Meaning of the term "debt capital"

::content-image{src="/images/legacy/maxda/themen/fremdkapital/image-thumb__168166__auto_1f891bd5eb142807016c2634ecc9a380/fremdkapital-maxda_100p_01.png" alt="Meaning of the term "debt capital" explained by MAXDA" align="center" size="lg" provider="none"} :: Debt capital refers to the financial obligations shown on a company's balance sheet toward third parties (debt providers or creditors). It is presented on the liabilities side of the balance sheet—normally after equity.

Debt capital usually arises from a temporary provision of capital by lenders to finance business activities or from unilateral financial obligations of the company.

In a broader sense, the term debt capital is also used for private financing projects, for example as part of a mortgage. In this article, the term is addressed with regard to corporate financing.

Debt capital: essential characteristics and components

Debt capital can be characterized as follows: it is usually made available to the company for a limited time and against interest payments that are independent of earnings. The amount of debt capital is not affected by the company's losses or profits.

Capital providers, unlike owners, do not take on liability obligations for the company, but they also have no decision-making or participation rights. In the event of insolvency, creditors of debt capital are paid from the insolvency assets before the owners. These design features distinguish debt capital sharply from equity.

Equity represents the counterpart of the funds that owners have provided to the company in the form of capital contributions or have left in the form of reserves. In the balance sheet, debt capital is shown as liabilities or provisions depending on the origin of the funds. This minimum classification applies to sole proprietorships and partnerships (§ 247 I HGB). Corporations must break down their debt capital in even more detail (§ 266 III HGB).

Liabilities and debts - debt capital in the context of external financing

Debts, i.e. liabilities, primarily arise in a company from credit relationships that serve to finance the company's assets. Some debts are based on unilateral obligations, for example tax liabilities. Liabilities are often distinguished according to their maturity.

A distinction is made between short-, medium- and long-term liabilities. Many companies present them in a liabilities schedule in the notes to the financial statements. According to § 268 V HGB, corporations must separately disclose liabilities or debts with a remaining term of less than one year and, according to § 285 No. 1 HGB, liabilities with a remaining term of more than five years and must also provide information on the extent of collateral.

Typical short-term liabilities include supplier and overdraft credits, advance payments received on orders, and bill loans.

Medium- and long-term liabilities are usually multi-year bank loans, promissory note loans, bonds or corporate bonds. Liabilities show funds that have been provided to or left with the company from outside (temporarily).

Provisions - debt capital in the context of internal financing

Provisions are the company's financial obligations whose existence or amount is uncertain. Unlike liabilities, there is no inflow of funds from outside here; the provision amounts must instead be generated from the company's ongoing revenue process.

Corporations must break down provisions according to § 266 III HGB into: provisions for pensions and similar obligations, tax provisions and other provisions. For many companies, pension provisions represent the largest volume. Since they must be built up over long periods—often decades—the funds for pension provisions are available to the company for a particularly long time and therefore have an equity-like character. Legally, however, they are clearly contractual obligations.

The item "other provisions" includes a number of types of provisions, e.g. provisions for impending losses from pending transactions, warranty and goodwill provisions, litigation and commission provisions, etc. Depending on the reason for the provision, they can have a short-, medium- or long-term character.

A special case are so-called expense provisions. These are provisions for deferred maintenance and removal of overburden (§ 249 I No. 1 HGB). These provisions—unlike other provisions—do not represent obligations to third parties.

Hybrid forms: mezzanine capital and others

There have been and still are a number of capital forms that represent a hybrid between equity and debt. These formerly included the so-called special items with reserve components.

These were tax financing aids in the form of tax-free reserves that had to be reversed over time to increase earnings. They contained an equity component (contribution to profit) and a debt component (tax contribution) and were each half-allocated to equity and debt in balance sheet analysis. They were eliminated as part of the 2009 Accounting Law Modernization Act (Bilanzrechtsmodernisierungsgesetz).

In addition, some capital forms are legally predominantly attributable to debt but have design features that, in economic terms, are more akin to equity. These are often grouped under the term "mezzanine capital" (from Italian mezzo = middle, between).

Examples include convertible and warrant bonds, subordinated or participating loans, profit participation rights and shareholder loans. Convertible and warrant bonds are interest-bearing securities that give the holder the right to exchange the bond for shares or the option to additionally acquire shares.

Subordinated loans are in principle "normal" liabilities but are only served in the event of insolvency after other, non-subordinated debt. Profit participation rights are also contractual capital provision relationships that come with owner-like rights—for example profit participation—and subordinated liability.

Shareholder loans are funds provided to the company by owners under a debtor-creditor relationship. Depending on the legal form, special rules regarding liability apply in the event of insolvency.

Debt capital in balance sheet analysis

In balance sheet analysis, debt capital—particularly the debt ratio when examining the financing structure—plays an important role for a company's profitability and liquidity. For the financing structure, the so-called static degree of indebtedness is determined:

Debt ratio = Debt / Total capital (Debt + Equity)

It is an important measure of corporate stability and the effect of the so-called leverage effect (the impact of indebtedness on equity return). With a rising debt ratio, and with constant company success, the return on equity increases or decreases disproportionately. For assessing company success, among other things, the return on total capital is determined. It indicates how profitable the total capital used to finance the company (total capital) is in the period under review.

Return on total capital = (Net income + interest on debt) / (Equity + Debt)

With regard to liquidity, various horizontal balance sheet structure ratios are calculated by forming ratios between individual items on the assets and liabilities sides of the balance sheet. One essential ratio is the so-called fixed-asset coverage ratio, which is defined as follows.

Fixed-asset coverage ratio = (Equity + long-term liabilities) / Fixed assets

The fixed-asset coverage ratio indicates to what extent the company's long-term asset investments are financed by equity and long-term debt. If fixed assets are only partially financed by long-term capital, this means an increased risk for financial stability, as short-term funds will repeatedly be needed to finance fixed assets. The debt ratio does not play a significant role in the fixed-asset coverage ratio.

In the context of liquidity of the 1st, 2nd and 3rd degree, liquid funds and other short-term asset positions of the company are set in relation to short-term liabilities. These liquidity ratios allow conclusions as to the extent to which the company's short-term liabilities can be covered by liquid funds or assets that can be liquidated quickly. If this is not the case, financial stability is potentially at risk.