What Is Debt Financing?
Debt financing is the process through which a company generates funds for working capital or capital expenditures by selling debt instruments to people and/or institutions. Those who lend money become creditors, and they obtain a promise that the principle and interest on the loan will be returned in exchange for their generosity.
Equity financing is a method of raising funds in the debt markets that differs from issuing shares of stock in a public offering.
How Debt Financing Works
When a corporation is in need of money, it can receive it through one of three methods: selling equity, taking on debt, or a combination of the two methods. Equity signifies an ownership share in the firm. In exchange for the investment, the shareholder receives a claim on future earnings, which does not have to be repaid. In the event of a company’s bankruptcy, equity investors are the last to get any compensation.
When a firm chooses debt financing, it is offering fixed income products to investors in order to raise the cash it needs to grow and expand its operations. Debt financing is one of the most common types of financing available to businesses. When a corporation issues a bond, the investors who acquire the bond are lenders, who are either retail or institutional investors that provide debt financing to the firm in the form of the bond purchase. The amount of the investment loan—also known as the principal—must be repaid at some future date that has been previously agreed upon. The lenders have a greater claim on the firm’s liquidated assets than the shareholders if the company goes bankrupt.
Debt Financing Options
A common form of debt financing is a bank loan. Banks will often assess the individual financial situation of each company and offer loan sizes and interest rates accordingly.
2. Bond issues
Another form of debt financing is bond issues. A traditional bond certificate includes a principal value, a term by which repayment must be completed, and an interest rate. Individuals or entities that purchase the bond then become creditors by loaning money to the business.
3. Family and credit card loans
Other means of debt financing include taking loans from family and friends and borrowing through a credit card. They are common with start-ups and small businesses.
Debt Financing Over the Short-Term
Businesses use short-term debt financing to fund their working capital for day-to-day operations. It can include paying wages, buying inventory, or costs incurred for supplies and maintenance. The scheduled repayment for the loans is usually within a year.
A common type of short-term financing is a line of credit, which is secured with collateral. It is typically used with businesses struggling to keep a positive cash flow, such as start-ups.
Debt Financing Over the Long-Term
Businesses seek long-term debt financing to purchase assets, such as buildings, equipment, and machinery. The assets that will be purchased are usually also used to secure the loan as collateral. The scheduled repayment for the loans is usually up to 10 years, with fixed interest rates and predictable monthly payments.
Advantages of Debt Financing
Because debt financing does not involve taking an ownership stake in your company, it has several advantages over equity financing. You maintain complete ownership, and the lender has no influence on the day-to-day operations of the firm.
As a business expense, debt interest expenses are entirely deductible. In the event of long-term financing, the payback period can be stretched over a number of years, decreasing the amount of money paid each month in interest charges. The interest expenditure is a predictable amount that may be used for budgeting and business planning reasons, assuming the loan does not have a fluctuating interest rate. Other advantages are as follows:
- Builds up business credit
- Provides leverage for owners’ equity
- Gives stability in budgeting and planning for future
- Long-term debt can eliminate reliance on more expensive short-term options
Disadvantages of Debt Financing
Banks typically ask that assets belonging to the company be pledged as collateral for the loan in order to get extended funding. If the business does not have adequate collateral (as is frequent with small firms), the lender will seek personal guarantees from the business owners in order to continue lending to them. The Small Business Administration (SBA) states that:
Because you are the business owner, you are personally liable for the loan repayment, regardless of whether your company is incorporated. If your company is unable to make loan payments, the bank may be entitled to confiscate any personal assets you pledged as security, such as your home, vehicle, or investment accounts.
For businesses using debt finance, the set payback schedule and high cost of loan repayment might make it difficult for them to grow their operations. Capital is invested in the firm in exchange for ownership interests. Equity financing is a type of debt financing. There is no set payback timetable, and investors are often looking for a high rate of return on their money over the long term.
You must have a great business plan in place before any lender or investor would consider lending you money or investing in your company. If your company is in need of debt financing or equity investment, you must first develop a sound business plan. This comprises financial information about your company, such as an income statement, cash flow estimates, and a balance sheet, among other things.