About Debt Securities

Debt securities ia another market's invention to fund capital requirements through debt financing. It is so popular as another form of leverage for business financing. Explained in simple term, this means that the company borrows money at an interest rate which is lower than the rate it can earn on that money.

For example, if a company borrows $25 million at 10 per cent per year interest rate, and employs the money so that it produces a return of 15 per cent per annum, it makes a net gain (before taxes) of four per cent. With $25 million loans, the company can simply gain $1.25 million!

Isn't that cool?

In this way, the company is able to enhance the earnings rate on shareholders' equity, which in return results to high ROE. Another reason is that interest charges are legitimate tax deduction (at least for most of the countries).

The decision on how far a business corporation should finance their long term capital requirements through debt securities as opposed to equity financing shall take into consideration its potential impact on margins of profitability and solvency.

If a company is highly geared, a significant portion of gross profits will be channelled to meet financial charges. The cost of borrowing becomes a drain on the company's cash flow. It also makes the company more vulnerable to changes in the business environment and on the continued goodwill of creditors.

Thus, decisions to finance capital requirements through debt should strike an equitable balance between debt and equity capital in the firm's capital structure. Nevertheless, for most companies, the combination of moderate interest rates and high levels of corporate income taxes enable debt capital to produce significantly better EPS than a comparable amount of capital provided by and issue of stock.

Bonds and loan stocks are two best examples for debt securities.

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