Understanding the basics of debt is key for businesses to make prudent financial choices. In this article, we explore the differences between funded and unfunded debt and look at their traits, uses, and what they mean for managing finances.
What is a funded debt?
Funded debt, also referred to as long-term debt, is debt that takes a long time to mature—typically more than a year or a business cycle. For the loan, the borrowing corporation will make interest payments to cover the cost of this kind of debt. Long-term initiatives like growing operations, doing research & development, creating additional locations, or introducing new product lines are frequently financed via funded debt.
Funded debt is different from equity financing in that it doesn't require selling shares to raise money; instead, it entails issuing debt instruments or getting bank financing. Lenders and investors receive money from interest paid on funded debt.
Also read: Difference between Assets and Liabilities
Types of funded debt
Debt financing involves a company raising capital by selling debt instruments like bonds, bills, or notes to investors. The key types of funded debt include:
- Bonds: These are fixed-income securities issued by a company that must be repaid at a future date, with interest paid to the bondholders. This includes corporate bonds, government bonds, and municipal bonds.
- Long-term notes payable: These are long-term loans from banks or other lenders that are repaid over an extended period, typically more than one year.
- Convertible bonds: Convertible bonds are bonds that can be converted into equity shares of the company at a predetermined price and time.
- Debentures: Debentures are unsecured bonds backed only by the general creditworthiness and reputation of the issuer rather than by specific assets.
- Term loans: Term loans are lump sum loans from banks or financial institutions that are repaid over a fixed period, often with regular monthly payments.
The key characteristic of funded debt is that it has a maturity period of more than one year, unlike short-term "unfunded" debt. Funded debt provides long-term financing for companies and is considered a safer investment for lenders compared to equity.
Examples of funded debt
Funded debt refers to a company's long-term debt that matures in more than one year or one business cycle. Some examples of funded debt instruments include:
- Bonds with fixed maturity dates of over a year
- Convertible bonds
- Debentures
- Long-term notes payable
- Mortgages
Funded debt is considered a safer financing option compared to short-term or unfunded debt, which matures in a year or less and is used to cover more immediate expenses. Funded debt is recorded as a long-term liability on the borrowing company's balance sheet, while for lenders, it is listed as an asset.
Also read: Difference between equity and assets
How to analyse funded debt?
Here are the key points to analyse funded debt:
- Funded debt instruments: Funded debt can take the form of bonds with fixed maturity dates over a year, convertible bonds, debentures, long-term notes payable, and mortgages. These are long-term borrowing instruments that provide long-term financing for the company.
- Funded debt ratio: Analysts use the capitalisation ratio (or cap ratio) to compare a company's funded debt to its total capitalisation (long-term debt + shareholders' equity). A higher capitalisation ratio indicates the company has more long-term debt relative to its capital structure, which can be risky if not serviced properly.
- Debt to net capital ratio: This ratio compares the company's long-term debt to its net working capital. An ideal ratio is below 1, indicating the long-term debt does not exceed the net capital available.
- Advantages of funded debt: Funded debt provides companies with long-term financing at fixed interest rates, which can be advantageous compared to short-term "unfunded" debt. The interest payments on funded debt are also tax-deductible.
- Risks of funded debt: High levels of funded debt increase a company's leverage and insolvency risk if the debt cannot be serviced. Analysts look at metrics like the funded debt to EBITDA ratio to assess the company's ability to cover its debt obligations.
- Comparison to equity financing: Funded debt allows companies to raise capital without diluting ownership, unlike equity financing, where companies sell shares to investors.
Also read: What are non-current assets
Understanding unfunded debt
Short-term financial liabilities that are normally due in a year or less are referred to as unfunded debt. Companies employ these commitments to pay for urgent costs in situations where they might not have enough cash on hand to cover their regular operating expenses. Short-term bank loans and corporate bonds with short maturities—typically within a year—are examples of underfunded debt. Unfunded debt is a more immediate approach to managing cash flow and liquidity than funded debt, which entails longer-term financing and has fixed maturity dates greater than a year.
Also read: SIP investment in mutual funds
Types of unfunded debt
Unfunded debt refers to short-term debt obligations that have a maturity period of less than one year. The key types of unfunded debt include:
- Treasury bills: These are short-term government securities that mature in less than one year, typically ranging from a few days to 52 weeks. Treasury bills are sold at a discount to their face value and do not pay regular interest.
- Commercial paper: A commercial paper is an unsecured short-term debt instrument issued by a corporation to meet short-term financing needs, with maturities ranging from 1 to 270 days.
- Short-term bank loans: These are loans from banks or other lenders that must be repaid within one year and are often used to cover temporary cash flow gaps.
- Accounts payable: This is the money a company owes to its suppliers and creditors, typically due within 30-90 days.
Examples of unfunded debt
Unfunded debt refers to short-term financial obligations that mature within a year or less, in contrast to funded debt, which has a maturity period of more than a year.
Examples of unfunded debt include:
- Corporate bonds maturing within a year
- Short-term bank loans
- Short-term floating debt not represented by bonds
Also read: What is current ratio
How to analyse unfunded debt
To analyse unfunded debt, the key considerations include:
- Maturity profile: Examine the breakdown of unfunded debt by maturity dates, as shorter maturities increase refinancing risk.
- Interest rate sensitivity: Assess how changes in interest rates would impact the cost of servicing unfunded debt.
- Liquidity position: Evaluate the company's ability to repay unfunded debt from cash flows or other liquid resources.
- Debt service coverage: Calculate ratios like the current ratio to gauge the firm's capacity to meet short-term obligations.
- Funding sources: Understand the company's access to and reliance on short-term financing, such as bank lines of credit.
Funded vs Unfunded debt
Funded debt differs from unfunded debt in several ways. Key differences include:
Funded debt
- The maturity period exceeds one year
- Has fixed maturity dates, bears interest, and is considered long-term
- Commonly used for long-term projects
Unfunded debt
- Typically matures within a year
- Includes short-term obligations like treasury bills and short-term bank loans
- Used for covering immediate financial needs
- Poses interest rate and refinancing risks
Key takeaways
- Often used for large, long-lasting projects, funded debt, also known as long-term debt, takes more than a year to pay off and includes paying interest over time.
- The funded debt to EBITDA ratio is a way to check a company's risk and financial health by weighing its profit against its long-term debt.
- Short-term costs, like corporate bonds that need to be paid off soon and short-term bank loans for quick cash needs, are handled by unfunded debt, which is due within a year.
Summary
Funded debt lets businesses safely fund big, long-lasting projects by paying interest over time. In contrast, unfunded debt helps with quick expenses but carries more risk due to its short lifespan. Knowing the difference helps manage a company's debts well.
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