Analysis of Financial Statements_8

Debentures

Introduction:

Akin to promissory note, Debentures represent creditor ship securities and debenture-holders are long-term creditors of the company. As a secured document, it is a promise to pay interest and repay the principal at stipulated times.

Attributes of a Debenture:

Trust Indenture:

When a debenture is sold to investing public, a trustee is appointed through an indenture/trust deed. It is a legal agreement between issuing company and trustee who is a financial institution/bank/insurance company.

Interest:

It carries a fixed rate of interest, the payment of which is legally binding. Debentures interest is tax deductible an dis payable annually/semi-annually/quarterly. Company is free to choose coupon rate which could be fixed or floating.

Maturity:

It indicates the length of time for redemption of par value. Typically it is 7-10 years. It can be accomplished in either of two ways:

1)Debentures Redemption Reserve 2) Call and Put Option

Debentures Redemption Reserve:

A DRR has to created for the redemption of all debentures with a maturity period exceeding 18 months equivalent to at least 50% of the amount of issue.

Call & Put Option:

It provides an option to the company to redeem the debentures at a specified price before maturity. Call price may not be at face value but more than it, generally

Security:

These are generally secured by a charge on the present and future immovable assets of the company by way of an equitable mortgage.

Convertibility:

Debentures can also be converted into equity shares at the option of debenture-holder. The conversion ratio and the period during which conversion can be affected are specified at the time of issue. They may be fully convertible or partly convertible.

Credit Rating:

To ensure timely payment of interest and redemption of principal by borrower, all debentures must be compulsorily rated by one or more of four credit rating agencies, Crisil, Icra, Care, FITCH India.

Claim On Income And Assets:

Payment of interest and repayment of principal is a contractual obligation enforceable by law. Failure would lead to bankruptcy of the company.

Advantages:

- Lower cost due to lower risk and tax deductibility of interest.

- No dilution of control as debentures do not carry voting rights.

Disadvantages:

(For the company) Restrictive covenants in the trust deed legally enforceable contractual obligations in respect of interest payment and repayment, increased financial risk and associated high cost of equity.