay back the debt. The secondary or collateral security refers to the company’scurrent 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 ofloans. This may make it mandatory for the borrower to keep the lender informed about the financial health ofits 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 theapproval of the lender. Liability-related covenants may restrain the firm from incurring any additional debt. Insome cases, a lender may impose cash-flow related covenants which would restrain the firm’s cash outflowby restricting capital expenditures, salaries and perks of managerial staff.