Debt financing occurs when a company raises money by selling debt instruments, most commonly in the form of bank loans or bonds. Such a type of financing is often referred to as financial leverage.
As a result of taking on additional debt, the company makes the promise to repay the loan and incurs the cost of interest. It can then use the borrowed money to pay for large capital expenditures or fund its working capital. In general, well-established businesses that demonstrate constant sales, solid collateral, and are profitable will rely on debt financing.
On the other hand, newly launched businesses that face uncertainty in the future or businesses with high profitability but lower credit ratings will more likely rely on equity financing.
Debt financing is also referred to as financial leverage.
The cost of debt is the interest charged.
Debt financing preserves company ownership, and the interest paid is tax-deductible.
Debt Financing Options
1. Bank loan
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 (expenses are higher than current revenues), 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
1. Preserve company ownership
The main reason that companies choose to finance through debt rather than equity is to preserve company ownership. In equity financing, such as selling common and preferred shares, the investor retains an equity position in the business. The investor then gains shareholder voting rights, and business owners dilute their ownership.
Debt capital is provided by a lender, who is only entitled to their repayment of capital plus interest. Hence, business owners are able to retain maximum ownership of their company and end obligations to the lender once the debt is paid off.
2. Tax-deductible interest payments
Another benefit of debt financing is that the interest paid is tax-deductible. It decreases the company’s tax obligations. Furthermore, the principal payment and interest expense are fixed and known, assuming the loan is paid back at a constant rate. It allows for accurate forecasting, which makes budgeting and financial planning easier.
Disadvantages of Debt Financing
1. The need for regular income
The repayment of debt can become a struggle for some business owners. They need to ensure the business generates enough income to pay for regular installments of principal and interest.
Many lending institutions also require assets of the business to be posted as collateral for the loan, which can be seized if the business is unable to make certain payments.
2. Adverse impact on credit ratings
If borrowers lack a solid plan to pay back their debt, they face the consequences. Late or skipped payments will negatively affect their credit ratings, making it more difficult to borrow money in the future.
3. Potential bankruptcy
Agreeing to provide collateral to the lender puts their business assets at risk, and sometimes even their personal assets. Above all, they risk potential bankruptcy. If the business should fail, the debt must still be repaid.