Debt is an amount of money borrowed by one party from another. By ‘debt’ we mean financing with explicitly costs or interest to pay, usually bank debt. Debt is used by many corporations and individuals as a method of making large purchases that they could not afford under normal circumstances. Essentially, debt financing is where you borrow money from a lender that you will eventually pay back, plus interest. If you have ever taken out a loan, you have financed something with debt . The most common forms of debt are loans, including mortgage and auto loans, and credit card debt.
Clients and students frequently ask me this question ‘when to ask for debt’. My answer has always been ‘ask for debt when you need it’. You will need it when your investment in NA (NFO+FA) is greater than the company’s equity. But do not ask debt when you are in desperate need of it. Bank do not like that. Plan the borrowing in advance (how much and when to borrow). For this purpose you will need the comprehensive income statement and statement of position forecast. Prepare and present the ‘image’ of the company as if you were looking for a partner (in a way, the bank is a partner in your company). If you are not a very big company, accept the debt when banks are ready to give it to you on favorable terms, even though you may not need it right way. A time will come when you will need the money and nobody will want to give it to you.
I will try to answer four questions that I am frequently asked about the type of debt to take on.
- Short-term or long-term debt?
Conventional wisdom (and many textbooks) says that fixed assets (FA) should be financed with long-term debt because they themselves are long-term debt. I disagree. Example: a company with a net income of $100M wants to invest $100M in a new plant. No other investments are expected. It makes no sense to ask a ten year loan, because in one or two years the loan will be repaid. Why pay interest for money you do not need.
I will recommend two criteria for deciding the on the maturity of your debt.
- The loan maturity must be as long as you need in order to pay it back, even in bad years. For this purpose you will need a comprehensive income and statement of financial position forecast. A short cut: look at the size of the cash flows from operations (CFO) (net income + depreciation) in bad and normal years, compare it with the investments needed in the future, and you will see how much money you have available to pay the debt back. With this figure, you can see if you need three, five or ten years to pay it off. Another quick short cut: the size of your net income is the maximum debt you can pay back per year. Better to pay in five years at a moderate pace than in three years with a lot of pressure on the company. Do not be over optimistic in your CFO forecast. Avoid surprises. Banks do not like surprises of the type ‘Sorry, I will have to delay this payment but don’t worry…’
- I recommend having a strong working capital (WC), that provide solid and permanent financing for the company. It is better to have a long term loan than to go bank every year asking for more money. Banks do not like bad forecasting any more than they like surprises.
The cost of the loan will be different from every maturity: for example, 6% if your loan is ten years, 5% if it is five years and 4% if it is three years. This is not a criterion for deciding the maturity of the loan. If you want a lower rate you may ask for a ten year loan at a floating rate.
- Variable rate or fixed rate?
The bank may offer you a ten year loan at a variable rate plus a spread (the spread is the risk premium). The variable rate is usually the interbank rate for three, six or twelve months (e.g. Euribor, Libor). This rate changes frequently and the bank will adjust the rate you pay accordingly. In fact, borrowing at a variable cost is like borrowing for, say 12 months and renewing the credit every 12 months. But in this case you do not need to do the paper work for the renewal of the credit, because you have agreed on a ten-year loan.
If you take a ten-year loan at fixed rate, you will pay the rate of ten-year government bonds at the time of the borrowing, plus a spread. That rate will remain the same over the full ten years. Which one should you choose: variable or fixed rate? Let us look at the pros and cons of each alternatives:
- If you do not want any uncertainty about the financial expenses you will have to pay, choose a fixed rate, and be sure that you can pay that amount every year even in bad years.
- But you add a fixed cost to your comprehensive income statement, you may be adding more risk to it. Usually, when there is an economic crisis and lower sales, there are lower interest rates and fewer financial expenses. But with a fixed rate you will continue to pay the same financial expenses.
- If you feel that the ten-year rate is at a historical low, you may go for the fixed rate, but be aware that by doing so you are somehow speculating on the movements of the yield curve.
- Very often you will be offered only one alternative, the variable rate, so there will be no decision to take. In fact, the tendency of banks to lend at variable rates indicates that they see the variable rate as less risky for themselves and for their clients. Less risky because in times of economic slowdown companies do worse, but interest rates go down, too. The opposite happens during economic booms.
- Domestic or foreign currency?
You may borrow in your local currency (for example, in Brazil, Brazilian reals at 18 per cent) or in a foreign currency (for example, Japanese yen at 2 per cent). Why this big divergence in interest rates? The reason is that every currency has its own yield curve-its own interest rates for each maturity-according to local circumstances as regards inflation, public deficit, trade deficit, economic growth, etc. The difference between the Brazilian real and Japanese yen rates is appealing. Should we borrow in the cheaper currency? Some comments on that:
First, this alternative is only available if you are a big corporation or if you work in a very well developed financial market.
Second, in the long run the currency with the lower rate will appreciate against the currency with higher rate. That means that if we are in Brazil and borrow in yen, we may save financial expenses initially, but if there is a devaluation of the Brazilian real against the yen, we may lose a lot of money. In fact, borrowing in a foreign currency always means more uncertainty or risk: if you are lucky you will make extra profit; but if you are unlucky you will have extra loss. That is the meaning of risk.
Borrowing in a foreign currency makes sense only if part of your revenues or sales comes in that currency. For examples, if you operate in Brazil and export to Europe and get paid in Euros, it makes a lot of sense to borrowing in Europe.
- Capital markets: Bonds and commercial paper
Most debt financing is bank-financed, or debt lent by banks. Nevertheless, very big companies and companies listed on the stock market may sell bonds in the capital markets to institutional or private investors.
Bonds issued (sold) by company with long maturity are known as corporate bonds or simply corporates. Bonds issued with a maturity of less than 18 months are known as commercial paper. The bonds sold may have a collateral or guaranty in case of default (secure bonds). In this case the risk of the bond is smaller and the rate the company pays is lower. If a bond does not have any colleratal, it is called a debenture.
To issue a bond, you will need the help of an investment bank, whose role is to design the deal, file that papers with the regulator, and sell the bonds in the market. The investment bank’s fee will increase with the difficulty of selling the bonds. In fact, small companies cannot sell bonds. Usually, only big companies that regularly issue large quantities of bonds are able to borrow on the capital markets.
About the author:
The writer is a lecturer, banker and Managing Partner Spint Consult Limited