What is Debt financing?
Debt financing is one of the means by which a company generates funds by borrowing money by making debt instruments like bonds, loans, etc. from individuals or other institutional investors. In return for the borrowed sum, the company agrees to repay the principal amount along with interest at regular intervals.
This type of funding allows a company to generate the amount required for operations or expansion without giving up ownership. Owners of the borrowed funds do not gain ownership but are guaranteed fixed repayments. Debt financing is valuable to small or new corporations planning to expand by purchasing essential resources.
However, it would be riskier if this business fails to earn the expected returns, as they will still be needed to repay the debt borrowed and thus will lead the company to bankruptcy.
How does it work?
Debt financing is the buying of debt securities issued by a company by lending money to a company in return of periodic payment of interest and repayment of the principal at a specific date. This means that a company can raise its capital for growth and expansion without distributing its shares and, thus, not diluting ownership, unlike in equity financing.
The company gets cash as the loan amount, but that loan becomes liable to be paid back with interest irrespective of the financial status of the company. Debt holders become more superior to the equity holders at the time of bankruptcy to claim the assets liquidated. Debt financing provides benefits such as tax benefits on the interest expense but having too much debt may increase the financial risk of the firm.
Types of Debt Financing
Bank Loan: A company borrows money from a bank and has to repay the amount borrowed along with interest at either fixed rate or at rates that may change over time.
Corporate bonds: A company borrows money by issuing the corporate bond. Company has to pay interest periodically and repay the full amount at the maturity date of the bond.
Mortgages: When you borrow money to buy property, the security is the property itself. The lender can seize the property in case you default on paying the mortgage.
Convertible Notes: Venture funds often use this type of debt security. These behave like loans but can be converted into equity shares at the choice of the investor instead of getting repaid in cash.
Lines of Credit: It’s like a business version of a credit card. Companies can only borrow to the limit and pay interest on what they borrowed.
Government Bonds: The government will issue bonds to raise capital from the public, which is then repaid with a return.
Factoring: Factoring is a form of debt finance to source funds for a short-term by an enterprise. The enterprise sells its accounts receivable to another party from which they want to raise the necessary funds.
Revolving Credit Facilities: It is similar to a line of credit but more extensive in size and used by larger-scale businesses. Companies can withdraw and repay over and over again until they reach the limit.
Equipment Financing: This refers to a loan for purchasing equipment, which is secured by an interest in the equipment itself. In the event that the loan is not paid, the creditor can take possession of the equipment.
Merchant Cash Advances: Companies receive cash up front, but lose a certain percentage of their future sales until the loan is repaid. Expensive, but works for businesses that have a lot of card sales.
Trade Credit: When suppliers let companies buy now and pay later. It helps businesses maintain stock without having to pay immediately.
Convertible Debt: It is a form of loan that can be changed into companies shares at a later stage and companies don’t have to pay back the loan.
Debt Financing vs. Equity Financing
Debt finance is basically when the company obtains money from the lender and agrees to repay the loan with interest or a fixed fee, over an agreed period of time. Companies don’t have to give up their ownership to the investors. The company is liable to pay the loan amount to the lender with interest irrespective of any profit generated over an agreed period. Generally, debt finance is less risky than equity finance because the firm is not sacrificing any ownership in the business.
In equity finance, a company raises funds through the sale of shares of ownership in the business to outside investors. Such investors own part of the business proportionate to the amount of capital invested. Investors have no claim for the return of their investment except when the business is sold or put under liquidation. Equity finance is always riskier than debt finance because an investor surrenders ownership of the business for a share of the future profits and potential losses.
Advantages and Disadvantages of Debt Financing
Pros:
Debt financing allows easy growth since funds are instantly available.
Business owners completely own businesses and have complete control over the same.
The paid interest is tax-deductible, thus reducing the amount of taxable income.
Once the amount is repaid, there will no further liability toward the lender
Cons:
Has a principal and interest repayment obligation that becomes costly.
Requires periodic repayments that do not show the absolute performance of the business.
High debt makes the business riskier to investors.
If the money could not be repaid, then the assets can be seized or the company can be declared bankrupt.
Thus, debt financing is crucial for those business organizations that want capital expansion and growth without diluting their ownership. On the other hand, tax deductibility along with predictable repayment schedule and instant availability of funds are benefits which equity financing cannot provide.
There are some negative impacts too like paying interest, consequences of insolvency risks and collateral requirements, which are not there in equity financing. Therefore, it is necessary for business to understand what debt means and seeks the right financing options that will allow it to achieve its goals and support long-term success, then it can use debt the right way.