Debt Capital
Definition of Debt Capital
Debt capital refers to the portion of a company’s capital that belongs not to the owners themselves but to external creditors and thus constitutes debt. Debt capital can be classified as short-term (up to one year), medium-term (one to less than five years), or long-term (more than five years). For corporations, the breakdown of debt capital is defined in Section 266(III) of the German Commercial Code (HGB). A distinction must be made, in particular, between liabilities and provisions. On a balance sheet, debt capital, together with equity, constitutes the liabilities, which are offset against the assets.
Advantages and Disadvantages of Debt Capital
Unlike equity investors, debt providers do not hold an ownership stake in the company. As creditors, they typically have a claim to repayment (amortization) and the payment of interest, which is not tied to the company’s performance. Raising debt capital can be advantageous for a company, as it offers the opportunity to make investments and grow without the owners having to relinquish voting and control rights to the lenders. In practice, however, depending on the financing volume and the company’s creditworthiness, debt providers are regularly granted rights to information and approval. Unlike equity investors, debt providers are not liable for the company’s obligations and therefore bear a lower risk.
Leverage Effect
Due to the lower risk involved, a company’s cost of debt is typically lower than the cost of equity. This cost advantage comes into play, for example, through the so-called leverage effect. In this context, the return on equity can be increased by raising debt, as long as the return on the company’s total capital exceeds the cost of debt. Additionally, debt financing costs have a tax-reducing effect, as they reduce taxable income.
Debt-to-Equity Ratio
However, it is important that the company is always able to meet its interest and principal payments. Even in difficult times, when no profit is generated, the contractually agreed-upon debt service (interest and principal payments) must be met. To ensure a company can always meet its payment obligations, there should therefore be a healthy balance between debt and equity. An important ratio in this context is the debt-to-equity ratio, which compares debt to equity. The lower this ratio is, the less indebted and the more financially independent a company is. It is then financed primarily by equity. The optimal debt-to-equity ratio depends primarily on the company’s business model and the associated operational risk.