Capital is required to manage the various operational costs of a business. Be it managing the day-to-day operations of a business or financing its expansion expenses, finance is required. While there are different ways of securing this capital, debt financing is one of the most common one businesses leverage, especially during their growth stages. During the growth and expansion stage, businesses need sizable capital for a longer duration. They can meet these requirements by borrowing funds from external sources through the various types of debt financing tools.
What is Debt Financing
Debt financing is the process whereby enterprises raise capital by selling debt instruments to individuals or institutional investors. The enterprise borrows money from external sources against an obligation to repay the principal amount plus interest within a stipulated time frame. Debt financing is an alternative to equity financing which entails issuing shares to investors in exchange for capital investments. Bonds, term loans, lines of credit, and invoice factoring are some of the most common types of debt financing tools leveraged by enterprises. The capital raised using debt financing methods is used to fund working capital requirements or substantial capital expenditures.
How Debt Financing Works
Understanding the meaning of debt financing helps clarify how the financing process works. When a company requires capital for funding day-to-day operations, expansion, or growth, it can choose from three primary financing options to raise said capital. It can either sell equity, take on debt, or leverage a hybrid form of both. If the company chooses the equity option, it will have to issue and sell shares to investors, who will consequently gain ownership stake in the company as well as claim on its future earnings. However, the capital raised through equity financing does not need to be repaid to the investor.
Conversely, if the company opts for debt financing, it will have to sell fixed-income products like bonds, debentures, and notes to investors to obtain the required capital or apply for business loans. The repayment structure may vary depending on the type of debt financing chosen. If the company sells debt instruments, the principal borrowed must be repaid on the agreed-upon future date, while interest payments happen at the applicable coupon rate. In case of loans, the loan agreement outlines the specific loan terms, including the applicable interest rate and repayment schedule. Typically, business loan payments start from the month after the principal amount is disbursed. However, lenders offer repayment flexibility to companies by providing them with multiple payment options. Depending on their convenience and cash flow requirements, enterprises can choose monthly installment (EMI) payments or bullet payments where the principal is repaid at the end of the term.
Types of Debt Finance
As mentioned earlier, there are various types of debt financing tools available at the disposal of enterprises. Access to different types of debt financing avenues helps companies choose the most suitable option depending on their needs and circumstances. Let’s have a closer look at the various types of debt financing modes:
Bank Loans
Bank loans are one of the most common types of debt financing tools available to businesses. Companies can borrow term loans from banks and NBFCs to finance their capital requirements and repay the borrowed sum over a predetermined tenure. The funding may be sanctioned at a fixed or floating rate and the repayment structure may vary. Enterprises can also avail short-term business loans to meet their working capital requirements. This type of debt financing generally comes with a relatively shorter tenure of 1 to 24 months.
Corporate Bonds and Debentures
Companies can also issue bonds and debentures to raise capital. The bond certificate outlines the principal sum borrowed, the maturity date, and the interest rate (coupon rate) applicable on the bond. When investors purchase these bonds, they become creditors for the company.
Mortgages
Mortgages are commonly used in the world of real estate as a form of debt financing. Here, a mortgage is secured by the home buyer and secured using the same property.
Convertible Notes
Convertible notes is a form of short-term debt financing tool that’s generally used by start-ups and early-stage companies. Under this type of hybrid financing option, the convertible notes issued by the company can be converted into equity shares in the company at a later date.
Lines of Credit
A line of credit is a type of flexible loan that offers businesses access to a specific amount of capital that can be drawn upon as needed. In simple words, businesses can flexibly withdraw funds up to a certain predetermined credit as and when needed, paying interest only on the borrowed amount.
Government Bonds
Backed by sovereign guarantee, government bonds are a common type of debt financing tool used by governments all over the world. The government issues bonds to retail investors to raise capital to fund various developmental and operational costs and pays interest to the bondholders on the borrowed funds. Depending on the type of bond in question, the interest rate may be fixed or floating.
Credit cards
Credit cards are a common type of debt financing option for individuals that allows them to borrow funds up to a certain pre-given credit limit. Business credit cards are also used by businesses to make or cover business expenses. However, business credit cards generally have a higher rate of interest than other types of debt financing tools, making them unsuitable for covering high-value business expenses.
Factoring
Factoring is a type of short-term debt financing option where businesses sell their accounts receivable to another party. The buyer pays the equivalent amount minus their commission charges. The funds obtained from the sale are then used to finance the business’s capital requirements.
Advantages of Debt Financing
The top advantages of debt financing are listed below:
- Ownership retention
One of the chief advantages of debt financing is its ability to preserve company ownership. Under equity financing, common and preferred shares are sold to investors giving them proportional equity ownership stakes and voting rights (available only to common shareholders). However, with debt financing, the business owners do not have to dilute their ownership stakes. They continue to retain control over the operations and decision-making processes of the company.
- Predictable repayment structure
Debt financing offers borrowers the benefit of a fixed and predictable repayment schedule. In other words, borrowers know when the EMIs (in case of loans) and principal sum plus interest (in case of bonds) are due. A clear and specific repayment schedule allows them to plan and budget to meet the fixed financial obligations.
- Immediate access to capital
Businesses with a strong cash flow seeking to expand operations can tap into various types of debt financing avenues to access capital immediately. They do not have to list shares and lose equity ownership in the company to access capital for growth.
- Leverage benefits
Leveraging is a significant advantage of debt financing. Raising capital through debt financing avenues allows businesses to leverage the small borrowed sum and invest the funds in projects with a higher return potential. This can mean greater profits for the enterprise if the returns on investment exceed the cost of borrowing.
- Lower tax liability
A primary advantage of debt financing is that businesses can claim tax deductions on the interest payments. Deducting interest from their overall taxable income helps lower the overall tax liability of a business.
Disadvantages of Debt Finance
Despite the many advantages of debt financing, using debt avenues to raise capital can also have the following disadvantages:
- Interest payments
Mandatory interest payments on debt financing instruments means that the amount paid to the lender will be more than the amount borrowed. In other words, a significant portion of the company’s revenue goes towards servicing its debt compromising the flexibility of the business. In the absence of debt, the business could have used these funds to pursue other investment options that promote growth.
- Fixed repayment obligations
As mentioned earlier, the fixed repayment obligations of debt financing must be met regardless of the business revenue. This can be particularly challenging for new businesses that have yet to establish a secure and stable cash flow. It can also affect established firms during periods of market down-turns and economic uncertainties.
- Higher chances of insolvency
There is a possibility of insolvency if the business has an inconsistent cash flow and fails to meet its debt obligations. Apart from bankruptcy, defaulting on loan payments can also negatively impact the credit score of the firm, making it difficult to secure credit in the future.
- Collateral requirements
Secured business loans require collateral which may be seized by the lender if the business defaults on the loan. Insufficient collateral can also restrict the loan amount for businesses.
- Interest rate risk
The cost of debt financing is tied to the prevailing interest rates in the market. If the rates rise, the cost of borrowing also rises, making debt financing more expensive for the borrower.
Short-term Debt Financing
Businesses leverage short-term debt financing avenues to secure capital to meet their working capital requirements for their day-to-day operations. Working capital may be required to pay wages and salaries, buy inventory, or fund maintenance and supplies. MSMEs can choose from different types of debt financing for the short-term including lines of credit and a short-term working capital loan. A line of credit must be secured using a collateral, while a working capital loan may be secured or unsecured. Generally, such loans need to be repaid within 24 months.
Long-term Debt Financing
Generally, long-term debt financing is required to access substantial capital amounts to fund expenses like purchasing assets, equipment, property, and machinery. The repayment for the loan can be spread over a longer tenure, making long-term debt financing more manageable than short-term debt financing options.
Measuring Debt Financing
Now that you know all about the meaning of debt financing and its various advantages and disadvantages, it’s time to understand how debt financing is measured. The debt-to-equity ratio is a commonly used metric when trying to measure debt financing of a company. The debt-to-equity ratio of a company outlines how much capital of the company’s capital has been raised through debt financing and how much has been raised through equity financing. For instance, if the total debt of a company is Rs. 3 Crores and the total equity held by shareholders is Rs. 15 Crore, then the debt-to-equity ratio for the company will be 1:5. When converted into a percentage, this translates to 20%. While certain industries may have a higher tolerance for debt, generally, a low debt-to-equity ratio is considered favourable. Too much debt can negatively impact the company’s financial ratios and balance sheet.
Debt Financing: Examples
Let’s take an example to understand the meaning of debt financing. Suppose, Company ABC Ltd. is a cement manufacturing company looking to open new branches. It opts for a term loan worth Rs. 10 Lakhs from a bank at a 6% interest rate for a period of 5 years. Since the company has a steady cash flow, it opts for an EMI repayment structure. Over the next 60 months, ABC Ltd. pays fixed EMIs chipping away at both principal and interest amounts. At the end of 5 years, the loan repayment is completed.
Conclusion
Debt financing is a pivotal financing tool available to businesses. Companies can leverage various types of debt financing options like bank loans, issuing bonds, lines of credit, and factoring to finance their capital requirements. Advantages of debt financing like retaining ownership, tax benefits, and leverage make it an attractive financing option over equity financing. However, businesses with an unsteady cash flow should be careful with debt financing as defaulting on payments can impact their credit ratings and result in insolvency.
Frequently Asked Questions
Is debt financing good or bad?
Debt financing is generally good for most MSMEs. It is a good option for companies that want to stimulate growth without giving up ownership stakes. However, businesses should be careful about keeping their repayment obligations.
Which is better: debt financing or equity financing?
It depends entirely on the needs of the company and its prioritises. Generally, debt financing is considered better than equity financing because the latter involves dilution of ownership stake in the company to secure capital. However, the final choice depends on the company’s financials, long-term goals, and growth stage.
What are the benefits of debt financing?
The chief advantages of debt financing include ownership retention, lower tax liability, leveraging benefits, and immediate access to capital.
What are the instruments of debt financing?
Common types of debt financing instruments include bank loans, bond issuance, lines of credit, factoring, and convertible notes.
