Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In exchange for lending money, individuals or institutions become lenders and receive a promise that the principal and interest on the debt will be repaid.
Key things
Debt financing occurs when a company raises money by selling debt instruments to investors.
Debt financing is the opposite of equity financing, which involves issuing shares to raise money.
Debt financing occurs when a firm sells fixed-income products such as bonds, bills, or notes.
Unlike equity financing, where lenders receive equity, debt financing must be repaid.
Small and new companies in particular rely on debt financing to purchase resources to facilitate growth.
How debt financing works
When a company needs money, there are three ways to get financing: sell equity, take on debt, or use some hybrid of the two. Equity represents an ownership stake in the company. It gives the shareholder a right to future profit, but it does not have to be repaid. If a company goes bankrupt, stockholders are the last in line to receive money. Another way to raise capital in the debt markets is to issue shares in a public offering; this is called equity financing.
A company may choose debt financing, which involves selling fixed income products such as bonds, notes, or notes, to investors to raise the capital needed to grow and expand its operations. When a company issues a bond, the investors who buy the bond are creditors who are either retail or institutional investors who provide debt financing to the company. The investment loan amount – also known as the principal – must be repaid at some agreed date in the future. If a company goes bankrupt, creditors have a higher claim on liquidated assets than shareholders.
Special considerations
Cost of debt
A firm’s capital structure consists of equity and debt. The cost of equity is dividend payments to shareholders and the cost of debt is interest payments to bondholders. When a company issues debt, it not only promises to repay the principal amount, but also promises to compensate its bondholders by paying them annual interest, known as coupon payments. The interest rate paid on these debt instruments represents the cost of the loan to the issuer.
The sum of the cost of equity financing and debt financing is the company’s cost of capital. The cost of capital represents the minimum return a company must earn on its capital to satisfy its shareholders, creditors and other providers of capital. A company’s investment decisions regarding new projects and operations should always generate returns greater than the cost of capital. If a company’s returns on its capital expenditures are less than its cost of capital, the firm is not generating positive profits for its investors. In this case, the company may need to reassess and rebalance its capital structure.
The formula for the cost of debt financing is:
KD = interest expense x (1 – tax rate)
where KD = cost of debt
Since interest on debt is tax-deductible in most cases, interest expense is calculated on an after-tax basis to better compare with the cost of equity, since equity gains are taxed.
Measurement of debt financing
One metric used to measure and compare how much of a company’s capital is financed by debt financing is the debt-to-equity (D/E) ratio. For example, if total debt is $2 billion and total stockholders’ equity is $10 billion, the D/E ratio is $2 billion / $10 billion = 1/5, or 20%. This means that for every $1 of debt financing, there is $5 of equity. In general, a low D/E ratio is preferable to a high one, although some industries have a higher tolerance for debt than others. Both debt and equity can be found on the balance sheet.
Other types of debt financing
In addition to simply issuing a bond, here is a list of the more common types of debt financing. Note that some options may be more difficult for small businesses to secure, especially if they have not been in business for a long time or if their financial position is not as strong as that of larger companies.
Term Loans: Term loans involve borrowing a lump sum of capital from a bank or financial institution that must be repaid over a predetermined period of time. It can have fixed or variable interest rates. These loans are usually structured with regular monthly payments that include both principal and interest.
Lines of Credit: A line of credit is a flexible loan that gives businesses access to a certain amount of capital that can be drawn on as needed. It’s kind of like how a credit card works because businesses only pay interest on the funds they actually use. Lines of credit are particularly useful for managing cash flow, covering short-term operating costs and dealing with unexpected costs.
Revolving credit facilities: Revolving credit facilities work similar to lines of credit, but are usually larger and used by larger businesses. These facilities provide a pool of capital that the business can draw on and repay multiple times (but not exceed the credit limit up to a certain amount).
Equipment Financing: Equipment financing involves borrowing funds specifically for the purchase of critical equipment, with the equipment itself serving as collateral. This type of loan or lease allows businesses to acquire machinery, vehicles, technology and other assets necessary for operations without immediate cash outlays.
Merchant Cash Advances: Merchant cash advances provide businesses with a one-time payment in exchange for a percentage of future credit card sales. This type of financing is popular with businesses with high credit card transaction volumes that need cash now. However, business cash advances can come with higher costs compared to traditional loans.
Trade credit: Trade credit is a form of short-term financing provided by suppliers. This is when a company can buy something and pay for it 30 or 60 days later. This type of financing helps businesses manage the inventory and produce the goods they need to have the cash flow to pay the invoice.
Convertible Debt: Convertible debt is a hybrid form of financing where the loans can later be converted into equity in the company. A company may choose to issue a bond but give the holder the option to switch from debt financing to equity financing at a later date.
Importance of Debt financing
Debt financing is a vital tool for businesses seeking to fuel growth and manage operational needs without relinquishing ownership. By securing loans or issuing bonds, companies can access substantial capital required for expansion projects, purchasing new equipment, or entering new markets. This access to external funds enables businesses to undertake significant investments and strategic initiatives that might be otherwise out of reach if relying solely on internal cash flow or equity financing. Notably, debt financing allows business owners to retain full control and ownership, unlike equity financing, which demands giving up a portion of the company’s equity and decision-making power. This preservation of ownership is particularly valuable for entrepreneurs who wish to maintain their vision and control over the company’s direction.
In addition to enabling growth, debt financing offers several financial benefits, including tax advantages. The interest payments on debt are typically tax-deductible, which can reduce a company’s taxable income and overall tax liability, effectively lowering the cost of borrowing. Moreover, debt financing often involves fixed interest rates and structured repayment schedules, providing a predictable financial commitment that simplifies budgeting and cash flow management. This predictability helps businesses plan effectively and avoid financial strain, as they can forecast their obligations and align them with their revenue streams.
Furthermore, prudent use of debt can enhance a company’s financial leverage and return on equity. By utilizing borrowed funds, businesses can amplify the returns on their investments if the returns generated exceed the cost of the debt. This leverage can significantly boost profitability and shareholder value. Additionally, responsible management of debt, including timely repayments, can improve a company’s credit rating, making it easier to secure future financing on favorable terms. Overall, while debt financing presents opportunities for growth and financial management, it is essential for businesses to balance debt levels carefully to mitigate risks and ensure long-term financial health.
Bottom lines
In conclusion, debt financing is a powerful mechanism that enables businesses to access essential capital for growth, maintain ownership control, and benefit from financial advantages like tax deductions and predictable payments. By leveraging borrowed funds wisely, companies can enhance their profitability and return on equity while building a strong credit history for future opportunities. However, it’s crucial to manage debt responsibly to avoid excessive financial risk and ensure stability. When used strategically, debt financing not only supports immediate financial needs but also contributes to long-term success and competitive advantage in a dynamic market environment.
