What is Debt Financing?
Debt financing is a phenomenon that occurs when a company raises money for its working capital or capital expenses by selling debt instruments to investors. These investors can be individuals or corporate in nature.
Similarly, debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes for money. In debt financing, the money is paid back unlike in equity financing where lenders receive stock in exchange for their money.
As a means of simplicity, the highlights of debt finance is shown below:
- It occurs when a company raises money by selling debt instruments to investors.
- Debt financing is the opposite of equity financing. Equity financing means issuing stock to raise capital.
- In debt finance, a firm sells fixed income products such as bonds, bills, or notes.
- Creditors are repaid their debt with interest.
- Small and new companies use debt finance to purchase resources that will foster growth.
How Does Debt Financing Work?
There are basically three financing options whenever a company needs capital. They can either opt for the equity finance, debt finance or a hybrid of the two.
Since the topic of our discussion borders on debt financing, we will concentrate on it.
When a company is in need of finace, it can sell fixed income products such as bonds, bills or notes to investors in order to obtain the capital necessary to expand and grow.
These investors who can be retail or institutional investors provide the issuing company with debt financing equivalent to the bond or bill. The loan amount is called the principal.
The issuing firm doesn’t just promise to repay the principal, it also compensates the bondholders by making interest payments called coupon payments annually. These amounts are repaid at an agreed time.
To the issuer, this interest paid represents the cost of borrowing. Therefore, the cost of debt is the interest paid to bondholders.
Here here are a few different methods of receiving the funds:
- A loan from a bank or credit union
- Selling bonds to lenders or the public
- Loans from friends or family
- A cash advance on a credit card
- Peer-to-peer lending
Conversely, if the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.
What are the Advantages and Disadvantages of Debt Financing?
Debt financing has numerous advantages over other forms of financing.
First, it allows a business to leverage and convert small amounts of money into much large sums that aids fast growth and expansion.
Again, the company does not have to give up any ownership control, as is the case with equity financing. Debt financing is often less costly than equity financing.
To itemize the advantages, take a sneak peak below:
- Debt financing allows a business to leverage a small amount of capital to create growth
- Debt payments are generally tax-deductible
- A company retains all ownership control
- Debt financing is often less costly than equity financing
Moving on to the disadvantages. In, debt financing, interest must be paid to the lenders, which signifies the amount paid must include interest.
Repayment of debt must be made regardless of business revenue, and this can be particularly risky for small or new businesses that have yet to establish a secure cash flow.
Similarly, the itemized disadvantages of debt financing are:
- Interest must be paid to lenders
- Payments on debt must be made regardless of business revenue
- Debt financing can be risky for businesses with inconsistent cash flow
Types of Debt Financing
Debt finance can be in the form of installment loans, revolving loans, and cash flow loans.
Installment loans are ones with set repayment terms and monthly payments. The loan amount is received as a lump sum payment upfront. These loans can be secured or unsecured.
Revolving loans provide access to an ongoing line of credit that a borrower can use, repay, and repeat. Credit cards are an example of revolving loans.
Cash flow loans provide a lump-sum payment from the lender. Payments on the loan are made as the borrower earns the revenue used to secure the loan. Merchant cash advances and invoice financing are examples of cash flow loans.
Additionally, these are the types of debt finance:
- Non-Bank Cash Flow Lending
- Recurring Revenue Lending
- Loans From Financial Institutions
- Loan From a Friend or Family Member
- Peer-to-Peer Lending
- Home Equity Loans & Lines of Credit
- Credit Cards
- Bonds
- Debenture
Debenture:
A debenture is similar to a bond, however, it isn’t backed by a collateral, rather by the reputation of the borrower.
In other words, they’re high-risk-high-reward investments, paying higher interest rates than standard bonds.
While with a bond, the borrower issues an indenture to the lender, outlining the details of the loan, maturity date, interest rate, debenture terms vary from one investment to another. They typically run longer than 10 years.
Debt Financing vs Equity Financing
The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation but debt finance must be repaid, but the company does not have to give up a portion of ownership in order to receive funds.
The funding type companies use is dependent on the option most accessible to them, the state of their cash flow, and the importance of maintaining ownership control.
Debt-equity ratio shows how much financing is obtained through debt vs. equity. Creditors tend to look favorably on a low D/E ratio, which benefits the company if it needs to access additional debt finance in the future.
Sources of Debt Financing
The sources of this finance option include:
#1. Financial institutions
Banks, building societies, and credit unions offer a range of finance products both short and long-term. These include:
- Business loans
- Lines of credit
- Overdraft services
- Invoice financing
- Equipment leases
- Asset financing
#2. Retailers
If you need finance to buy goods like furniture, technology, or equipment, many stores offer store credit through a finance company. Generally, this is a higher-interest option. It suits businesses that can pay the loan off quickly within the interest-free period.
#3. Suppliers
Most suppliers offer trade credit. This allows your business to delay payment for goods. Trade credit terms vary. You may only get it if your business has a good reputation with the supplier.
#4. Finance companies
Most finance companies offer finance products through retailers. Finance companies must be registered. So before you get finance, check the business registration.
What Are Examples of Debt Financing?
Debt finance includes bank loans; loans from family and friends; government-backed loans, such as SBA loans; lines of credit; credit cards; mortgages; and equipment loans.
Conclusion
Most companies will need some form of debt financing. Additional funds allow companies to invest in the resources they need in order to grow. Small and new businesses, especially, need access to capital to buy equipment, machinery, supplies, inventory, and real estate. The main concern with debt financing is that the borrower must be sure that they have sufficient cash flow to pay the principal and interest obligations tied to the loan.
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