What is debt financing? definition, pros and cons, types

What is debt financing?

Debt financing is essentially the act through which businesses borrow money or capital in order to fund their operations or grow the business. The money borrowed must be repaid according to the debt financing agreement or terms and must be paid with the interest. The amount of money borrowed is referred to as the debt capital and the interest paid on the debt capital is known as the cost of debt.

The amount borrowed, with interest added on top of it now forms the debt that must be repaid. These debts come with terms and conditions that must be followed, and failure to comply results in penalty fees or enforced liquidation.

Is debt financing a loan?

Yes, debt financing is a loan because it comes with interest that you have to pay back to the lenders either through profits of future sales or by selling off assets used for the business.
Loans are agreements between lenders and borrowers where the lender transfers money or resources to the borrower at some point in time with a condition that this sum will be paid back by a certain date. If payment fails, there may be penalties such as late charges or compound interest rates (which increase exponentially).

Defintion of Debt Financing in Business

Debt financing can be defined as one of the ways in which a business can raise funds or capital by borrowing from individuals or organizations. To further explain debt financing, is a method of raising capital that makes use of borrowing money from a bank or other lending institution. There are two main forms: a business can borrow the money to buy equipment, supplies, and other assets to grow revenues; alternatively, it can take out a loan for working capital – to pay salaries, rent, suppliers, etc., until its sales revenue comes in.

In both cases, lenders will hire an outside agency to assess the creditworthiness of the borrower – this process is called underwriting. In return for giving up their cash now, lenders will be repaid according to an agreed-upon schedule (called a term sheet, or debt note). This repayment could include interest paid by the borrower as well as a certain percentage of profits, called a dividend.

debt financing
The cost of debt financing can be measured

How do you calculate debt financing?

The formula for calculating the cost of debt financing is:
Cost of debt = Interest Expense x (1 – Tax Rate)

Characteristics

These simply refer to the features of debt financing and they are:

  • Debt financing involves a business borrowing capital
  • Typically debt financing requires the use of debt as a means of business financing
  • Debt financing is financing obtained from commercial banks, private institutions, credit unions, investment firms as well as through venture capital companies.
  • Debt financing refers to the ways through which businesses can finance through debt without parting with their equity or ownership.

Example

  1. Friends and family can decide to fund your business and in return you pay back the debt after the agreed period with any interest. This is one example of debt financing for small business.
  2. Another example of debt finance is the use of angel investors to fund the operations of a startup with the promise of converting the capital to equity.
debt financing 1

Pros and Cons of Debt financing

There are pros and cons of debt financing when used as a source of funding for your business operations or growth.

Advantages of debt financing

  • One of the major advantages of debt financing is that it allows you to have more control over your company’s destiny.
  • Another major advantage of debt financing is that it is easy to secure, and typically a business can get a loan approved within just a few days.
  • As an example in small business, you are using debt to finance future growth of your startup or small business.

These are just a few positives.

Why is debt financing good?

Debt finance is good especially for small businesses or startups because it is an easy way to raise money to fund operations.

Disadvantages of debt financing

It’s important to note that debt finance also has some disadvantages going for it.

  • One major risk of debt financing is that the lenders may seize the asstes or even takeover the business when there is a default.
  • A disadvantage of debt financing is businesses must make interest and principal payments whether they are profitable or not.
  • Too much debt financing means that a significant portion of a company’s cash flow could be going toward servicing debt, this means slower growth; imagine what happens when sales drop?
  • The owners of a business may use it to expand growth because more capital when channeled well can increase growth, however, in terms of equity, the use of debt financing increases the riskiness to owners.

The benefits and risks of debt financing depend solely on the type of business, the situation of the business, and the unpredictable circumstances that may arise in the future.

Debt financing vs Equity Financing vs Mezzanine Financing

The two principal sources of financing for corporations are debt and equity financing. Both have their pros and cons; what may be good for one company may not be of benefit to another depending on their situation. Here are the ways in which debt financing is different from both equity and mezzanine financing.

In debt finance who gets paid first?

In debt finance, lenders get paid first before shareholders because they take on the risk that the business might not succeed and be able to pay them back (loss-given default). However, if the business does succeed, shareholders don’t make any money until after lenders recoup their money.

With equity financing, there’s no set schedule for when investors get paid back; it will depend on how well the company performs over time.

Whereas with mezzanine financing, investors are somewhere in between: they may get paid first if the company doesn’t do well but later than creditors if it does well.

Businesses acquire long-term financing from two major sources, which are debt and equity financing.

Is debt or equity financing better?

Equity financing is better than debt financing for the business but not for the lenders because debt is typically backed by assets, so if your business fails, lenders have recourse against those assets if you are unable to repay your loan. Investors who finance a business through equity, on the other hand, are putting their money into an idea rather than a concrete asset. That means if your company tanks, they lose out on future profits that might have been derived from owning part of your company – essentially throwing away their money.
Therefore, for an investor, debt funding is better because you can sell the assets of the company to recover your money; this however is bad for the business. For a business, equity financing is better because the loan is tied to the equity, when the business fails, the equity of the investors becomes worthless; this is bad for the investors but good for the owner in some way.

How does debt financing work?

A company typically raises capital by obtaining loans from financial institutions such as banks, using the cash raised from those loans to finance any activities that generate earnings for future repayment of the loan, and then repay the principal amount on that loan with interest.

It is used in a wide variety of circumstances by different companies – some needing money quickly while others have a more long-term view of their finances. Smaller businesses usually negotiate favorable terms with local banks as they are seen as less of a risk than large multinational corporations, which can borrow more cheaply due to their stability. In cases where access to adequate working capital is limited, companies must resort to borrowing (and interest) to maintain their business.

Businesses that need significant amounts of capital for new projects or to expand their operations often turn to finance through debt. If the company’s management is confident they can repay the loan, then they may take on more funds than would be available if they relied solely on equity (or owners’ funds).
Borrowing is not without risks; increased levels of debt mean increased risks if the company fails to meet its repayment obligations. Interest payments must be paid regularly and on time, otherwise, interest rates are likely to increase. Furthermore, some loans have clauses that allow for cancellation of the loan at short notice by the bank, allowing them an easy way out of lending money should things go wrong.

Many companies use a mixture of both debt and equity to finance their operations (this is known as balanced financing). The exact mix varies from one company to another, depending on the investment opportunities available, the projected cash flows, and the desired level of financial leverage, which affects how much profit is retained within the business rather than paid out in dividends.

When to use debt financing

Assuming you have poor sales one quarter, debt financing enables you to invest in marketing efforts or add staff while still making payments on the debt, rather than having less money at your disposal as would be the case with equity financing.

Different types of debt financing

Debt financing is often used in business and can take many different forms; some are good for startups while others are for large companies, the different types of debt financing are the methods of raising debt finance and they include:

  • Bank loans, the primary source of corporate debt financing.
  • Venture Capital debt financing is good for small businesses or startups.
  • Friends and family (F&F), good for startups or small businesses.
  • Private Equity (PE) Funds – Angel investors, one of the sources of debt finance for entrepreneurs.
  • Government grants & subsidies are types of debt financing for large companies as well as small businesses that meet the requirements.

Debt finance also includes capital leases, securitizations, factoring, and other loan types as well.

Three general types of debt financing for small businesses

The common types of debt finance for small businesses are installment sales, revolving loans (or a line of credit), and government loans.

Installment sale

The first type, an installment sale, is defined as the purchase of goods or equipment for cash and then leasing them back over a period of time. Though it can be used to help with immediate capital needs, the risk is that the business might not have enough income to maintain payments during lean times. The amount of taxes owed on lease payments is also uncertain, especially if the payments are based on a percentage of income.

Lines of credit

The second type of debt financing, a line of credit or revolving loan, is available from a bank or other financial institution and allows for periodic draws of up to a specified limit. It functions as an open-ended credit card account in that there is no fixed repayment schedule. Interest is charged only on the amount used, many businesses use a line of credit to borrow money for operating expenses and other short-term needs during cash flow problems.

Government loans

A third common method is to secure a loan from a government agency or other organization. These loans sometimes come with easier qualifications than private loans and may have a fixed or flexible repayment schedule. Generally, it is easier for a smaller business to secure a loan from a government agency than it is to get one from a bank because of the small business’s lack of collateral and steady income stream.

Is stock a form of debt financing

Stock is not a form of debt financing. However, some stocks do pay dividends on a periodic basis to stockholders which are similar to interest payments on debt instruments like bonds and debentures. It should be noted that stocks typically sell at prices above or below the par value whereas debt finance cannot go above or below the par value.


Why are bonds considered a form of debt financing?

Bonds are a form of debt financing because they provide an organization with a way to raise capital quickly through selling pieces of paper that represent the investment in the organization. Bonds also retain a high perception of stability due to their low risk of default for organizations of all sizes. These factors make them a useful tool for raising money quickly while maintaining a lower cost of borrowing than other forms of financing such as equity or preferred shares.

Debt financing options

Various methods of borrowing money are common in the modern world, including bank loans, bonds, commercial paper, and debentures.

Why use debt financing?

Debt financing is employed by many different types of organizations in a variety of ways. Profit-making institutions will often use debt to invest in new projects or start-up new divisions. Non-profit organizations, on the other hand, will often use debt finance to expand their programs. Governments, finally, will employ the use of debt finance when they need to finance particularly expensive projects or in times of emergency.

FAQs on Debt Financing

What does debt financing mean?

Debt financing is a method of capitalization in which an organization borrows money from another party to finance its transactions; the borrowed money must be paid back plus interest within an agreed time. Financing through debt can come from individuals, business entities, or public entities such as governments. Organizations that use debt finance may be either profit-making or non-profit-making and their motivation is often based on anticipated return on investment.

What are the four types of debt financing?

The four types of debt financing are secured loans, unsecured loans, seller financing, and trade credit.

What are the main sources of debt financing for small businesses?

The main sources of debt financing for small businesses include family or friends, equity investors, and suppliers or customers.

Why is debt financing bad?

The major reason why debt financing is bad is that interest has to be paid overtime. This means that the company issuing the debts has a higher payment burden than those who have equity or increase revenues. Since it’s an increased payment burden, this reduces the ability of companies to spend money elsewhere like on Research and Development (R&D), advertising, and other investments that can help them grow faster in the future.

Is equity more expensive than debt?

Typically debt financing costs more than equity financing because lenders need to be compensated for the higher risk they take on when lending to a new business.

Is debt or equity riskier?

A business financed through debt is riskier because the owner has to repay creditors even if their business fails.

Is it better to have debt or equity?

Generally, equity financing is better than debt finance because equity financing is less risky (you only sacrifice part of the company, even if it fails, all shareholders share the loss), this makes it less expensive compared to debt finance which the entrepreneur pays interest plus the debt capital.

What are the risks associated with debt financing?

There are several risks associated with debt financing. The first is bankruptcy, which means the company cannot repay its creditors. This can happen for a number of reasons, but it is generally because the company does not bring in enough revenue. In addition, using debt finance can be risky if the company does not have enough revenue to pay back its creditors. Another risk is that there are fees and other costs associated with taking on a loan, which means fewer profits for the company.

How does debt financing affect the balance sheet?

A balance sheet is a financial statement that summarizes a company’s assets (what the company owns), its liabilities (what it owes), and the owners’ equity (how much of the company they own). Debt financing affects this balance by decreasing how much of the business the owners have. If more debt is taken on, then there will be larger interest fees paid in order to service that debt in future periods. Interest expense in turn decreases net income because more money is going out than is being earned. This decreases total equity which increases leverage ratios such as debt-to-equity ratio or times interest earned ratio (interest coverage ratio). Increasing these ratios increase risk exposure to creditors so this would not be an optimal move for most companies.

How can debt capital work to your advantage?

Typically, debt capital refers to money borrowed with the expectation that it will be paid back with interest.
When you own or operate a business, taking on debt capital works to your advantage when you use it strategically to grow your company’s value. Debt financing can achieve many goals of growing companies including buying equipment, inventory, and other assets. It also allows them the opportunity to expand their operations by hiring more employees. If everything goes accordingly, they are able to pay off the principal of the loan as well as any interest charges over time while reaping all of the benefits of having new assets at their disposal.

What is debt financing for startups?

It is common for startups to use debt finance during the early stages of their development due to low operational costs and high costs of equity-based financing. Debt finance provides access to capital in the near-term that can be invested in growing or expanding the business.

What are the sources of debt financing?

There are many sources of debt financing, but the most common source is through bank loans (and other financial institutions), others include family and friends, private investors, etc.

Which type of debt financing is a lease considered?

A lease is not considered debt financing; it does not meet the definition of debt finance even though leases are recorded as assets and liabilities. Leases pass on ownership rights to users, making them similar to purchased items that are recorded as assets. Debt financing refers to the loaning of money by lenders to either general governments or corporations under conditions where the loan is made up of interest-bearing money that will need to be paid back with additional amounts.

How can debt financing constrain managers?

Debt financing puts pressure on management to make sure all debts are paid back as soon as possible before any profits are made, which could lead to less funding for research and development (R&D), advertisement, etc, which can limit the growth of the business.

What is a convertible debt financing?

A convertible debt financing is a type of funding that allows the company to receive capital from investors at an early stage in return for equity at a later date.

Bill Reichert on Startupedia talks about “What is debt financing?”

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