When a company takes out a loan, it does so either by issuing debt in the open market or securing financing with a lending institution. Loans are categorized as unfunded or funded, and are taken out by a company to finance its long-term capital projects, such as the addition of a new product line or the expansion of operations. Unfunded debt are short-term financial obligations that are due in a year or less. Examples of short-term liabilities include corporate bonds that mature in one year and short-term bank loans. A firm may use short-term financing to fund its long-term operations. This exposes the firm to a higher degree of interest rate and refinancing risk, but allows for more flexibility in its financing.
Funded debt refers to any financial obligation that extends beyond a 12-month period, or beyond the current business year or operating cycle. It is the technical term applied to the portion of a company’s long-term debt that is made up of long-term, fixed-maturity types of borrowings. Examples of funded debt include bonds with maturity dates of more than a year, convertible bonds, long-term notes payables, and debentures. Funded debt is sometimes calculated as long-term liabilities minus shareholders’ equity.
Funded debt is an interest-bearing security that is recognized on a company’s balance sheet statement. A debt that is funded means that it is usually accompanied by interest payments which serve as interest income to the lenders. From the investor’s perspective, the greater the percentage of funded debt to total debt disclosed in the debt note in the notes to financial statements, the better.
Analysts and investors use the capitalization ratio, or cap ratio, to compare a company’s funded debt to its capitalization or capital structure. The capitalization ratio is calculated by dividing long-term debt by the total capitalization, which is the sum of long-term debt and shareholders’ equity. Companies with a high capitalization ratio are faced with the risk of insolvency if their debt is not repaid on time, hence, these companies are considered to be risky investments. However, a high capitalization ratio is not necessarily a bad signal, given that there are tax advantages associated with borrowing. Since the ratio focuses on financial leverage used by a company, how high or low the cap ratio is depends on the industry, business line, and business cycle of a company.
Another ratio that incorporates funded debt is the funded debt to net working capital ratio. Analysts use this ratio to determine whether or not long-term debts are in proper proportion to capital. A ratio of less than 1 is ideal; in other words, long term debts should not exceed the net working capital. However, what is considered an ideal funded debt to net working capital ratio may vary across industries.
A funding agreement is a type of investment institutional investors may utilize for its low-risk, fixed-income characteristics. Generally it refers to an agreement between two parties, offering the investor a return for a lump sum investment paid to the issuer.
A funding agreement product requires a lump sum investment paid to the seller who then provides the buyer with a fixed rate of return over a specified time period, often with the return based on LIBOR, the most popular benchmark in the world for short-term interest rates. Funding agreement products are similar to capital guarantee funds or guaranteed investment contracts. Mutual funds and pension plans often buy funding agreements due to the safety and predictability that they offer.
Guarantee funds can typically be invested in without risk of loss and are generally considered to be risk free. However, these types of investments often have liquidity limitations. Therefore, they are often targeted for high net worth and institutional investors with substantial capital for making long-term investments.
Funding agreement products can be offered globally. They typically don’t require registration and often have a higher rate of return than money market funds. Some products may be tied to put options allowing an investor to terminate the contract after a specified period of time. As one might expect, funding agreements are most popular with those wishing to use the products for capital preservation in a portfolio rather than growth.
Funding Agreement Contracts
Generally, two parties may enter into a legally binding funding agreement providing a lump sum to an issuer in return for a guaranteed investment return. Lump sum investments may be made to various types of issuers for capital investment. Terms of the funding agreement will typically outline the scheduled use of capital and the expected return over time for the investor.
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