What is Debt financing?
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.
- 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.
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. It gives the shareholder a claim on future earnings, but it does not need to be paid back. If 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, such as bonds, bills or not, to investors to obtain the capital needed to grow 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—also known as the principal—must be paid back at some agreed date in the future. If the company goes bankrupt, lenders have a higher claim on any liquidate assets than shareholders.
Advantages of Debt financing
There are some advantages of debt financing :
1.Debt financing allows a business to leverage a small amount of capital to create growth
2. Debt payments are generally tax-deductible
3. A company retains all ownership control
4. Debt financing is often less costly than equity financing
Disadvantages of Debt financing
There are some disadvantages of debt financing :
1.Interest must be paid to lenders
2. Payments on debt must be made regardless of business revenue
3. Debt financing can be risky for businesses with inconsistent cash flow
Sources of Debt financing
Some important sources of Debt financing are:
Loans are the most common and popular mode of debt finance for a company. Businesses borrow money from commercial lenders like banks by keeping some collateral security against the loan. Loans from banks and other commercial lenders are for a fixed period, and business needs to pay regular interest for it. The loans can be for short, intermediate, or long-term, depending upon the financial requirements of the business.
2. Trade credit:
Trade credit is an arrangement in which the business can purchase the goods now and pay for them later. This way, the business can avail of debt financing for the short term. Trade credit is a good mode of finance for startups as they cannot afford to obtain loans of a higher amount by placing a collateral society.
3. Asset- based lender:
Asset-based lenders are those finance companies that lend money to the business for purchasing the assets. The business, in return, has to pledge its assets like inventory, accounts receivables, etc. This type of debt financing is very useful for businesses with higher inventory, account receivables, real estate, or any other asset that can be pledged.
Bonds are a source of debt capital for businesses that are well established and need funds for the business’s long-term growth. The company can raise funds by selling bonds to different buyers and sharing profits on the projects for which bonds are issued.
5. Insurance companies:
Insurance companies act as a major source of finance for small companies. They provide two types of loans to businesses: mortgage loans and policy loans. A mortgage loan can be avail by mortgaging any asset of the company. On the other hand, a policy loan is based on the amount of money that is paid in the form of a premium on the insurance policy.
These are few debt financing sources. There are numerous more debt financing instruments are accessible and available in the market. The business can choose any prospects after figuring out which source suits them the best. Need for different sources of debt financing will keep on increasing rapidly with the growing numbers of start-ups as well as small businesses.