What is financed debt?
Debt financed is the debt of a company that matures over more than a year or an economic cycle. This type of debt is classified as such because it is financed by interest payments made by the borrowing company during the term of the loan.
Funded debt is also called long-term debt because the term exceeds 12 months. It is different from equity financing, where companies sell shares to investors to raise capital.
Key points to remember
- Debt financed is the debt of a company that matures over more than a year or an economic cycle.
- Funded debt is also called long-term debt and is made up of long-term, fixed-term debt.
- Examples of funded debt include bonds with maturities of more than one year, convertible bonds, long-term notes payable and debentures.
Understanding funded debts
When a company takes out a loan, it does so either by issuing debt on the open market or by obtaining financing from a credit institution. Loans are taken out by a business to finance long-term investment projects, such as adding a new product line or expanding operations. Debt financed refers to any financial obligation that extends beyond a 12-month period or beyond the current financial year or operating cycle. This is the technical term applied to the part of the long-term debt of a company which is made up of long-term loans with a fixed maturity.
Debt financed is an interest-bearing security which is recognized in the company’s balance sheet. Debt that is financed means that it is usually accompanied by interest payments that serve as interest income for lenders. From the investor’s perspective, the higher the percentage of debt financed out of total debt indicated in the debt note in the notes to the financial statements, the better.
Debt financed means that it is generally accompanied by interest payments which serve as interest income for lenders.
Because it is a long-term credit facility, financed debt is usually a safe way to raise capital for the borrower. Indeed, the interest rate that the company obtains can be blocked for a longer period.
Examples of funded debt include bonds with maturities of more than one year, convertible bonds, long-term notes payable and debentures. Debt financed is sometimes calculated as long-term liabilities less equity.
Funded or unfunded debt
Corporate debt can be classified as funded or unfunded. While funded debt is a long-term loan, unfunded debt is a short-term financial obligation that matures in a year or less. Many companies that use short-term or unfunded debt are those that can run out of money when they don’t have enough income to cover their day-to-day expenses.
Examples of short-term liabilities include corporate bonds that mature in one year and short-term bank loans. A business can use short-term financing to finance its long-term operations. This exposes the company to higher interest rate and refinancing risk, but allows more flexibility in its financing.
Analysis of financed debt
Analysts and investors use the capitalization ratio, or capitalization ratio, to compare a company’s funded debt to its capitalization or capital structure. The capitalization ratio is calculated by dividing long-term debt by total capitalization, which is the sum of long-term debt and equity. Companies with a high capitalization rate face the risk of insolvency if their debt is not repaid on time, these companies are therefore considered risky investments. However, a high capitalization rate is not necessarily a bad signal, since there are tax advantages associated with borrowing. Since the ratio focuses on the financial leverage used by a company, the rise or fall of the capitalization ratio depends on the industry, the line of business and the economic cycle of a company.
Another ratio that includes funded debt is the funded debt / net working capital ratio. Analysts use this ratio to determine whether long-term debt is out of proportion to capital. A ratio of less than one is ideal. In other words, long-term debts must not exceed net working capital. However, what is considered an ideal ratio of funded debt to net working capital can vary from industry to industry.
Debt financing vs equity financing
Businesses have several options when it comes to raising capital. Debt financing is one. The other choice is equity financing. In equity financing, companies raise funds by selling their shares to free market investors. By buying shares, investors take a stake in the business. By allowing investors to own shares, companies share their profits and may have to cede some control to shareholders over their operations.
Using debt versus equity financing has several advantages. When a business sells corporate bonds or other facilities through debt financing, it allows it to retain full ownership. No shareholder can claim a participation in the capital of the company. The interest that companies pay on their debt financing is generally tax deductible, which can reduce the tax burden.