Debt financing occurs 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 way to raise capital is by issuing shares of stock in a public offering; this is called equity financing.
Key Takeaways
- Debt financing occurs when a company raises money by selling debt instruments to investors.
- Debt financing is the opposite of equity financing, which entails issuing stock to raise money.
- Debt financing occurs when a firm sells fixed income products, such as bonds, bills, or notes.
- Unlike equity financing where the lenders receive stock, debt financing must be paid back.
- Small and new companies, especially, rely on debt financing to buy resources that will facilitate growth.
Fueling Growth: How Debt Financing Works
When a company needs money, there are three ways to obtain financing: sell equity, take on debt, or use some hybrid of the two. Equity represents an ownership stake in the company, giving shareholders a claim on future earnings without needing to be paid back. If the company goes bankrupt, equity holders are the last in line to receive money.
Opting for debt financing entails selling fixed income products, such as bonds, bills, or notes, to investors to obtain needed capital. When a company issues a bond, the investors that purchase the bond are lenders providing the company with debt financing. The principal must be paid back by an agreed future date. If the company goes bankrupt, lenders have a higher claim on any liquidated assets than shareholders.
Cost of Borrowing: Special Considerations
Cost of Debt
A firm’s capital structure comprises equity and debt. The cost of equity is the dividend payments to shareholders, and the cost of debt is the interest payment to bondholders. Issuing debt involves promising to repay the principal repay amount and compensate bondholders through interest payments, known as coupon payments, annually. The interest rate paid on these instruments represents the cost of borrowing.
The sum of the cost of equity financing and debt financing is a company’s cost of capital, reflecting the minimum return a company must earn to satisfy shareholders, creditors, and other capital providers. Investment decisions should generate returns above this cost.
The formula for the cost of debt financing is:
KD = Interest Expense x (1 - Tax Rate)
where KD = cost of debt
Since interest on debt is usually tax-deductible, it’s calculated on an after-tax basis for comparability with equity costs, as earnings on stocks are taxed.
Gauging Impact: Measuring Debt Financing
One metric to measure and compare a company’s capital financed through debt is the debt-to-equity ratio (D/E). For example, if 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. A low D/E ratio is generally preferable, although industry benchmarks vary. This ratio can influence future funding likelihood positively by signaling fiscal responsibility.
Navigating Interest Rates and Debt Financing
Some debt investors prioritize principal protection, while others seek returns via interest. Interest rates are dictated by market conditions and borrower creditworthiness. Higher rates imply a greater default risk and, thus, are compensated by higher interest. Borrowers must often comply with financial performance covenants.
For many companies, debt financing offers funding at lower rates than equity, especially during low-interest periods. An advantage is that debt interest is tax-deductible. Nevertheless, excessive debt can increase capital costs and reduce the company’s present value.
Weighing Options: Debt Financing vs. Equity Financing
The main difference between debt and equity financing is that equity provides additional working capital without a repayment obligation, while debt must be repaid. However, equity financing requires giving up some ownership to obtain funds.
Most companies use a mix of debt and equity financing. A company’s decision hinges on accessible funding types, cash flow states, and ownership control importance. Debt-to-equity ratios spotlight these financing strategies, influencing lender perceptions and future access to debt.
Pros and Cons: Advantages and Disadvantages of Debt Financing
Advantages
- Allows leveraging capital for growth
- Payments generally tax-deductible
- Company retains ownership control
- Often less costly than equity financing
Disadvantages
- Interest payments exceeding borrowed amount
- Obligatory payments irrespective of revenue
- Risky for businesses with inconsistent cash flow
Common Questions: Debt Financing FAQs
What Are Examples of Debt Financing?
Debt financing includes bank loans, loans from family and friends, government-backed loans, such as SBA loans, lines of credit, credit cards, mortgages, and equipment loans.
What Are the Types of Debt Financing?
- Installment Loans: Set repayment terms and monthly payments.
- Revolving Loans: Ongoing line of credit, e.g., credit cards.
- Cash Flow Loans: Payments tied to borrower revenue.
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. If it stimulates growth that meets payment obligations, it’s beneficial. Companies must evaluate their ability to meet principal and interest payments.
Conclusion
Most companies will require debt financing at some point to fund necessary growth resources. For small and new businesses, access to capital is vital for acquiring equipment, inventory, and real estate. The essential consideration should be the company’s capacity to manage the debt and ensure cash flow sufficiency for meeting obligations.
Related Terms: Debt Instruments, Equity Financing, Cost of Debt, Debt-to-Equity Ratio.
References
- Corporate Finance Institute. “Debt Financing”.
