Debts in corporate finance is not a new concept. In fact, its been around for the same time as corporations themselves; companies routinely borrow money, either from banks or investors, for expenses that need upfront money.
For example, to buy machinery or overhaul the existing IT structure, companies which don’t have enough operating balance on their hands at the moment might turn to corporate debt to cover said expenses. But corporate finance debt goes way beyond that; there are many sorts of debts that companies can use. So, here are the 2 main types of debt in corporate finance.
The difference between a regular debt (like car or student loans) and a corporate debt is the difference in repayment methods and interest rates. For personal loans, interest rate is usually kept a notch down.
That helps bring in more people for a loan from the bank. The repayment method is also a simple affair; you borrow the money, then pay it back in cash to the bank via monthly payments.
With corporate finance debt, things are a tad bit different. For one, since the borrower is a big corporation and not some individual, it is generally assumed that they can pay exorbitant amounts in interest; and that’s what they charge to corporate debts.
Similarly, repayments can be in the form of monthly payments (very unusual and unlikely) or in the form of bonds or stocks/ shares. With this basic difference in mind, lets see what are the two main types of debt in corporate finance.
Types of Debt in Corporate Finance
As explained beforehand, debt in corporate finance is a common thing, common enough for banks to have entire programs based around lending money to corporations, which adds a hefty chunk to their yearly earnings. As such, there are a number of types of debt in corporate finance, options the companies can use in place of a conventional lending and borrowing process. These are comprehensively explained below,
Commercial papers, unlike their naming, are not academic papers for commercial entities. Instead, they are a sort of unsecured debt that can be procured by corporations and businesses. A quick definition of a commercial paper is ‘a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities.’
Maturities on commercial paper typically last several days, and rarely range longer than 270 days. Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.
Commercial paper is a form of unsecured loan, which means that there is no backing of an existing collateral put up by the borrower. These papers differ from asset-based commercial papers, simply by the fact that the debt in this category is usually backed by an asset put up as a collateral.
In this case, the asset is usually selected by the issuing authority. However, commercial paper is only issued by firms with high-quality debt ratings. Only these kinds of firms will be able to easily find buyers without having to offer a substantial discount (higher cost) for the debt issue.
Bonds allow companies to raise funds by selling a repayment promise to interested investors. Institutions and individual investment organizations can procure bonds that typically come with a predefined interest rate, or coupon. If an entity wants to raise a million dollars to purchase new machinery, for instance, it can provide the public with 1,000 bonds each worth $1,000.
Once individuals or other companies purchase the bonds, the holders are guaranteed a face value on a given date, commonly known as the maturation date. This amount is in addition to regular interest on the bond throughout the period the bond is active.
Bonds work on a similar principle to that of conventional loans. However, a company is the one borrowing while investors are either creditors or lenders. Commercial paper is a short-term debt that comes with a repayment period of less than or equal to 270 days.
Other types of Debt in Corporate Finance
Good & Bad Debt:
Good and bad types of debt are related much to the actual usage and the overall profitability of the services or products acquired from the debt money. Simply put, if you use debt to acquire a depreciating asset, say, a car, it will be classified as a bad debt.
Whereas student loans, or corporate debts used for purposes like employee training or overhauling the existing IT structure will be considered good debts; their spending was not in vain, to put it bluntly.
The many types of debt in corporate finance are usually of the good debt types, used for overhauling of an existing structure or to be expended in resources used to increase capital or human resources.
Secured & Unsecured Loans:
Secured and unsecured loans differentiate on the basis of their returnability and what sort of collateral is put up as a guarantee of repayment. As the name and concepts imply, a secured loan is a loan which has been backed by a collateral over the question of paying back the amount.
Collateral varies, by loan type, by the borrower’s own capacity and by the terms and conditions a bank puts up. In an individual type of loan, anything with a considerable value can be considered a collateral; vehicle, house, business or any precious belonging that has a certain monetary value.
Failure to pay back the amount will result in the lending authority seizing the collateral; the ownership of said collateral item is transferred to the lending party.
Unsecured loans, on the other hand, have no collateral or agreement in black and white over repayment terms and conditions.
Instead, these types of debts are usually issued on laxer conditions and are usually issued to parties or corporations with matching goals or interest or simply at the word of a corporation. Unsecured debts and loans are rare; no bank touches such loans even if they’re posted for sale.
This is a comprehensive guide to the types of debt in corporate finance.