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Summary: Learn how to grow your business through various debt financing options.
Debt Financing
Debt financing is the activity of raising capital for a business by selling debt instruments or taking on loans. Unlike equity financing, where investors receive stock in return for their investments, debt financing requires debt to be paid back, almost always with interest. When a company takes on a debt, it must make a legally binding promise of repayment of the capital and interest.
Once a business secures debt financing, it can use the money it borrows to fund its work. In this way, debt financing allows some businesses to grow, make large purchases, and build value so that they can pay back their debts and still record profits in the future.
Debt Financing Options
While the most common form of debt financing that people think of is a bank loan, there are other forms of debt financing available. These options different options include:
- Bank loans: Businesses can approach banks for loans to help their businesses. Banks will assess businesses’ financial stability and credit risk before offering loans of different amounts and rates of interest. When operating internationally this can be facilitated by overseas banking services.
- Business lines of credit: A business line of credit might be offered by a bank or other financial institution to provide capital to businesses. A line of credit has a set limit, which is the total amount the institution is willing to risk. However, a business can take out individual loans on the line of credit when needed and pay them back whenever possible. Each withdrawal is seen as an individual loan with its own interest level and repayment schedule.
- Private loans: Many small businesses take out small loans from their friends, family, and other associates. These private loans may be their only form of funding and may also be given at favorable rates. However, the businesses are still obligated to repay these loans as they would to a bank.
- Credit cards: A business credit card can allow a small business to borrow money in the short term from a credit card company. The period of these loans is usually very short (one month) before very high interest is accrued. Still, credit cards present opportunities for financing for businesses with low cash flows.
- Bond issues: Companies can also issue debt instruments like bonds to obtain capital for medium- or long-term use. A bond is simultaneously a certificate of debt and a promise of repayment. Bonds are secured by physical assets and other capital so that if they’re not repaid, the bondholder may recoup their investment. Bond interest is typically paid back in regular “coupon payments,” and the principal is paid upon maturity, which is often five or ten years after issue. This gives a company time to use the capital to build its business before it must repay its investors.
- Debenture issues: A debenture is technically a type of bond that is unsecured by collateral. It pays interest in coupon payments and repays the principal upon maturity like a normal bond. However, debentures are not backed by collateral and therefore carry higher risk but normally also higher interest rates than bonds.
Advantages of Debt Financing
Most businesses use debt financing at one time or another for the strategic advantages they can gain. These include:
- Tax benefits: Interest payments and even principal payments may be considered business expenses and can often be deducted from corporate income tax according to international accounting rules.
- Retaining ownership: Equity financing requires selling shares of the company to investors and, with them, control. In contrast, debt financing allows the owners to retain their equity and control over a business.
- Building credit: By taking on debt and repaying it on time, a business can build its ever-important credit rating. That may allow it to search out larger loans in the future.
Risks and Challenges of Debt Financing
There are also negative sides to debt financing. Some of them include:
- Interest obligations: Interest payments can be a big burden on a growing business.
- Impact on cash flow and credit rating: While debt financing can bring in large amounts of cash for business expenses initially, it will require constant cash outflows in the future. If interest isn’t paid on time, it can also damage the business’s credit rating, making it very difficult to secure loans in the future.
- Dependence: Taking on debt financing may lead to a cycle of dependency that a business is not able to get out of.
Strategies for Effective Debt Financing
Before a business decides to use debt financing, it should carefully consider its financial needs and ability to repay debts. It should choose an amount of debt it is sure it can repay by selecting both a reasonable principal for its needs and interest rates that it can manage to keep up with. This necessitates careful financial planning and risk assessment.
Balancing debt and equity financing can help a business avoid over-reliance on debt, which can also turn away potential investors.
Using Debt Financing to Raise Capital
Debt financing like issuing bonds or taking out loans can help a business secure funding without losing giving away equity. However, it also requires repayment and interest payments that can be difficult to manage. Each business needs to examine its needs carefully and choose to take on only the debt it can reasonably manage.
FAQ
Debt financing is recorded as a liability on a company’s balance sheet. With too much debt, a company can lose financial leverage and scare away investors.
Larger companies often issue bonds as debt instruments. For businesses of all sizes, bank loans are very common. Small and new businesses often focus on credit cards, lines of credit, and personal loans as their main options for debt financing.
