Debenture is a written instrument issued by a company acknowledging a debt borrowed from the public. It is a certificate under the company’s seal stating that the company has taken a loan and promises to repay the principal amount after a specified period along with interest at a fixed rate. Debenture holders are therefore creditors of the company, not owners.
Meaning and Definition
A debenture represents a loan capital of the company. The company borrows money from investors and gives them a debenture certificate as evidence of debt. The certificate contains:
Interest on debentures is a charge against profit and must be paid whether the company earns profit or not.
Features of Debentures
Debentures are one of the most important sources of long-term borrowing for companies. They represent a loan taken by the company from the public or institutions. The essential characteristics of debentures are explained below:
- Written Acknowledgement of Debt
A debenture is a written document issued under the company’s seal acknowledging a debt owed by the company. It specifies the amount borrowed, rate of interest, and repayment date. By issuing debentures, the company legally accepts its obligation to repay the borrowed amount. Therefore, a debenture is not a share in ownership but a certificate of borrowing. It acts as proof that the company has received money and must return it according to agreed terms.
- Debenture Holders are Creditors
Debenture holders are considered creditors of the company, not its owners. They lend money to the company and in return receive interest. Unlike shareholders, they do not participate in management or decision-making. Their relationship with the company is purely contractual. Because they are creditors, they have priority over shareholders at the time of repayment and also during liquidation of the company.
Debentures carry a predetermined and fixed rate of interest. The company must pay this interest at regular intervals, usually half-yearly or annually. Interest payment is compulsory and does not depend on profits. Even if the company incurs a loss, it must pay interest to debenture holders. Thus, debentures provide a stable and predictable income to investors and represent a fixed financial obligation for the company.
Most debentures are secured by a charge on the company’s assets. This means that specific assets like land, building, or machinery are kept as security. If the company fails to repay, debenture holders have the legal right to recover their money by selling the charged assets. This security feature makes debentures a safer investment compared to shares.
Debentures are generally issued for a fixed period and must be repaid on a specified date or after a certain time. This repayment is known as redemption. The company may redeem debentures at par or at a premium. Because of this feature, debentures are temporary capital and do not remain permanently in the business like equity share capital.
Debenture holders do not possess voting rights in company meetings. They cannot participate in management decisions or election of directors. Their role is limited to receiving interest and repayment of principal. This feature clearly distinguishes debentures from shares, as shareholders enjoy ownership rights and participate in policy decisions of the company.
In case of liquidation of the company, debenture holders are paid before shareholders. They have priority both for interest payment and repayment of principal amount. Because they are creditors, their claims must be satisfied first from the company’s assets. This priority provides greater security and confidence to investors who subscribe to debentures.
Debentures are generally transferable by delivery or endorsement according to their type. Investors can sell or transfer debentures to other persons without affecting the company’s capital structure. This liquidity makes debentures an attractive investment, as investors can convert them into cash whenever needed through the securities market.
Types of Debentures
1. Secured Debentures (Mortgage Debentures)
Secured debentures are those debentures which are backed by a specific asset or charge on the property of the company. The company creates a mortgage or charge on its land, building, plant, or other fixed assets in favour of debenture holders. In case the company fails to repay the debenture amount or interest, debenture holders have a legal right to sell the charged assets and recover their money. Because of this security, investors feel safer and the company can issue such debentures at a lower rate of interest. These debentures are very common in large companies.
2. Unsecured Debentures (Naked Debentures)
Unsecured debentures are not backed by any specific security or charge on the assets of the company. Debenture holders are treated only as general creditors of the company. In case of liquidation, they are paid after secured creditors but before shareholders. Since they carry higher risk, companies generally offer a higher rate of interest to attract investors. These debentures are usually issued by well-established and financially strong companies that have a good reputation in the market and enjoy public confidence.
3. Registered Debentures
Registered debentures are those debentures in which the name, address, and other details of the debenture holder are recorded in the company’s Register of Debenture Holders. Interest and principal amount are paid only to the registered holder. Transfer of such debentures can be made only through a proper transfer deed and after intimation to the company. The company records the transfer and issues a new certificate in the name of the new holder. This type provides safety to investors but the transfer procedure is comparatively formal and time-consuming.
4. Bearer Debentures
Bearer debentures are payable to the person who holds the debenture certificate. The company does not maintain any register for such debentures and interest is paid to the holder by presenting the interest coupon attached to the certificate. These debentures are easily transferable by mere delivery without any formalities. They are very convenient for investors who want liquidity and easy transfer. However, they involve risk because if the certificate is lost or stolen, the company is not responsible for the loss.
5. Redeemable Debentures
Redeemable debentures are those debentures which are repaid by the company after a specified period. The terms of redemption, such as date, instalments, or premium on redemption, are mentioned at the time of issue. Most companies issue redeemable debentures because they do not want to keep long-term liabilities permanently. The company must arrange funds for repayment either by profits, fresh issue of shares, or sale of assets. These debentures may be redeemed at par or at premium according to the agreement.
6. Irredeemable (Perpetual) Debentures
Irredeemable debentures are those debentures which are not repayable during the lifetime of the company. They are repaid only when the company goes into liquidation. The company continues to pay interest regularly every year. Such debentures provide a permanent source of finance to the company. However, they are rarely issued in modern practice due to legal restrictions and investor preference for redeemable securities. Investors hesitate to invest because their principal amount remains locked for an indefinite period.
7. Convertible Debentures
Convertible debentures are those debentures which can be converted into equity shares or preference shares of the company after a specified period or on certain conditions. The conversion ratio and time of conversion are decided at the time of issue. These debentures are attractive to investors because they provide both fixed interest income and an opportunity to become shareholders. Companies also prefer them because they reduce long-term debt in the future and strengthen the capital structure.
8. Non-Convertible Debentures (NCDs)
Non-convertible debentures are those debentures which cannot be converted into shares. They remain purely a debt instrument throughout their life. The company repays the principal amount on maturity along with regular payment of interest. Since investors do not get ownership rights, the company generally offers a higher rate of interest compared to convertible debentures. NCDs are widely used by companies to raise long-term finance without diluting control or ownership of existing shareholders.
9. First Debentures
First debentures are debentures which have the first charge on the assets of the company. In case of liquidation, holders of first debentures are paid before all other debenture holders and creditors except statutory liabilities. Because of the highest level of security, they carry a lower rate of interest. Investors prefer such debentures because the risk of loss is very low and repayment is almost certain.
10. Second Debentures
Second debentures are those debentures which have a second charge on the assets of the company. They are paid only after the claims of first debenture holders are satisfied. Since they are comparatively riskier, they generally carry a higher rate of interest. Investors who are willing to take moderate risk for better return invest in these debentures. They are less secure than first debentures but still safer than equity shares.
Advantages of Debentures
Debentures enable a company to raise a large amount of long-term finance from the public. Instead of depending only on shareholders, the company can collect funds from many investors at the same time. This is especially useful for expansion, purchase of fixed assets, modernization, and new projects. Raising such a big amount through equity shares may dilute ownership, but debentures help the company obtain funds without giving ownership rights. Therefore, debentures are considered an effective and reliable source of long-term capital for business growth.
Debenture holders are creditors of the company and not owners. They do not have voting rights or control over management decisions. As a result, existing shareholders and promoters retain their ownership and control over the company. This is a major advantage compared to issuing equity shares, where control is shared with new shareholders. Companies that want funds but also want to maintain managerial control generally prefer debentures. Thus, debentures provide finance without affecting the ownership structure of the company.
Debentures carry a fixed rate of interest, which is predetermined at the time of issue. This helps the company in financial planning because the interest amount is known in advance. Even if the company earns large profits, it only has to pay the agreed interest and nothing more. Unlike equity shareholders who expect higher dividends during profitable years, debenture holders cannot demand extra returns. Therefore, the company can manage its financial obligations easily and maintain stable cash outflow.
- Tax Benefit (Interest is Tax-Deductible)
Interest paid on debentures is treated as a business expense and is allowed as a deduction while calculating taxable profit. This reduces the taxable income of the company and lowers its tax liability. Dividends on shares, however, are not tax-deductible. Because of this tax advantage, debentures become a cheaper source of finance compared to equity shares. The company can save tax and improve net profit after tax, making debenture financing economically beneficial.
The cost of raising funds through debentures is usually lower than equity shares. Debenture holders accept a fixed interest rate and do not participate in profits beyond that. Equity shareholders, on the other hand, expect higher dividends and capital appreciation. Also, due to tax deduction on interest, the effective cost further decreases. Therefore, debentures help the company obtain funds at a comparatively low cost and increase overall profitability.
- Suitable for Investors Seeking Fixed Income
Debentures are beneficial not only for companies but also for investors. Investors who want stable and regular income prefer debentures because interest is paid periodically, usually half-yearly or annually. Unlike dividends on shares, interest on debentures must be paid even if profits are low. This makes debentures a safe and predictable investment option, especially for conservative investors such as retirees and risk-averse individuals.
In case of liquidation of the company, debenture holders are paid before shareholders. Secured debenture holders even have a claim on specific assets of the company. This priority reduces the risk for investors and increases their confidence in lending money to the company. Because of this safety, companies can easily attract investors and raise funds from the public.
- Flexibility in Redemption
Debentures can be redeemed in different ways such as lump-sum payment, instalments, purchase in the open market, or conversion into shares. The company can select a convenient method according to its financial position. It can also redeem debentures at maturity or before maturity if permitted. This flexibility helps the company manage its long-term liabilities effectively and plan its finances efficiently.
- Does Not Affect Profit Sharing
Debenture holders receive only fixed interest and do not share in the profits of the company. Even if the company earns very high profits, the payment to debenture holders remains the same. The remaining profit belongs entirely to shareholders. Therefore, issuing debentures allows the company to retain higher profits for shareholders and improves earnings per share.
- Enhances Creditworthiness
Regular payment of interest and timely redemption of debentures increases the goodwill and reputation of the company in the financial market. A company with a good record of servicing its debt gains trust from investors, banks, and financial institutions. This improves its creditworthiness and helps it obtain future loans or issue securities easily. Hence, debentures help in building a strong financial image of the company.
Disadvantages of Debentures
Debentures create a permanent financial obligation for the company. Interest on debentures must be paid regularly whether the company earns profit or suffers loss. This fixed payment becomes a burden during periods of low earnings or financial crisis. Failure to pay interest on time may damage the reputation of the company and may also lead to legal action by debenture holders. Therefore, debentures increase the financial pressure on the company.
Debentures have a fixed maturity period and the company must repay the principal amount on the due date. The company has to arrange sufficient funds for redemption, which may be difficult if its financial position is weak. Even profitable companies may face liquidity problems at the time of redemption. Arranging large cash for repayment may affect working capital and normal business operations.
If the company fails to pay interest or repay the debenture amount, debenture holders can take legal action and may apply for liquidation of the company. Secured debenture holders can even sell the charged assets to recover their money. This increases the risk of insolvency and closure of business. Hence, excessive issue of debentures can be dangerous for the financial stability of the company.
- No Flexibility in Payment
Dividend on shares can be skipped during poor financial performance, but interest on debentures cannot be postponed or avoided. The company must pay interest on the due date regardless of profit. This reduces financial flexibility and limits the company’s ability to manage cash during difficult times. It also restricts the management in making other important business investments.
Secured debentures require the company to create a charge or mortgage on its assets. Because of this, the company cannot freely use or sell those assets without the consent of debenture holders. It restricts borrowing power because lenders may hesitate to give additional loans when assets are already pledged. This reduces the company’s financial freedom and operational flexibility.
- Reduction in Borrowing Capacity
After issuing debentures, the company’s debt level increases. Financial institutions and banks may consider the company highly leveraged and risky. As a result, the company may find it difficult to obtain further loans or credit facilities in the future. Thus, debentures reduce the borrowing capacity of the company.
- No Participation of Debenture Holders
Debenture holders do not participate in the management of the company because they have no voting rights. While this is an advantage for the company, it can also become a disadvantage. Since they are not involved in decision-making, debenture holders may lose interest in the company’s performance and long-term development. They are concerned only with interest and repayment, which may affect investor relations.
When the company earns very high profits, it still has to pay only fixed interest to debenture holders, but redemption and servicing costs remain constant. However, if market interest rates fall, the company continues paying higher agreed interest, making debentures expensive compared to new sources of finance. Therefore, during prosperous periods or falling interest rates, debentures may become a costly source of capital.
- Legal and Procedural Formalities
Issue of debentures involves many legal formalities such as preparation of trust deed, appointment of debenture trustees, creation of charge, registration with authorities, and compliance with company law provisions. These procedures are time-consuming and involve legal and administrative expenses. Small companies may find it difficult to complete all these formalities.
Regular interest payment and redemption instalments require continuous cash outflow. This reduces available working capital and may affect day-to-day business activities. If cash inflow is irregular, the company may face difficulty in meeting its obligations. Hence, debentures can create cash flow problems, particularly for companies with unstable earnings.
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