Debt Structure Considerations

What is Debt Structure？

Debt is one of the principal mechanisms for companies to raise funds in the capital markets. It includes short-term borrowings, long-term debt, and a portion of the principal amount of operating leases and redeemable preferred stock. Long-term debt, such as bonds payable and notes due, has maturities that exceed one year. Short-term, or current debt, is due within 12 months and includes accounts payable, credit card balances, commercial paper, and payroll due. Secured debt, such as a mortgage, requires the borrower to provide collateral, while unsecured debt requires no financial guarantees. Generally speaking, long-term debt has a higher interest rate while short-term debt has a lower interest rate, but the financial risk is higher than that of long-term debt.

Debt structure refers to features such as maturity, principal repayment terms, and prepayment provisions on loans. Statements of debt structure, which typically rank a company’s liabilities by factors such as maturity and security, provide a historical window into a company’s liabilities. It shows investors the maturity date of corporate debt and whether the company has enough money to pay it off.

Benefits of Structured Debt

Companies often choose structured debt options to increase working capital reserves, helping to enhance cash flow efficiency while saving on repayments and helping the business develop through refinancing options, acquisitions or mergers, or expansion.

Some of the key benefits of structured debt are:

• The amount of funds lenders are able to make available to mid-market businesses.
• Significant capital injection, so structured debt finance options offer significant growth opportunities for most SMEs and mid-market businesses.
• Investment opportunities for lenders, make them more likely to offer financial support.
• Easier debt management.

Most Important Debt Structure Considerations

As with all financing options, each business must make an informed decision based on its own financial situation and debt structure. Considerations in debt structure include the types of debt allowed (i.e. short or long term), what each type of debt may be used for, and when each type of debt is appropriate.

Some of the most important considerations are:

Capacity for raising funds

A company’s size may affect its debt structure and the availability of funds from different sources. Small companies can find it difficult to get long-term loans, while large companies have significantly more flexibility in structuring debt. Large companies can often obtain loans on easy terms and sell common and preferred stock as well.

Financial flexibility and business strategy

Financial flexibility is an important consideration in structuring debt. Financial flexibility refers to a company’s ability to adjust debt structure to meet evolving financial needs. The company’s financial plan should be sufficiently flexible to alter the debt structure according to the business strategy and needs.

Appropriate timing for debt

Debt increases the total cost of assets due to the interest payable, but it also allows businesses to save time, and complete capital projects more rapidly by borrowing in advance and spreading payments over a longer period. This makes it possible to conveniently time expenses and creates more predictable cash flows. If a business chooses to use debt, the maturity of the debt should not exceed the expected life of the facility or infrastructure.

Long-term debt

Long-term debt is primarily used for capital improvements included in capital facilities plans or capital improvement plans, or for capital improvements that will provide ongoing benefits.

Short-term debt or inter-fund loans

Ideally, fund reserves should cover any cash flow problems, but if not, short-term borrowing or lines of credit can compensate for temporary shortfalls. Companies need to determine if and when they can use inter-fund loans for short-term borrowing.

Impact on annual and future operating budgets

While debt can cover upfront capital costs, companies should also consider long-term maintenance costs over the expected life of a project. In general, it is recommended that businesses require all debt proposals to identify future operating and maintenance costs and how they will be paid.

Examples

1)     The impact of debt on cash flow

The impact of debt on cash flow is less direct but significant. Companies need to determine the appropriate debt structure throughout the economic cycle. For example, a company’s financials show $1 million in loans due over 12 months at a 4.5% interest rate. The debt due in one year is equivalent to $1 million at an interest rate of 6.5%. As a result, the organization’s debt structure shows total debt of $2 million, with 50% short-term debt and 50% long-term debt.

If the current interest rate on short-term debt was reduced to 3%, the company could seek to refinance its existing debt to increase the proportion of short-term debt. This will reduce both interest expenses and monthly payments, improving the company’s bottom-line profitability and cash flow as well as increasing capital reserves.  Debt structure consideration is a common and straightforward method used to broker better terms for a company.

2)     Key calculations in debt financing

Calculate the interest and principal paid for Year 4 of the following debt facility. These are key calculations in debt financing.

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Conclusion

Debt structure encompasses the duration and timing of principal and interest payments. Structured debt typically refers to a combination of different debt products that are designed to cover the total amount of funds required. The primary objective of structured debt is to provide capital to help a business grow.  Structured debt also offers great benefits to businesses, including royalty repayment methods and restructuring plans that accelerate profits and growth. Debt structure considerations should address general repayment terms, including maximum repayment periods, debt service patterns (such as equal payments or equal principal amortization), and the use of variable or fixed-rate coupons.

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