Funding Operations

Funding operations involve converting short-term debt into long-term debt. This process creates a more stable repayment forecast by moving to predictable, fixed-interest vehicles.

Funding operations provide governments and business entities an opportunity to consolidate short-term debt obligations into long-term debt instruments, such as bonds, that carry a fixed rate. Most investors consider debt instruments with repayment dates of a year or less to be short-term in nature, while long-term debt typically does not require full repayment for a year or more. While the interest rate on short-term debt typically runs lower than the interest rate on long-term debt, the variability of interest rates issued over the short term presents downside risk for companies or governments that need debt funding over the longer term.

When governments or businesses undertake funding operations, they look for a long-term debt vehicle that can provide appropriate funding for their expected operational expenses over the long term, while also replacing short-term debt currently on the balance sheet. Holding short-term obligations provides an opportunity to purchase long-term debt more strategically and less frequently, as the chances of large interest rate movements remain relatively low over the shorter term.

While companies and governments can obtain short-term debt on fixed-rate or variable-rate terms, any funds that do not get repaid within a year become subject to rate changes by definition, as the companies or governments would need to refinance the debt in some way as it came due. The interest rate on variable-rate debt vehicles resets periodically, at an interval set by the debt issuer. Interest rates on short-term fixed-rate debt would effectively reset as companies or governments refinance into new instruments at prevailing rates.

Issuers offer higher interest rates on long-term debt to match the higher risk of default over a longer maturity period. At the same time, the fixed nature of the rates provides the entity taking the loan with greater stability, since interest accrues more predictably over the course of repayment. Fixed rates also provide protection in a rising interest rate environment, as short-term interest rates rise and floating rates reset to higher levels.

Companies consider short-term debt on their balance sheet to be unfunded. Short-term debt may include both bank loans or corporate debt issuances with maturity dates under one year. Companies consider long-term debt to be funded debt for balance sheet purposes.

Investors use funded debt to calculate two important ratios that they use to determine the financial health of a company. The capitalization ratio looks at a company’s long-term debt as a proportion of its total capitalization. A company’s net working capital ratio looks at long-term debt as a proportion of the company’s existing capital. In most cases, investors prefer to see net working capital ratios under 1:1.