What are Debentures?
Long Term financing is very commonly used by companies in order to provide capital for expansion, as well as for other relevant needs of the company.
When raising money for a longer time period, there are numerous different options that are available to the company for expansion.
Debentures tend to be one of those main options that organizations, as well as governments, can utilize in order to raise finance in the longer run.
Debentures can simply be defined as a type of debt instrument that is not usually backed by any collateral, and has a term greater than 10 years.
They are mostly issued on the basis of the reputation and the creditworthiness of the issuing party. Hence, mostly those organizations issue debentures that are less likely to default, and have stabilized earnings or operations over the course of time.
They span across a considerable time period and incur a monthly interest rate that needs to be borne as a result of this loan that is drawn.
Therefore, the salient features of debentures can be summarized as follows:
- Debentures are long-term loan financing instruments.
- Debentures incur a flat interest rate over their timeline.
- Debenture holders need to be paid their interest fees, regardless of the volume of profit that the company generates.
- Raising money through debentures is mostly contingent on the creditworthiness of the company, as well as the ability of the company to generate profits.
- In order to incentivize investors, debenture packages can be tailored in accordance with the needs and requirements of the investor. For example, convertible debentures can be issued in order to attract investors to invest in the company for a certain period of time, after which their investment would be converted to shareholding in the company.
Advantages of Debentures
There are several different advantages of issuing debentures from the perspective of the issuer. These advantages are as follows:
- Debentures can easily promote long-term financing for the company.
- It is relatively easier to raise funds via debentures as compared to other long-term financing alternates.
- Raising money via debentures is also considered to be a viable option because it provides financial protection and reassurance for directors, as well as their own personal funds.
- Since debentures have fixed interest rates occurring over the course of time, it gets relatively easier to estimate the finance cost for the amount that needs to be paid over the course of tenure.
- From the perspective of the creditor, debentures normally have a higher priority for repayment as compared to other users. In this regard, it is imperative to consider the fact that upon liquidation, there is a certain pecking order that needs to be maintained. In this regard, debenture holders are also in line with those payments. This acts as an incentive for the investors.
- Since debentures do not cause dilution of ownership, it does not alter the voting rights or the voting structure within the company. Hence, companies can be able to raise considerable sums of finance without having to worry about these aspects.
- Since debenture payments (interest payments) have to be paid irrespective of the volume of profit, this implies that they are not entitled to a share in profit. They will be entitled to the flat interest rate in the market.
- Issuing debentures do not require any collateral. Hence, it is relatively easier to raise money via debentures as compared to conventional bank loans.
Disadvantages of Debentures
Regardless of the fact that debentures are considered to be an extremely vital source of income for the company, it can be seen that there are certain drawbacks and limitations that also need to be taken into account. These disadvantages are as follows:
- Each company has a certain borrowing capacity they have to work with. Therefore, this option might not be easily available to companies that already have a high gearing ratio.
- Interest payments have to be made regardless of the level of profit that the company is operating at.
- Since debenture is mostly extended to companies on the basis of their history and reputation, it can be seen that this option might not be readily available to companies that have recently been formed.
- It might be harder to find investors who are willing to get into such a long-term arrangement with the debenture issuer. Mostly debentures are issued for a period of 10 years and have a fixed interest rate. Hence, risk-averse investors prefer to invest in these ventures. However, it might be hard to get them into a long-term arrangement, against already decided interest rates.