Debt Financing

What Is Debt Financing?

Debt financing happens when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise that the principal and interest on the debt will be repaid. The other method for bringing capital up in debt markets is to issue shares of stock in a public offering; this is called equity financing.

How Debt Financing Works

When a company needs money, there are three methods for getting 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 claim on future earnings, yet it does not need to be paid back. On the off chance that the company goes bankrupt, equity holders are the last in line to receive money.

A company can choose debt financing, which entails selling fixed income products, like bonds, bills, or notes, to investors to get the capital needed to develop and expand its operations. When a company issues a bond, the investors that purchase the bond are lenders who are either retail or institutional investors that provide the company with debt financing. The amount of the investment loan — otherwise called the principal — must be paid back at some agreed date from now on. In the event that the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.

Special Considerations

Cost of Debt

A firm's capital structure is made up of equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. When a company issues debt, besides the fact that it promises to repay the principal amount, it likewise promises to compensate its bondholders by making interest payments, known as coupon payments, to them yearly. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer.

The sum of the cost of equity financing and debt financing is a company's cost of capital. The cost of capital represents the base return that a company must earn on its capital to fulfill its shareholders, creditors, and other providers of capital. A company's investment decisions relating to new projects and operations should continuously generate returns greater than the cost of capital. In the event that a company's returns on its capital expenditures are below its cost of capital, the firm isn't generating positive earnings for its investors. In this case, the company might need to re-evaluate and re-balance 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 the interest on the debt is tax-deductible much of the time, the interest expense is calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed.

Measuring Debt Financing

One metric used to measure and compare the amount of a company's capital is being financed with debt financing is the debt-to-equity ratio (D/E). For example, on the off chance that 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 for every $1 of debt financing, there is $5 of equity. In general, a low D/E ratio is preferable to a high one, albeit certain industries have a higher tolerance for debt than others. Both debt and equity can be found on the balance sheet statement.

Creditors tend to approve of a low D/E ratio, which can increase the likelihood that a company can get funding from now on.

Debt Financing versus Interest Rates

Some investors in debt are just interested in principal protection, while others need a return as interest. The rate of interest is determined by market rates and the creditworthiness of the borrower. Higher rates of interest infer a greater chance of default and, therefore, carry a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk. In addition to paying interest, debt financing often requires the borrower to adhere to certain rules regarding financial performance. These rules are referred to as covenants.

Debt financing can be difficult to get. However, for some companies, it provides funding at lower rates than equity financing, especially in periods of historically low-interest rates. Another advantage to debt financing is that the interest on the debt is tax-deductible. In any case, adding too much debt can increase the cost of capital, which reduces the present value of the company.

Debt Financing versus Equity Financing

The primary difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation. Debt financing must be repaid, yet the company does not have to give up a portion of ownership to receive funds.

Most companies use a combination of debt and equity financing. Companies choose debt or equity financing, or both, depending on which type of funding is most easily accessible, the state of their cash flow, and the importance of keeping up with ownership control. The D/E ratio shows how much financing is obtained through debt versus equity. Creditors tend to approve of a relatively low D/E ratio, which benefits the company on the off chance that it needs to access additional debt financing from now on.

Advantages and Disadvantages of Debt Financing

One advantage of debt financing is that it allows a business to leverage a small amount of money into a lot larger sum, enabling more rapid growth than could otherwise be possible. Another advantage is that the payments on the debt are generally tax-deductible. Additionally, the company does not have to give up any ownership control, similarly as with equity financing. Because equity financing is a greater risk to the investor than debt financing is to the lender, debt financing is often less costly than equity financing.

The principal disadvantage of debt financing is that interest must be paid to lenders, and that means that the amount paid will exceed the amount borrowed. Payments on debt must be made regardless of business revenue, and this can be especially risky for smaller or newer businesses that have yet to establish a secure cash flow.

Debt financing includes bank loans; loans from family and friends; government-backed loans, for example, SBA loans; lines of credit; credit cards; mortgages; and equipment loans.

What Are the Types of Debt Financing?

Debt financing can be as installment loans, revolving loans, and cash flow loans.

Installment loans have set repayment terms and regularly scheduled payments. The loan amount is received as a lump sum payment upfront. These loans can be secured or unsecured.

Revolving loans provide access to an ongoing line of credit that a borrower can use, repay, and repeat. Credit cards are an example of revolving loans.

Cash flow loans provide a lump-sum payment from the lender. Payments on the loan are made as the borrower earns the revenue used to secure the loan. Merchant cash advances and invoice financing are examples of cash flow loans.

Is Debt Financing a Loan?

Yes, loans are the most common forms of debt financing.

Is Debt Financing Good or Bad?

Debt financing can be both good and bad. On the off chance that a company can use debt to stimulate growth, it is a good option. However, the company must be sure that it can meet its obligations regarding payments to creditors. A company should use the cost of capital to decide what type of financing it should choose.

The Bottom Line

Most companies will need some form of debt financing. Additional funds allow companies to invest in the resources they need to develop. Small and new businesses, especially, need access to capital to buy equipment, machinery, supplies, inventory, and real estate. The fundamental concern with debt financing is that the borrower must be sure that they have sufficient cash flow to pay the principal and interest obligations tied to the loan.

Highlights

• Debt financing happens when a company raises money by selling debt instruments to investors.
• Small and new companies, especially, rely on debt financing to buy resources that will facilitate growth.
• Unlike equity financing where the lenders receive stock, debt financing must be paid back.
• Debt financing is the opposite of equity financing, which entails giving stock to raise money.
• Debt financing happens when a firm sells fixed income products, like bonds, bills, or notes.