Debt financing is when a business collects funding for working capital by selling their debt to investors and/or finance companies. This type of financing entails selling any fixed income product such as notes, bills, or bonds. Additionally, the borrower will have a set maturity date with a fixed rate of interest for the cash that is borrowed. The lender determines loan agreements, and you can choose to repay them either in full or with partial payments until the borrowed principal amount is fully repaid. In contrast to equity financing, with debt financing businesses may borrow money without selling any ownership rights of the business away.
Types of Debt Financing
Debt financing can occur in various forms, such as: installment loans, revolving loans, cash flow loans, and many more. Installment loans give businesses a fixed amount of funding that must be repaid within scheduled payments. Each payment will be a portion of the principal loan amount plus interest on the balance due. Revolving loans give businesses access to a line of credit that is due for payment only when utilized, like a credit card. Lastly, lenders typically assess your future capability to repay cash flow loans, and these loans are usually unsecured. Additionally, you can choose to repay them with a percentage of the sales or over a predetermined period until the principal amount is fully paid off.
Advantages and Disadvantages of Debt Financing
Some advantages of debt financing include not having to give away any ownership rights of your business. Businesses remain in control and have the right to run and operate their business as they please. Another advantage is that you can choose the duration of the loan, and once the borrowed amount and interest is repaid, the relationship with the lender may end. In most cases, the interest on the debt is tax-deductible.
Debt financing disadvantages include a specific agreed-upon payback period and typically higher repayment costs compared to the average financing cost. Furthermore, a business is required to pledge assets as collateral until the loan is fully repaid. Regardless of how much revenue your business generates, you must make payments, which could be a downside to debt financing.
How this financing is measured
Normally, you measure debt financing using a debt-to-equity ratio (D/E). For example, if the total debt is $2 million, and the stockholder’s equity is $10 million, the debt-to-equity ratio would be 20%. This percentage comes from dividing the debt by the equity: $2 million / $10 million = 1/5. In other words, for every $1 of this financing, there will be $5 of equity.
Debt vs. Equity Financing
|The financers can borrow funds without needing to sell their shares of the company.||The company raises funds by selling shares to investors.|
|Businesses must repay the amount borrowed, plus interest.||Businesses have no or minimal obligation to repay the amount borrowed.
|Used for short-term financing.||Used for long-term financing.
|Falls under low-risk investments.||Falls under higher-risk investments.
|The debtor must pay a fixed and mandatory amount of interest.||Dividends are irregular as it depends on the profit earnings of the business.
|Security is necessary and required.||No security is necessary.|
It is a liability of the company.
It is an asset of the company.