What is debt capital and how it is calculated
Are you planning to start and run a startup? Remember these 2 words: debt capital. This is a source of funding that will prove essential for you, as it plays an invaluable role at the treasury management level. To best handle debt capital you need to know exactly what it is and how it is calculated. Get ready because you are about to find out.
Debt capital: meaning
The first step, of course, is to explore the meaning of debt capital. To delve into this concept, it is necessary to start with the sources of financing that your startup (as well as, more generally, any company) can rely on: these are divided into equity financing and debt financing.
The category of “equity capital” includes contributions made into enterprises by owners or shareholders. This item, therefore, refers to the various forms of self-financing by parties within the company.
Debt capital, on the other hand, refers to financing that a firm obtains as debt from lenders other than the owner or shareholders, that is, from parties outside the firm. This capital, which can consist of loans of various kinds, is a valuable aid to the company’s coffers but does not become part of the company’s assets. It must be repaid within a set maturity and may increase in the event that interest is payable.
What is the debt capital of a company?
In order to understand in more detail and in more practical terms what a company’s debt capital is, it is necessary to refer to a further distinction: within the macrocategory “debt capital,” it is in fact possible to distinguish between operating debt, that is, the total debts incurred by the company to its suppliers, and financing debt, that is, the total credits obtained by the company from banks and lending institutions.
This is a very important distinction because operating debt and financing debt act differently on cash balances. Let us now analyze these two concepts so you will know how best to develop your funding plan.
Operating debt: what is it?
Operating debt, as mentioned, is in practical terms the debt that a startup (and, more generally, a company) has with its suppliers. In order to make the business operational, after all, as you already know, it is inevitably necessary to rely on external goods and services (just think of the raw materials your startup needs), but these kinds of supplies are generally not paid on delivery, since payment is almost always deferred over time.
You should know that supplies that have not yet been paid for represent precisely operating debts: they are, therefore, third-party capital that supports the company in carrying out its operations, and they represent a very important resource for you and for anyone running a startup (or a company), since having the ability to postpone the payment of a supply gives you more time to have access to the liquidity needed to cover the payment itself, thus relieving the pressure on the company’s cash flow.
Be careful, however, because taking advantage of this opportunity and not managing operating debts as well as possible can sour your relationship with suppliers and, at worst, condemn your startup to bankruptcy.
Financing debt: what is it?
Financing debt, on the other hand, is the set of loans and financing obtained from banks and lending institutions and involving repayment by a given due date and with interest.
Based on the duration of the debt, you can distinguish between short-term debt capital and medium- to long-term debt capital. When you approach a bank to apply for a loan, in fact, you can choose from several options, including, for example, a bank overdraft valid for a few months or a mortgage with a term of several years.
The choice, of course, is linked to your specific needs, but always keep in mind the risks involved in this solution: getting a bank loan can save your startup’s present but, precisely because of the aforementioned interest to be paid over time, it could jeopardize the future of your entrepreneurial venture.
Debt capital: how is it calculated?
It is necessary, at this point, to emphasize once again the importance of debt capital: it serves, in practical terms, to give you the ability to be able to make up for any temporary lack of liquidity in your startup’s cash and helps to balance your cash flow. Even in view of the dangers just mentioned, however, it becomes crucial for you to know how to calculate and monitor it, especially in case you need to draw up the business plan. Only by knowing how to calculate debt capital, in fact, can you keep track of your startup’s borrowing costs and, therefore, know how far you can go in applying for loans and financing. To your rescue in this quest comes a balance sheet index called Return on Debts (ROD). Let’s get to know it better.
What is the ROD
As just pointed out, the ROD (Return on Debts) is a balance sheet index that can measure the onerousness value (as a percentage) of a borrowed capital. You should, first of all, know that it can be calculated from the total amount of financing obtained from banks, lending institutions, or other third parties, and from the total finance charges, i.e., interest charges and any other management costs.
Its value is expressed in percentage terms and is calculated by a specific formula:
ROD = FINANCE CHARGES/FINANCING RECEIVED * 100
Knowing the formula, however, will not help you much if you do not compare the ROD, which thus expresses the cost of debt, with the ROI (Return on Investment), which is the index that expresses in numerical terms the rate of return on all types of invesments in the business. For the long-term survival of your startup you need to make sure that the ROD is always lower than the ROI because if it is not, it means that you will have to take action to manage your debt capital more efficiently. On the contrary, when ROI is greater than ROD, your enterprise has convenience in financing investments by taking on debt. In fact, the return the enterprise gets from investing the borrowed resources (ROI) is greater than the cost incurred to acquire them (ROD).
Risk and debt capital: differences
The time for goodbyes has not yet come. To fully understand what debt capital is, in fact, you need to introduce another concept: venture capital. These two terms are often mistakenly used as synonyms, so knowing what distinguishes them can be an extra gear for you in your race toward success.
In practical terms, debt capital can be thought of as the cause of the risk, while risk capital is to be understood as what, effectively, you are risking. While debt capital risks the stability of the company, risk capital is what you need to bring to the table to counteract debt. Like debt capital, venture capital is often derived from third parties; however, unlike debt capital, which remains the property of third parties (banks or lenders) and, for that very reason, must be repaid (with interest), venture capital is part of the company’s actual assets.
Concluding this overview of debt capital, it is appropriate to make one final point: debt and risk have been mentioned often in this in-depth discussion, but you should not let this discourage you because you now have the knowledge and tools to best handle any potential problematic situation. Not only that: you must also keep well in mind that, quoting Robert Schuller‘s famous words:
“Hard times never last, but hard people do.”
Never forget that!