Debt Structure
Category: Financial Risk Management
Just as it is vitally important that the lending banker ensures that the business has the right total amount of finance needed to keep the business going, has repayment capacity for that finance, and has given us adequate security, it is equally important for the banker to ensure that the business has the mix of debt finance most appropriate to its needs.
The banker should be aware that particular types of debt introduce different types of financial risk to the business. In particular, time is a significant risk factor. The longer the term of the loan, the greater the risk to the bank. Assessing risk, particularly through evaluation of projections, becomes increasingly difficult as the period of the loan extends and the element of uncertainty becomes greater. Risk on short-term debt is more easily and confidently assessed and controlled.
Because banks generally reflect this risk profile in their pricing, there is a temptation for businesses to seek to reduce financing costs by having higher weightings of short-term debt in their debt structure. However, this may put undue strain on their repayment capacity.
Types of Finance
It is normal to categories types of debt finance by maturity, and while broad definitions may vary from bank to bank and from country to country, next shows a well accepted categorisation.
Types of finance:
— Short Term Up to 1 or 2 years
— Medium Term 2 to 5 or 7 years
— Long Term 5/7 years and longer
In deciding which of these types of debt finance to use, the main consideration should be the maturities of the assets for which the finance will be used. Banks and customers should avoid use of short-term debt to finance long term assets. While the short-term debt may be cheaper, it carries considerable financial risk in terms of the inability to meet the debt commitments when they fall due.
In choosing debt structure, the bank and customer should pay particular attention to likely future cash flows and the availability of funds to make capital and interest repayments. Broadly, the following general rules might apply.
Short Term debt is generally only suitable for fluctuations in working capital and for normal trade finance.
Medium Term debt is appropriate for the purchase of most plant and machinery.
Long Term debt is suitable for financing investments in productive assets with a long life, such as land and buildings and heavy plant and machinery.
Working Capital needs contain elements of needs that range from short term to very long term, so, if possible, it should be financed by a combination of all three types of debt.