What Is Debt Financing?

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What Is Debt Financing?

Let me explain debt financing directly: it's when a company raises money for working capital or big purchases by selling debt instruments to individuals or institutional investors. You, as the investor, become a creditor, and in return, the company promises to repay the principal plus interest.

Key Takeaways

Debt financing means borrowing money through tools like bonds or loans that you have to pay back with interest. It's not like equity financing where you issue stock and give up some ownership; here, the company keeps full control but must repay no matter what. You'll see upsides like tax breaks and maintaining control, but too much debt can restrict your options and deter future funding.

How Debt Financing Works

When a company needs cash, it has three main options: sell equity, take on debt, or mix them. Equity gives investors ownership and a claim on earnings without repayment, but they're last in line if things go bankrupt. You could issue stock publicly for equity financing. With debt financing, the company sells fixed-income products like bonds, bills, or notes to get capital for growth. Buyers of these bonds are lenders providing the funds. The principal must be repaid by an agreed date, and lenders get priority over shareholders in bankruptcy. I want you to understand that this setup gives lenders security through higher claims on assets.

Special Considerations

Several factors affect debt financing, starting with the cost of debt. A company's capital structure includes equity and debt; equity costs come from dividends, debt from interest to bondholders. When issuing debt, the company repays principal and makes annual coupon payments, which are the interest. This interest rate is the borrowing cost. Together, equity and debt costs make up the cost of capital, the minimum return needed to satisfy providers. Your investment decisions should yield more than this cost; otherwise, you're not earning positively, and you might need to adjust your structure.

The Formula for Cost of Debt

The cost of debt formula is KD = Interest Expense x (1 - Tax Rate), where KD is the cost of debt. Since interest is usually tax-deductible, we calculate it after-tax to compare with equity costs.

Measuring Debt Financing

To measure debt in capital, use the debt-to-equity ratio (D/E). If debt is $2 billion and equity $10 billion, D/E is 0.2 or 20%, meaning $5 equity per $1 debt. Lower ratios are better, though some industries handle more debt. You'll find these on the balance sheet. Creditors like low D/E, improving future funding chances.

Other Types of Debt Financing

Beyond bonds, there are various debt options, some tougher for small or new businesses. Term loans give a lump sum repaid over time with fixed or variable rates, usually monthly. Lines of credit offer flexible access like a credit card, paying interest only on what's used—great for cash flow. Revolving credit facilities are similar but larger, with a limit you can draw and repay repeatedly. Equipment financing borrows specifically for assets, using them as collateral. Merchant cash advances provide upfront cash for a cut of future sales, costly but quick. Trade credit lets you buy now and pay later, aiding inventory. Convertible debt starts as a loan but can turn into equity later.

Debt Financing vs. Interest Rates

Investors in debt might seek principal protection or interest returns. Rates depend on market conditions and borrower credit; higher rates mean higher default risk. Debt often requires covenants on financial performance. It's harder to get but cheaper than equity in low-rate times, with tax-deductible interest. Too much debt raises capital costs and lowers company value.

Debt Financing vs. Equity Financing

Equity gives capital without repayment but dilutes ownership. Debt must be repaid but keeps ownership intact. Companies mix them based on access, cash flow, and control needs. A low D/E ratio helps with future debt.

Advantages and Disadvantages of Debt Financing

Debt lets you leverage small amounts into big growth and offers tax-deductible payments. You keep full ownership and control, unlike equity. It's often cheaper long-term, ending obligations once repaid. But you pay interest, exceeding the borrowed amount, and must pay regardless of revenue—risky for unsteady businesses. High debt hurts ratios, raises future costs, limits flexibility, and includes covenants restricting actions.

Pros

Leverages small capital for growth
Payments are tax-deductible
Retains ownership control
Often less costly than equity

Cons

Interest must be paid
Payments required regardless of revenue
Risky for inconsistent cash flow

What Are Examples of Debt Financing?

Examples include bank loans, family loans, SBA loans, lines of credit, credit cards, mortgages, and equipment loans.

What Are the Types of Debt Financing?

Types are installment loans with fixed terms and payments, revolving loans like credit cards for ongoing access, and cash flow loans like merchant advances repaid from revenue.

Why Would a Company Choose Debt Over Equity?

To avoid diluting ownership and because debt can be cheaper without ongoing dividends.

Is Debt Financing Good or Bad?

It can be good for growth if you meet payments, but use cost of capital to decide.

The Bottom Line

Most companies need debt to grow, buying essentials like equipment. Ensure you have cash flow for repayments.

What Is Debt Financing?

Highlights