No business can exist without funds, be it a small startup business or SME. Funds help business owners to deliver their products and services efficiently. And this cuts across the various resources, especially human resources, in order to foster service delivery of the business. This is because you must pay your workers adequately and have necessary equipment to ensure a standardized delivery of products and services. Therefore, this more or less opens the spot where debt financing dwells in businesses.
As you read along, you’ll learn more about debt financing, how it works, types, etc.
What is Debt Financing?
When a company raises money by selling debt instruments is termed Debt financing. Especially in the form of bank loans or bonds. They usually refer to this type of financing as financial leverage. Moreover, loans from family and friends, government loans. Also, lines of credit, credit cards, mortgages and equipment loans are all forms of it.
How Debt Financing Works
Let’s see how debt financing really works in companies. There are three ways a company that needs money can get financing. They can do so by; selling equity, taking on debt or using a combination of the two.
Equity is an ownership stake in the company. As a shareholder of a company, equity gives you a claim on future earnings. But they do not need to pay the equity back to you. If the company goes bankrupt, you and other equity holders are the last in line to receive money.
A company can subscribe to selling fixed income products, such as bonds, bills, or notes as debt financing. They can sell them to investors to get the capital they need to grow and expand their operations. Investors who usually purchase bonds from companies are lenders who could either be institutional or retail investors. Thereby providing the company with debt financing.
They require the company to repay the amount of the investment loan (principal) in the future on a date they agree. But if the company goes bankrupt, the lenders will have a higher claim on any liquidated asset than shareholders.
What Are Types of Debt Financing?
It is important to know types of debt financing that exist, you’d never know if you could one day need it for your business.
The following are its types:
- Revolving loans
Revolving loans grant access to an ongoing line of credit a borrower can use, repay, and repeat. The example of a revolving loan is credit.
- Installment loans
Installment loans can be secured or unsecured. They usually have set repayment terms and monthly payments. They can also receive the loan amount as a lump sum payment upfront.
- Cash flow loans
This type of loan provides a lump-sum payment from the lender. As the borrower earns the revenue used to secure the loan, he or she then repays the loan. Examples of cash flow loans are; merchant cash advances and invoice financing.
What are the advantages of debt financing?
The following are the advantages:
- A business can leverage on a small amount of capital to create growth with debt financing.
- The company will still keep all ownership control.
- Generally, debt payments are tax deductible.
- Debt financing is usually less costly than equity financing.
What are its disadvantages?
The following are the disadvantages:
- It can be risky for businesses with inconsistent cash flow.
- Interest must be paid to lenders.
- They do not consider the business revenue as you must pay the debt you owe.
Is Debt Financing a Loan?
Because of how the definition of debt financing isn’t just like that of loans. You might wonder if it’s a loan. Yes, debt financing is a loan because loans are the most common forms of debt financing.
Is it Good or Bad?
In order to be on the safer side of financial decisions such as getting a debt financing or not. You would need to know whether it is good or bad to venture into debt financing. However, debt financing could be good and bad. This is because, if a company uses debt to grow their business, then it’s a good idea. But the company must ensure they’ll meet terms of repayment of the loans. Moreover, the cost of the capital of the company should help them decide what type of financing they should choose.
At some point in business dealings, debt financing could be a great option to try out. This is because it’s safer for some companies not to use their capital for other business expenses. Such as the purchase of machinery, equipment, inventory, real estate and so on. Therefore, they seek additional funds to make things work out without involving the money in their purse. So, this additional fund lets the companies invest in the resources they need in order to grow. Nevertheless, borrowers must ensure they have sufficient cash flow to pay the principal and interest that comes with it.