Be it a partnership firm, a start-up or an established company, the need for funds is a constant requirement. Raising capital by issuing shares is one of the most popular funding methods. However, it is not a feasible option for companies which are not prepared to go public, especially those which have commenced operations recently.

Here comes into play another common source for obtaining funds – borrowing. This can be done through bonds and debentures. In this article, we will look at the various aspects of debentures.

Meaning of debentures

When a company needs funds but does not want to alter its share capital composition, it can borrow from the public. Issuing certificates against the borrowing, for a definite period which bears a fixed rate of return, is one such instrument. These loan certificates are debentures. They provide a fixed and assured return to the lenders/creditors/ buyers of the certificate, i.e. debenture holders.

The interest accrued against the loan provided by the debenture holders is paid back to them, on a specified date, as stipulated in the agreement. The document that entails the terms of the loan repayment is called the indenture or debenture deed.

Types of debentures

Primarily, there are six different types of debentures classified into three categories:

  • Based on security –
  • If a debenture is issued against a company’s assets, it is called a secured debenture. In case the company defaults or does not have enough funds to repay, then the same can be recovered by selling the associated asset(s). On the other hand, unsecured debentures do not have any collateral/asset as security. Usually, such debentures are not issued in India.

  • Based on redemption -
  • The life cycle of the redeemable debentures is fixed. The principal amount is paid at the maturity/expiry of the debenture. The interest accrued is paid at a certain date(s) as specified in the debenture deed. Alternatively, debentures that are not redeemed during the lifetime of the company are called non-redeemable debentures. The repayment of such debentures is made when the company is liquidated.

  • Based on convertibility -
  • Some debentures, on their expiry, can be converted into equity shares. They are called convertible debenture. Depending on the terms and conditions, a debenture holder can wholly or partly convert it and become a shareholder. On the other hand, non-convertible debentures are those which upon expiry don’t get converted into shares.

Benefits of debentures

Debentures allow firms to raise capital without diluting the shares of the company. Funding through debentures keeps the ownership of the company unaltered. Also, the cost of issuing debentures is relatively much lower than issuing shares. Additionally, interest on debentures is charged against profits and hence is eligible for tax deductions.

From the investors’ perspective, a debenture is a safe investment. On maturity, the company is obligated to pay interest returns, irrespective of the profit earned or loss incurred. Since the rate of return on debentures are fixed, these are considered to be ideal instruments for getting assured returns.

Unlike shares, debentures do not give ownership of the company, but they provide assured, stable and higher returns in comparison to other investment tools.

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DISCLAIMER

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.



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