In Disney’s 1997 cartoon adaptation of the Greek legend of Hercules, the evil Hades says to his kindhearted-but-enslaved underling, “Meg, Meg, Meg, my sweet deluded little minion. Aren’t we forgetting one teensy-weensy, but ever so crucial little, tiny detail?”
At Preferred CFO, we wish to express that same sentiment to any of our clients wishing to buy or sell debentures instead of bonds. Debentures can be confusing because in some parts of the world, debentures and bonds are the same financial instrument.
In the United States, there’s a teensy-weensy, but ever so crucial little, tiny detail: collateral.
The Five C’s
Lenders use the Five C’s to measure creditworthiness, and collateral is one of them. For review, here are all five with definitions.
Cash Flow
–the net amount of cash and cash-equivalents moving into and out of a business
Capital
–wealth in the form of money or other owned assets
Collateral
–something pledged as security for repayment of a loan, to be forfeited in the event of a default
Conditions
–the qualitative consideration of context and future prospects
Character
–mental and moral qualities distinctive to an individual
What Make Collateral Unique
Cash Flow, Capital, and Conditions all measure an entity’s ability to pay. Character measures an entity’s willingness to pay. Unfortunately, a breakdown in any one of those four factors can result in an entity failing to repay a loan.
Only Collateral measures what will happen in the event of default.
That’s a pretty crucial detail, and one that can’t be overstated. With collateral, the lender has claim on something. Without collateral, the lender has claim on nothing.
Interest
Since debentures have more risk, lenders require higher interest. Choosing between a collateral-backed bond and a no-collateral debenture requires weighing the comparative creditworthiness and risk against the increased interest.
Next Steps
Weighing those kinds of factors is a difficult and potentially costly job. We recommend professional assistance for that task, and we are (of course) happy to serve as those professionals.
You don’t need a full-time CFO to help you make this kind of a decision. A part-time, temporary, or project-based financial analyst can help with exactly these kinds of decisions.
Please call us at 801-804-5800 for help in weighing risk against both collateral and interest.
