Understanding debt financing and servicing

JULIANA AJAYI, in this piece, illuminates the benefits and risks attached to debt financing and servicing 

A man, who earns N50,000 monthly as salary, saved 20 per cent of his income, which is N10,000. In five years, he has N600,000. He set up a dry cleaning business in his neighbourhood, catering to various laundry needs.  

Two years later, he approached a bank for a loan so as to buy some equipment for his business. Following the purchase of these equipment, he was able to expand his laundry business. 

While his business thrived, he spent three years servicing his debt. 

Debt service is the total amount of money that an individual or company is expected to pay to clear its debt obligation. 

In servicing debts, the interest and principal on loans and bonds must be paid as and when due. Depending on the agreement, businesses may need to repay bonds, term loans, or working capital loans.

While debt servicing may involve money that is required to cover the payment of interest and principal on a loan or other debt for a particular time period, the term can also apply to mortgage loans and government debts.

In obtaining or seeking debts, the ability to service debt is always considered a major factor. This means that the ability to meet all financial obligations timely is very important.  


Why debt servicing?

When a business slows down on operations, accumulates debts or runs at losses without generating enough revenue, such business may be forced to take a loan. 

Depending on the prospect and viability of such business, profits could be generated to service debts. 

Since it is impossible to run a business without funds, borrowing may be the only way available to source funds. Lending institutions, such as banks and other financial institutions, must be convinced that the borrower is able to refund the loan when due. As a result of this, debt servicing capacity is a major indicator of the reliability of a business. 

Importantly, a business that services its debts is recognised as a business with a good credit score. This way, the reputation of the business is boosted among lending institutions, which the business would find useful for future operations. 

It is, therefore, essential that a going concern and a business with future prospects should ensure that its debts servicing capability is well managed. 

For individuals considering mortgage or car loans, learning to manage personal finances will help build a sustainable and efficient approach in servicing debts. Like businesses, organisations and government entities, a good credit score in servicing debts is needed when and borrowing. 


Determining debt service

Distinct from other forms of loans and payments, debt service is derived by calculating the periodic interest and principal payments due on a loan. In achieving this, the rate fixed for the loan and the date for repaying such loan must be understood. 

Calculating debt service is important to determine the cash flow required to cover payments. After calculating the debt service, the yearly debt service is calculated and used to compare the business’ yearly net operating income. For instance, if a school takes out a N500,000 loan at five per cent interest rate for a term of five years. Supposing it was an amortised loan, which requires equal principal payments. It means that the school will repay an equal amount of principal each period, plus the interest on the outstanding principal.

At the end of the five-year period, it would have repaid all the principal in addition to the interest. 


Debt servicing in Nigeria

Debt servicing in government entities could involve different countries of the world borrowing from lending institutions such as the World Bank, or other nations. 

In Nigeria, the debt servicing has been projected to cost N10.43tn by 2025, just three years away, according to the Federal Government’s 2023-2035 Medium Term Expenditure Framework and Fiscal Strategy Paper. It shows a 182.66 per cent increase from the N3.69tn budgeted for debt service in 2022.

While this may be considered as a concern for the economy, the Director-General, Debt Management Office, Patience Oniha, explained that the country has a revenue, rather than debt, problem. 

Oniha said, “High debt levels lead to debt service, which reduces resources available for investment in infrastructure and key sectors of the economy.”

Also, the Minister of Finance, Budget and National Planning, Dr Zainab Ahmed, hinted on the country’s struggles in handling its debt. 

At the launch of the World Bank’s Nigeria Development Update entitled, ‘The urgency for business unusual,’ in Abuja, she said, “Already, we are struggling with being able to service debt because even as revenue is increasing, the expenditure has been increasing at a much higher rate. So, it is a very difficult situation.”

The International Monetary Fund had earlier warned that debt servicing might gulp 100 per cent of Nigeria’s revenue by 2026, if the government failed to implement adequate measures to improve revenue generation.

According to IMF’s Resident Representative for Nigeria, Ari Aisen, based on a macro-fiscal stress test conducted on Nigeria, interest payments on debts might lap up the country’s entire earnings in the next four years.

Her words, “The biggest critical aspect for Nigeria is that we have done a macro-fiscal stress test, and what you observe is the interest payments as a share of revenue, and as you see us in terms of the baseline from the Federal Government, the revenue of almost 100 per cent is projected by 2026 to be taken by debt service.

“So, the fiscal space or the amount of revenue that will be needed, without considering any shock, is that most of the revenues of the Federal Government are now, in fact, 89 per cent and it will continue, if nothing is done, to be taken by debt service.”


Debt financing in businesses

Considered to be one of the most used methods in running business operations, debt financing could take a long-term or short-term form. 

Although there are differences, more often than not, short-term debt financing exists as a type of financing with a repayment period of one year or less, while long-term debt financing refers to financing with a repayment period of a year and more. 

Short-term financing is used by small and large businesses to cover more immediate, day-to-day, working capital needs, as well as emergencies. Long-term financing, on the other hand, is mostly employed for larger projects like buying a business, renovation, equipment purchase, real estate investment, and the likes. 


Nothing venture, nothing win

A baker, Esther Adebisi, said that debt financing comes with risks as well as benefits. 

According to the entrepreneur, feasibility studies must be carried out efficiently before a business owner can determine if the best method for financing their business is through debts. 

She said, “Saying that borrowing is all harm and no good would be unfair to any business. However, as a business owner, it is important to recognise the viability, potential and how well a business would do, should you decide to take a loan.” 

Some of the sources of debt financing for micro and macro businesses include banks and credit institutions, non-profit lenders, as well as friends and families. 

Debt financing also involves the risks of losing business and other assets. This could happen in cases where the repayment schedule for such debts is monthly, or a variable interest rate that could lead to a fluctuating rate negating the cash flow of the other. 

“Debt financing comes with benefits as well as risk. As an entrepreneur, one must take reasonable risks,” Adebisi added. 

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