There has been a shift in the tools for raising finance by businesses from traditional sources such as banks, businesses have started moving towards other financing alternatives available in order to mitigate risk, diversify the portfolio, etc. Non-convertible debentures (NCDs) have become a popular tool for enterprises to raise capital.
WHAT ARE DEBENTURES?
The term debenture is defined by Section 2(30) of Companies Act, 2013 as to include debenture stock, bonds, or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not. Debentures can be classified into many types based on their tenure, convertibility, placement, and security.
Convertibility in debentures refers to the feature of a debenture that allows the holder to convert the debenture into a predetermined number of equity shares/ predetermined valuation method of the issuing company after a specified period.
Based on these debentures can be classified into:
- Non-convertible debentures.
- Partly convertible debentures
WHAT ARE NON-CONVERTIBLE DEBENTURES?
Non-convertible debentures are the ones that cannot be converted into equity shares and can only be redeemed after the expiry of a specified time period. It is important to note that only a company can issue non-convertible debentures. Non-convertible debentures act as a long-term funding source for companies and the rate of interest offered to the investors is higher as compared to others.
WHAT ARE THE TYPES OF NON-CONVERTIBLE DEBENTURES?
There are two types of non-convertible debentures (NCDs):
- Secured non-convertible debentures are those that are supported by the issuing company’s assets. Investors have the right to seize corporate assets in the event of default in order to recoup their investment. Compared to unsecured NCDs, these debentures provide investors with a better level of security.
- Unsecured non-Convertible Debentures: NCDs without any Collateral or Security are referred to as Unsecured NCDs. Investors do not have a right to the company’s assets in the event of default. These debentures typically give a higher rate of interest to make up for the higher risk because they are thought to be riskier than secured NCDs.
WHAT ARE THE BENEFITS OF RAISING FUNDS THROUGH NON-CONVERTIBLE DEBENTURES?
NCDs offer the following benefits:
- Offers fixed Interest: NCDs provide investors with a set rate of interest, making them a desirable investment choice for risk-averse investors seeking a steady return on their investment.
- Reduced Risk: Because the chance of losing money in a non-convertible debenture is comparatively lesser than that of other investment options, such as equity shares, NCDs are thought to be less risky.
- No Equity Dilution: NCDs do not reduce the equity of the issuing company because they cannot be converted into equity shares.
- Diversification: Diversification of the investor’s portfolio will be achieved by investing in NCDs. It will also guarantee revenue.
- No Upfront Tax Provision: A company’s securities are not subject to TDS (Tax Deducted at Source), as required by Section 193 of the Income Tax Act. However, the ITA’s Section 195 specifies that TDS shall apply to NCDs of Non-Resident Indians (NRIs).
- Good liquidity: Due to their listing and trading on the stock market, Non-Convertible Debentures (NCDs) possess high liquidity. This attribute is significant as it enables investors to raise funds quickly in case of any urgent financial requirements.
WHAT ARE THE FACTORS TO BE CONSIDERED WHILE INVESTING IN NCDs?
The following are the factors that should be considered before investing in NCDs:
- Credit rating: Credit rating companies assign a rating to NCDs based on the issuer’s creditworthiness. It is important to invest in NCDs issued by companies with good credit ratings, as they are less likely to default on their payments. It is advisable to not invest in companies below the AA rating irrespective of the returns offered.
- The Financial status of the company: The financial health and stability of the issuing company should be evaluated before investing in their NCDs. This can be done by analyzing the company’s financial statements.
- Capital adequacy ratio: It’s crucial to assess the financial stability and health of the issuing company before making an NCD investment. The company’s Capital adequacy ratio (CAR) offers important information about its capacity to fulfil its debt commitments, including the settlement of principal and interest on the NCDs.
A higher CAR suggests that the corporation has more cash available to absorb possible losses and pay its debts. On the other hand, a lower CAR suggests that the company may have a larger risk of default and may be more subject to economic downturns or other financial shocks.
- Interest Coverage Ratio: The Interest Coverage Ratio measures the company’s ability to meet its interest payments on its debt. It is calculated by dividing the company’s earnings before interest and taxes (EBIT) by its interest expenses. A higher Interest Coverage Ratio indicates that the company has a stronger ability to meet its interest payments, which could reduce the risk of default on its NCDs. Therefore, it is important to look at the Interest Coverage Ratio of the company before investing in its NCDs to assess the level of risk associated with the investment.
- Debt Ratio
The debt ratio shows what percentages of a company’s total assets are financed by debt. It is calculated by dividing the total debt by the total assets of the business. A higher debt ratio means that a greater percentage of the company’s assets are financed by debt, which could raise the risk of NCD default. Consequently, it is vital to look at the Debt Ratio of the company before investing in its NCDs to estimate the level of risk involved with the investment.
There are several other factors such as the purpose of raising NCD and provisions of NPA by the company which are to be considered before making an investment decision.