Debenture capital definition
/What is Debenture Capital?
Debenture capital is a loan that an organization secures with its assets. This situation is most common for smaller organizations that cannot convince lenders to issue them debt without some form of collateral.
Disadvantages of Debenture Capital
Debenture capital has several potential disadvantages that can impact a company’s financial health and operational flexibility. Here are the main disadvantages:
Interest repayment risk. Debentures require the issuing company to make regular, fixed interest payments regardless of its profitability. In times of low earnings or economic downturns, these obligations can put significant financial strain on the company.
Risk of bankruptcy. Relying heavily on debenture capital can lead to over-leveraging, where debt outweighs equity significantly. This increases the risk of insolvency, especially if the company faces financial difficulties
Repayment obligation. Debentures are debt instruments with a maturity date, meaning the principal amount must be repaid at the end of the term. This can create a large financial burden on the company if it does not have enough cash reserves. To cover this repayment, companies may need to refinance, which can be challenging if interest rates have increased or if the company’s credit rating has declined.
Restrictive covenants. Debenture agreements often include restrictive covenants that limit certain actions, such as taking on more debt, selling assets, or paying dividends. These restrictions can limit the company’s operational flexibility and its ability to pursue new opportunities.
In summary, while debenture capital provides funds without diluting ownership, the fixed obligations, impact on cash flow, restrictive covenants, and risk of bankruptcy can make it a less flexible and potentially riskier source of capital for some companies.