Debt Instruments Definition Types How It Works

Debt Instruments Meaning

Types of Debt Instruments

There are two types of debts instruments, which are as follows:

Long-termMedium & Short-term

Let us now explain these in detail.

#1 – Long-Term Debt Instruments

The company uses these instruments for its growth, heavy investments, and future planning. These are those instruments which generally have a period of financing of more than 5 years. These instruments have a charge on the company’s assets and also bear an interest paid regularly.

A debentureDebentureDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more is the most used and most accepted source of long-term financing by a company. These carry a fixed Interest RateFixed Interest RateA fixed interest rate is a constant rate of interest levied on debts like loans, mortgages, or bonds.read more on the finance raised by the company through this mode of the debt instrument. These are raised for a minimum period of 5 years. Debenture forms part of the capital structureCapital StructureCapital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.read more of the company but is not clubbed with calculating share capitalCalculating Share CapitalShare capital refers to the funds raised by an organization by issuing the company’s initial public offerings, common shares or preference stocks to the public. It appears as the owner’s or shareholders’ equity on the corporate balance sheet’s liability side.read more in the balance sheet.

Bonds are just like debentures, but the main difference is that bonds are used by the government, central bank & large companies, and also these are backed by securities, which means these have a charge over the company’s assets. These also have a fixed interest rate, and the minimum period is also at least 5 years.

It is another method that is used by companies to get loans from banks, financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more. It is not as much a favorable option method of financing as the companies have to mortgage their assets to banks or financial institutions. And also, the Interest rates are too high as compared to Debentures.

Under this option, the company can raise funds by mortgaging its assets with anyone either from other companies, individuals, banks, or financial institutions. These have a higher rate of interest in funding the companies. The interest of the party providing funds is secured as they have a charge over the asset being mortgaged.

#2 – Medium & Short-Term Debt Instruments

These are those instruments which are generally used by the companies for their day to day activities and working capital requirements of the companies. The period of financing in this case of Instruments is generally less than 2-5 years. They don’t have any charge over the companies assets and also don’t have a high-interest liability on the companies. Examples are as follows:-

Working capital loansWorking Capital LoansA working capital loan is a loan taken out by a company to finance its day-to-day operations, such as funds to cover the company’s operational needs for a short period of time, such as debt payments, rents, or payroll, rather than for long-term investments or assets.read more are the loans that are used by the companies for their day to day activities like clearing of creditors outstanding, payment for the rent of the premises, purchase of raw material, repairs of machinery. These have interest charges on the monthly limit used by the company during the month from the limit allowed by financial institutions.

Banks and financial institutions also finance these, but they do not charge interest monthly; they have a fixed rate of interest, but the period for funds transferred is for less than 5 years.

Treasury BillsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more are short-term debt instruments that mature within 12 months. They are redeemed at the maturity in full, and if sold before maturity, then they can be sold at a discounted price. The interest on these T-bills is covered in the issue price as they are issued at a premium and redeemed at par valuePar ValuePar value is the minimum value of a security set and stated in the corporate charter or its certificate by the issuer when issued for the first time.read more.

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Advantages

Tax Benefit for Interest Paid:- In debt financing, the companies get the benefit of interest deduction from the profit before calculation of tax liability.Ownership of Company:- One of the major advantages of debt financing is that the company does not lose its ownership to the new shareholders as the debenture does not form part of the share capital.Flexibility in Raising Funds:- Funds can be raised from debts instruments more easily as compared to equity funding as there is a fixed rate of interest payment to the debt holder at regular intervalsEasier Planning for Cashflows:- The companies know the payment schedule of the funds raised from debt instruments such as there is an annual payment of interest and a fixed time period for redemption of these instruments, which helps companies to plan well in advance regarding their cash flow/funds flow status.Periodic Meetings of Companies:- The companies raising funds from such instruments are not required to send notices, mails to debt holders for the regular meetings, as in the case of equity holders. Only those meetings which affect the interest of the debt holders would be sent to them.

Disadvantages

Repayment:- They come with a repayment tag on them. Once funds are raised from debt instruments, these are to be repaid on their maturity.Interest Burden:- This instrument carries an interest payment at a regular interval, which needs to be met for which the company needs to maintain sufficient cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more. Interest payment reduces the company profit by a significant amount.Cashflow Requirement:- The company needs to pay interest as well as the principal amount for the company to keep the cash flows for making these payments well in time.Debt-Equity Ratio:- The companies having a larger debt-equity RatioDebt-equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. read more are considered risky by the lenders and investors. It should be used up to such an amount, which does not fall below that risky debt financing.Charge Over the Assets:- It has a charge over the companies assets, many of which require the company to pledge/mortgage their assets in order to keep their interest/funds safe for redemption.

Debt Instruments Meaning#

Types of Debt Instruments#

#1 – Long-Term Debt Instruments#

#2 – Medium & Short-Term Debt Instruments#

Advantages#

Disadvantages#

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