Debt capital is a type of capital that allows businessmen or women to rely on borrowings to fund their businesses. This term is used when we talk of leverage or gearing in accounting. More so, there is more to debt capital than just borrowing. In this article, let’s spit it out.
Definition of Debt Capital
Debt Capital is a type of capital that involves the use of borrowed money and other forms of fixed funds to finance a business. It can also be defined as the use of bank overdrafts, loans, bonds, debentures, and Preference shares to finance a company.
It is a type of capital. There is equity and debt capital. Equity capital deals with the use of owners’ or shareholders’ funds to finance a business. But the other, make use of debt funds to do the same. This type of financing isn’t popular with small businesses when compared with large ones. It is difficult for small businesses to secure loans from banks. Why? The owners of small businesses lack capacity in terms of the collateral security required by banks to provide a loan. Even if they do have collateral, the small business owner’s collateral source may not be enough to acquire a sizable loan from banks.
However, large businesses have been able to secure a huge amount of money as loans and overdrafts from banks. A solution for small businesses to access loan capital is through microfinance banks. Another source is through Angel and Venture capital firms. These financial intermediaries provide preference share capital which is also a form of borrowed capital.
Debt capital has a fixed charge attached to it. That means a fixed interest rate is charged on the principal amount required by the business. In Nigeria, it ranges from 18 percent to as high as 60 percent per annum. Commercial banks’ interest rates are mostly 18 percent. Microfinance banks’ interest rates start from 36 percent per annum. And fintech in Nigeria charged between 36% and as high as 60%. OPay charges 5% per month. If multiplied by 12 months, this gives 60 percent per year.
Debt Capital Examples
Examples of debt capital are bank overdrafts, bank loans, loans from friends, preference shares, and debentures (corporate bonds).
Bank overdraft is the allowance by the bank for a client to withdraw more than the balance in the bank account and only works with current account products. What this means is that, if your business owns a current account with a bank. And has up to 500,000 Naira in the account. But your business needs 750,000 Naira for a project or event. The bank can give an overdraft of 250,000 Naira to fund your business. This will make the balance in your account negative. That is, -250,000 Naira.
Bank loans can be provided to your business if your business meets the requirement. This includes collateral and other criteria. And it carries a fixed interest rate. The bank rate for a loan may be equal to or lower than that of an overdraft.
A loan from friends. A small business owner may request a loan from a friend or relative to run his/her business. Such a loan may or may not attract an interest rate. This depends on the agreement between both parties.
Preference shares, on the other hand, are provided by angel investors and venture capitalists. Although it is provided as a form of capital or investment to the business, it is a form of debt capital.
Debentures or corporate bonds are the same. They are a form of borrowing, not from a bank, but a selected set of people or the public at large. Debentures are debt certificates. And are issued by companies. Private limited liability companies can seek debentures from a selected group of people. However, Public limited liability companies issued corporate bonds to the public. These bonds can be listed in a recognized stock exchange market.
Why is Understanding Debt Capital Important?
Debt capital tells you about the capital mix of a business. That is when compared with equity capital. Also, it states whether a company is levered or geared. A levered firm has debt in its capital mixed. While a non-leverage entity only has equity capital.
In addition, debt capital is one way to avoid taxes legally. The interest paid on this loan capital is tax-free. For example, if a firm profit before tax is 100,000 Naira and a tax rate of 30% is charged. The tax paid will be 30,000 Naira. However, if it had to pay interest on a loan of say 20,000 Naira. The business profit before tax shall be 80,000 Naira. Thereby paying a lower tax of 24,000 Naira (that is, 30% × 80,000).
More so, debt capital holders are given more preference than equity capital holders. This is why they are referred to as senior security. Holders of loan capital are paid interest before dividends can be shared with shareholders. Also, if the company liquidates, debt holders are paid all their money before shareholders.
Debt or loan capital is a form of borrowing to finance a business. Although maybe discouraging, or use reduces tax paid while providing funds for operational use. In an inflationary period, it is the borrower that gains. How? He enjoys the money now that the value is high and pays back when the value of money falls due to inflation.