— In this article, Oke Abosede discusses the advantages and disadvantages of debt financing and servicing.
Learning what debt servicing helps to grasp how to run a business…
A man with a monthly salary of N50,000 saved N10,000, or twenty percent of his income. His current net worth is N600,000. He opened a dry cleaning company in his neighborhood to handle different kinds of laundry.
After two years, he went to a bank to get a loan so he could purchase some equipment for his company. After acquiring these tools, he was able to grow his laundry company.
He paid off his debt over a three-year period as his firm prospered.
The entire amount of money that a person or business is required to pay in order to satisfy its debt is known as debt service.
Principal and interest on bonds and loans must be paid on time in order to satisfy debts. Businesses may be required to repay bonds, term loans, or working capital loans, depending on the terms of the deal.
The word “debt servicing” can also refer to government and mortgage loans, however it usually refers to the amount of money needed to pay interest and principal on a loan or other debt for a specific amount of time.
The capacity to repay debt is always taken into consideration as a key consideration when taking on or pursuing debt. This implies that being able to pay all of your debts on schedule is crucial.
Why Pay Off Debt?
Businesses that experience operational slowdowns, debt accumulation, or losses without sufficient revenue may be obliged to take out loans.
The potential and sustainability of the firm will determine whether or not profits are made to pay off debt.
Borrowing could be your sole option to get money because a firm cannot operate without it. Banks and other financial organizations that provide loans need to be persuaded that the borrowers can repay the money when it’s due. Because of this, a company’s ability to service its debt is a key sign of its dependability.
Significantly, a company with a high credit score is one that pays off its debts. In this way, the company’s standing with lending organizations is enhanced, which will be beneficial for its operations going forward.
Therefore, it is crucial that a company with prospects for the future and a going concern make sure that its debt servicing capacity is properly handled.
Understanding personal finance management will help those thinking about taking out a mortgage or auto loan develop a practical and effective debt-servicing strategy. Similar to corporations, associations, and governmental bodies, having a high credit score is necessary for borrowing and debt servicing.
Calculating The Debt Service
In contrast to other loan arrangements and payments, debt service is computed as the total amount of principal and interest that must be paid on a regular basis. Understanding the loan’s set interest rate and the repayment deadline is necessary to accomplish this.
It is crucial to compute debt service in order to ascertain the necessary cash flow for payment. The annual debt service is computed once the debt service is determined, and this figure is then compared to the company’s annual net operating income. For example, let’s say a school borrows N500,000 for a period of five years at a five percent interest rate. Assuming that the loan was amortized, equal principle payments would be necessary. It indicates that the principal will be repaid by the school in equal installments.
It would have paid back all of the principle plus interest at the conclusion of the five-year term.
Nigerian Debt Servicing
Government agencies that have debt service obligations may borrow from other countries or from lending organizations like the World Bank.
The Federal Government’s 2023–2035 Medium Term Expenditure Framework and Fiscal Strategy Paper projects that Nigeria’s debt servicing will cost N10.43tn by 2025, or three years from now. Compared to the N3.69 trillion allocated for debt service in 2022, it demonstrates a rise of 182.66%.
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Although this would raise economic concerns, the nation’s revenue problem—rather than its debt—is what Director-General of the Debt Management Office Patience Oniha clarified.
Oniha said, “High debt levels lead to debt service, which reduces resources available for investment in infrastructure and key sectors of the economy.”
Additionally, Dr. Zainab Ahmed, the former Minister of Finance, Budget, and National Planning, made reference to the difficulties the nation faces in managing its debt.
She stated at the World Bank’s Nigeria Development Update event in Abuja, which was themed “The urgency for business unusual.”
Because expenses have been rising at a significantly faster rate than income, we are already having difficulty paying off debt. It is therefore an extremely challenging scenario.
The International Monetary Fund has previously issued a warning that, should the government fail to take appropriate action to increase revenue generation, debt payment may consume 100 per cent of Nigeria’s revenue by 2026.
Based on a macro-fiscal stress test done on Nigeria, IMF’s Resident Representative for Nigeria, Ari Aisen, stated that interest payments on debts might consume all of the nation’s earnings in the ensuing four years.
She said, “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.
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.
