Long term debt financing is majorly categorized into term loan and debentures. Debentures are one of the common long term sources of finance. They normally carry a fixed interest rate and a certain date of maturity. Interest is paid every year and principal is paid on the date of maturity. Term loan carry a fixed interest rate and the payment is done in installments which is consisted of both principal and interest.
Term loan is lent by a financial institution or a bank so the financier is the bank / financial institution whereas the debentures are issued to general public and therefore the financier is the general public. This is the basic difference between these two types of long term source of debt finance.
Since, both debenture and term loan are a type of debt financing, they share basic characteristics of a debt and hence their advantages and disadvantages are also similar. Following are some benefits and disadvantages of debt financing (debentures or term loans) from the point of view of a company.
From an investor point of view, the prime advantages of investing in debenture is the fixed and stable return with preferential rights of payment at the time of liquidation in comparison to equity or preference shares. The main disadvantage of preferring debenture over equities is that the debenture holder does not get right to vote and there is no profit sharing. The returns are limited to the extent of interest irrespective of the higher or lower earnings of the company.
Interest payment to the debenture holders’ or ‘installment and interest of term loan’ is a legal obligation and the business has to honor the same come what may. This feature of debt financing in general creates a problem for the business in the bad times. Economic and other environmental ups and down are certain to come. Under those situations, a new business which is just about to take off cannot have such disciplined cash flows to pay the interest or installment timely. Therefore, debenture and term loans are not a right kind of financing option for them especially in their nascent stage. This fixed expense may create big mismatch with their cash flows and the company may have to go for bankruptcy. Term loan can still be viable because banks provide moratorium or gestation period or at times adjust the obligation with the pattern of cash inflows of the company. Such modifications are not possible in debentures.
Enlarge Leverage Ratios: Debt financing raises the leverage of the business. High leverage means high risk of bankruptcy. Bankruptcy is not the only risk but if the rate of return of the company declines below the debenture interest rate at a later stage after issuing the debentures, it can bring the whole project on a toss. The costs of projects may increase due to market conditions but interest payment would not change to compensate such increase in costs.
Restrictive Covenants: In the trust deed formed between the company and the trustee bank or financial institution, there are certain restrictive covenants which restrict the hands of the management from doing business with liberty. There are various restrictions with respect to usage of assets, creation of liabilities, cash flows, control etc. They may stumble upon every business decision and affect the effectiveness of overall decision making process.
Bad for Low Inflationary Conditions: Although fixed interest has certain benefits like it is beneficial under high inflation environment, they are also accompanied with disadvantages. Under low inflationary conditions, the cash outflow remains constant but the value of the money increases. To compare it with business situations, the market price of the products of the company will decline in low inflationary conditions but the interest payment will remain same and hence that will create loss making mismatch.
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