Governments and companies use debentures to issue loans. They offer loans at a fixed interest rate based on the company’s reputation. When companies need to borrow some money to expand themselves they take the help of debentures. There are four different types of debentures. Let us learn the Debenture, features of debentures, advantages, and disadvantages of debentures in detail.
Debenture :
The word ‘debenture’ itself is a derivation of the Latin word ‘debere’ which means to borrow or loan. Companies issue debentures as written instruments of debt under their common seal. They are similar to a loan certificate.
Companies issue debentures to the public as a contract to repay the money borrowed from them. These debentures are for a fixed period and a fixed interest rate that can be payable yearly or half-yearly. Companies also offer debentures to the public at large, similar to equity shares. Actually, the most popular method of borrowing money for big businesses is through debentures.
Let us look at some important features of debentures that make them unique,
- Debentures are instruments of debt, which means that debenture holders become creditors of the company
- They are a certificate of debt, with the date of redemption and amount of repayment mentioned on it. This certificate is issued under the company seal and is known as a Debenture Deed
- Debentures have a fixed rate of interest, and such interest amount is payable yearly or half-yearly
- Debenture holders do not get any voting rights. This is because they are not instruments of equity, so debenture holders are not owners of the company, only creditors
- The interest payable to these debenture holders is a charge against the profits of the company. So these payments have to be made even in case of a loss.
Advantages of Debentures
- One of the biggest advantages of debentures is that the company can get its required funds without diluting equity. Since debentures are a form of debt, the equity of the company remains unchanged.
- Interest to be paid on debentures is a charge against profit for the company. But this also means it is a tax-deductible expense and is useful while tax planning
- Debentures encourage long-term planning and funding. And compared to other forms of lending debentures tend to be cheaper.
- Debenture holders bear very little risk since the loan is secured and the interest is payable even in the case of a loss to the company
- At times of inflation, debentures are the preferred instrument to raise funds since they have a fixed rate of interest
Disadvantages of Debentures
- The interest payable to debenture holders is a financial burden for the company. It is payable even in the event of a loss
- While issuing debentures help a company trade on equity, it also makes it to dependent on debt. A skewed Debt-Equity Ratio is not good for the financial health of a company
- Redemption of debentures is a significant cash outflow for the company which can imbalance its liquidity
- During a depression, when profits are declining, debentures can prove to be very expensive due to their fixed interest rate
Types of Debentures: Distribution and Classification
There are various types of debentures that a company can issue, based on security, tenure, convertibility etc. Let us take a look at some of these types of debentures.
- Secured Debentures: Companies secure these debentures against specific assets or all assets. They create a charge on the assets to ensure repayment in case of default. If the company lacks sufficient funds to repay, it sells the secured asset to cover the loan.
- Unsecured Debentures: Companies issue these debentures without securing them against any assets, whether fixed or floating. Typically, companies in India do not issue this type of debenture.
- Redeemable Debentures: These debentures are payable at the expiry of their term. Which means at the end of a specified period they are payable, either in the lump sum or in installments over a time period. Such debentures can be redeemable at par, premium or at a discount.
- Irredeemable Debentures: Such debentures are perpetual in nature. There is no fixed date at which they become payable. They are redeemable when the company goes into the liquidation process. Or they can be redeemable after an unspecified long time interval.
- Fully Convertible Debentures: Debenture holders can convert these into equity shares at their option. If they choose, they can convert all their debentures into equity shares after a specified time, becoming shareholders.
- Partly Convertible Debentures: Holders have the option to convert a portion of their debentures into shares. By choosing partial conversion, they become both creditors and shareholders of the company. If he opts for the conversion, he will be both a creditor and a shareholder of the company.
- Non-Convertible Debentures: These debentures do not provide any option for conversion into shares or equity, as indicated by the name. These debentures will remain so till their maturity, no conversion will take place. These are the most common type of debentures.