Chronicle Editor
Manyara Chigunduru The Business Gateway—
In our previous article,we discussed different debt finance options and touched briefly on how debt can be packaged so that it meets the strategic needs of a business.There are generally two forms to debt finance which businesses can obtain from lenders: secured and unsecured debt. In this article, we explore the two forms to debt finance, discussing what they entail and the benefits and drawbacks of each type of debt.
Secured debt involves the endorsement of security by the borrower to the lender and it can come at a comparatively lower cost than unsecured debt. On the other hand, unsecured debt does not require any form of security and is usually granted on the strength of the determinable cash flows that the lender draws sufficient levels of comfort to be in a position to make a favourable credit granting decision. Generally speaking, lenders want to derive comfort from strong business or project cash flows with security only providing a fall-back position in case the business or project experiences an unexpected bad patch.
Secured debt involves a form of collateral as an assurance that the loan will be repaid. If the debtor defaults on the loan, the collateral or security is realised to satisfy the repayment of the debt. Ideally, prudently run businesses or projects should be able to attract competitive debt finance without the need of elaborate security arrangements. Some types of security include but are not limited to:
Guarantors — One signs an agreement stating that they guarantee the payment of the loan. By signing the loan contract, the guarantor becomes a co – debtor indirectly in that if the principal debtor fails to repay the loan, the guarantor automatically becomes the debtor and should pay back the full outstanding amount of the loan and interest.
Fixed assets (equipment) — These can provide 60 to 65 percent of their value as collateral for a loan. When purchasing equipment using a loan, such equipment becomes the collateral of that loan. This is typical of asset finance funding structures. In the event of default on the loan, the equipment is sold to redeem the debt.
Real Estate —This is where a debtor cedes title of ownership to the lender e.g. a dwelling house or vacant stand as security for a loan. Title deeds are lodged with the lender until such a time when the loan is paid up. In the event of default, the lender calls for legal proceedings to have the property sold so that proceeds of sale of the property can be applied towards extinguishing debt.
Insurance policies — These can be considered as collateral for up to 95 percent of the policy’s cash value. For an example, a life policy can be used to secure large sums of money borrowed.
Tradable financial instruments such as Bankers Acceptances (BAs) —These are issued by a company as part of a commercial transaction and are normally short term debt instruments guaranteed by a commercial bank. They can be traded on the secondary money market at a discounted face value as the BAs may not need to be held until maturity.
Benefits of secured debt
If one is considering to take a secured loan, it is important to understand the benefits and drawbacks of such a facility and this can only be discussed with your financial advisor. Secured debt can benefit the borrower in the following manner:
Lower interest rates compared to unsecured loans;
Flexibility in the repayment of both the principal amount and the interest as the repayment is usually spread over a longer period of time, which will help projects with longer payback periods to qualify for debt funding; and borrowers are able to source comparatively larger sums of money, with collateral even with little credit history as the lender derives some level of comfort that debt repayment can occur from the realisation in the event of a default.
Drawbacks of secured debt
Businesses or projects without security may not access debt even if their credit risk profiles are acceptable to the lender; the repayment of the loan is generally longer compared to the tenure of an unsecured loan, which can pose as a burden on the borrower; the fact that one has to cede their rights over a property entails loss of control over that asset or property until the debt is fully repaid; and in the event of a default in repayments, the lender can take the asset pledged so as to recover the money owed.
Benefits of unsecured debt
Some of the benefits of unsecured loans include the following:
Debt can be obtained without the need for security. Normally the historical credit rating is used or bank account activity,over a period spanning at least three months,is considered;
When a business fails to repay the loan, the lender normally seeks to secure their interest by varying the timing and magnitude of principal and interest payments. In some cases, the lender can even put in place interventionist measures designed to remedy any operational, management or technical capacity deficiencies identified as adversely impacting on the debt repayment capacity; and
In the event that a business is liquidated or files for bankruptcy, normally unsecured debt is discharged.
Disadvantages of unsecured debt
It comes with a higher risk to the lender given the absence of collateral, thus it may result in a comparatively higher interest rate than secured debt. Because of the higher interest rate, the debt can be costly to the borrower, as more will be repaid over and above the principal amount borrowed. If a business has a poor credit rating or history, it is quite difficult to qualify for this type of a loan;
The debt is normally for a shorter period of time and comes with it higher repayments; and unsecured debt can be difficult to obtain in a market where default on repayments is high.
Successful businesses or projects are usually those supported by an optimal capital structure containing an efficient mix of debt and equity. Thus, a business needs to actively align its borrowings with its cash flows so that the debt burden is sustainable, and this can be done through the engagement of a professional financial advisor. A cleverly structured debt finance can be all a business or a project needs to succeed and even gain competitive advantage.
Disclaimer: The information contained in this article is of a general nature and does not address circumstances pertaining to any individual or entity. While we will strive to provide accurate and timely information, we urge readers to engage the appropriate professional advisors before acting upon it.
Manyara Chigunduru is the Managing Partner of Marianhill Chartered Accountants and the Managing Consultant at Marianhill Capital (Pvt) Limited. For feedback and comments, she can be contacted on +263 8644208460/1 or send emails to:[email protected]
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