Sunday, 17 August 2025

Navigating The World of Debt: An Introduction to Financial Instruments

Title:- Navigating The World of Debt: An Introduction to Financial Instruments

Sources:- CBSL, World Bank

Date of Published:- 17/08/2025

 

What is Debt?

Debt is a powerful financial tool that allows individuals and companies to raise funds for various purposes such as financing operations, investments or managing liquidity needs. When you take out a loan, you borrow money with promise to repay it over a specified period of time, usually with interest. Debt securities are a type of financial instruments that represents a loan made by an investor to a borrower, such as a company or government. These securities include a wide range of products from short-term loans to long-term bonds.

Let’s recognize Short-Term Debt Instruments,

A short-term debt instruments are loans and other financial instruments that companies use to obtain funds for a period of up to One year. They are often used to finance working capital needs, manage liquidity needs or cash flow mismatches and purchase inventory or stocks. Intermediate and direct short-term sources of funds used businesses are bank overdrafts, commercial bills, promissory Notes and certificates of deposit.

·        Overdrafts: This is a major source of short-term financing. It allows a company to put its operating account into a deficit(overdraft) up to a pre-negotiated limit with the bank. Interest is charged on the daily debit balance in arrears on the monthly basis and is based on a margin above a ‘Reference rate’ such as the Bank’s prime rate. It is a very flexible funding option as the bank can draw cheques against the overdraft without further notice.

·         Commercial Bills: These provide funding for normal business transactions and are typically issued with a maturity of 30 to 180 days. A distinguishing feature is that a bank can also become an ‘Acceptor’, assuming prime responsibility for payment on maturity, thereby increasing its credit standing.

·        Promissory Notes(P-Notes): Generally referred to as commercial paper, these are discount securities that do not have an acceptor, making them ’one-name paper’. The credit status of the note is therefore entirely dependent on the issuer’s creditworthiness. Issuers may use a credit rating agency to establish the creditworthiness of the notes. P-Notes have an active secondary market.

·        Negotiable Certificates of Deposit(CD’s): Banks issues these to raise short-term funds in the money market. CDs are also discount securities with a maturity range of up to 180 days and have an active secondary market.


Let’s recognize Medium to Long-Term Debt Instruments,




These general credit facilities are used to raise funds for business borrowers over a long period of time. They are usually used for specific purposes such as financing building or equipment. These too can be identified in several types.


·     Term Loan: This is a specific amount of funds lent for a specified period, typically ranging from 3 to 15 years. Interest rates may be fixed or variable at a margin above a reference rate. These loans often include loan covenants which are conditions designed to project the leader. A positive covenant may require the borrower to take certain actions such as maintaining a minimum level of working capital. A negative covenant restricts the borrower’s activities and financial structure, for example, by limiting the amount of dividend or setting a maximum debt-to-equity ratio. Breach of a covenant may result in a default of the loan contract. Repayment may be interest-only, fully amortized or deferred.

·      Mortgage Finance: This is a loan secured by real property and it’s used for both residential and commercial purposes. Residential loans typically range up to 30 years, while commercial loans are generally range up to 10 years. Installments are generally fully amortized, but interest only commercial mortgage loans are available.

·      Corporate Bonds: These are debt securities issued in the corporate bond market. Borrowers are riskier than lending indirectly through intermediaries but can earn a greater return since they share in the profit margin usually taken by intermediaries. Types of corporate Bonds;

1.      Debentures: A debenture refers to a bond of a company with a security attached to it, for instance, a fixed and floating charge over the issuing company’s assets. Debentures typically rank higher over a company’s assets than unsecured notes in the event of liquidation.

2.      Unsecured Notes: These are corporate bonds issues that are not secured with a higher level of risk attached to them, hence a higher cost of borrowing. They are usually issued only by firms with a good credit rating, well established.

 

The current situation in Sri Lanka, which is burdened by Global Debt ;

Sri Lanka has also experienced a serious economic crisis, which ran deep into its debt profile. Its debt crisis resulted in default on foreign debt, causing difficulties for both the private sector and the government to borrow money in the international capital markets. This increased the risk perception of Sri Lankan borrowers, perhaps with a perspective of charging higher interest rates and stricter lending conditions.

For a Sri Lankan company, it may be very difficult to obtain a term loan or mortgage financing at this time. The Central Bank of Sri Lanka has, in certain cases, pursued tight monetary policies in order to stem high inflation. The policies have resulted in a sudden increase in interest rates charged on local currency loans. This directly impacts the cash flow and profitability of a business, with the monthly payment on a loan for equipment like new machinery far higher than it was just a few years ago.


This situation highlights the importance of knowing different instruments of debt and their details since the capital market can drastically alter the borrow ability and capital cost for companies. Such loan covenants and clear repayment conditions become all the more critical to lenders as well as borrowers in such an unstable market. The local market, like banks and institutional investors, plays a crucial role as far as providing the necessary capital is concerned, but debt cost and availability are greatly influenced by the Central Bank's policy.

These are some trusted sources from Sri Lanka for more information:

 

Author : Ridmee Amarathunga

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