How does Debt Financing work?
When a company raises money by selling debt devices, most commonly in the form of bank loans or bonds
What is Debt Financing?
A company raises money by selling debt instruments like bank loans or bonds. It is a type of financing known as financial leverage.
That results in a company promising to pay back, which incurs the interest cost. Then the company can use the borrowed to pay its capital expenditure or work capital.
Usually, a well-established business that has constant sales, tight security, and profitability depends on debt financing.
The new start-ups that face insecurity in the business in the future or higher profitability also with a lower credit rating will look for equity financing.
Debt Financing Options
- Bank loan
A common form of debt financing is a bank loan. Banks will often assess the individual financial situation of each company and offer loan sizes and interest rates accordingly.
2. Bond issues
Another form of debt financing is bond issues. A traditional bond certificate includes a principal value, a term by which repayment must complete, and an interest rate. Individuals or entities that purchase the bond become creditors by loaning money to the business.
3. Family and credit card loans
Other debt financing means taking loans from family and friends and borrowing through a credit card. They are familiar with start-ups and small businesses. It would help if you were ready with the necessary documents if they want to ensure the viability of your business.
Debt Financing Over the Short-Term
Entrepreneurs use short-term finances to purchase inventory and other day-to-day running expenses to cover their work capital shortage, including wages and maintenance expenses. The loan repayments typically take a year.
Short-term financing helps businesses that struggle to maintain a positive cash flow (Their expenses are higher than their income) but are secure with collateral.
Debt Financing Over the Long-Term
Long-term debt financing is for businesses that want to purchase land, buildings, and machinery, but whatever they buy goes with the loan as collateral. The repayment of loans usually goes up to 10 years with a fixed interest rate and obvious monthly payments.
Advantages of Debt Financing
1. Preserve company ownership
You will not lose ownership, unlike equity financing. It would help to sell shares to investors who retained the business’s equity position. Then they get the shareholder voting rights, and the owner receives reduced ownership.
Debt capital is making the loan payments back to the lender with interest, and once that finishes, the complete ownership remains with the owner.
2. Tax-deductible interest payments
The interest payments you make on the loans are deductible from the tax, reducing your tax liability. The principal payment and the interest are the same and paid at a regular amount, which helps in making financial decisions like setting a budget and financial planning.
Disadvantages of Debt Financing
1. The need for regular income
The business owners need to ensure that the business is making enough income to cover their commitment to paying back the loan, the principal payment, and the interest.
The lenders want the business to post their assets as a security to save them from losing money if the company cannot make enough money to pay back the principal and the interest as agreed.
2. Adverse impact on credit ratings
If the business fails to pay back the loan installments on time could affect its credit ratings and harm the company in the long run. It will become impossible for future borrowings.
3. Potential bankruptcy
When the business owner gives the assets as security, the lender could face many issues later if the borrower cannot pay back the loan. And might come to a stage of losing the business and personal assets.