What Is Debt Financing? (With Advantages And Disadvantages)
Updated 30 September 2022
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Debt financing is the acquisition of capital from lenders to support various business operations. Companies repay the loan principal with interest at a later date and use this instrument to maintain a complete control over the business. Learning about debt financing can help you understand why companies use this financing option to pursue an aggressive growth strategy. In this article, we provide the answer to the question "What is debt financing?", discuss its various types and explain some of its advantages and disadvantages.
What Is Debt Financing?
The answer to the question "What is debt financing?" helps you to understand the nuances of this financing option, which companies utilise to pay for capital expenses or fund their working capital. A company pursues a debt financing option to improve its business earnings by recovering its cost and retaining its surplus, thereby benefiting its proprietors. Companies may borrow money from financial institutions, governments, individuals or suppliers. Enterprises opt for debt financing because it is relatively cheap and parties fix the debt interest in advance.
With debt financing, companies can efficiently plan their finances and enjoy a tax advantage, which helps them improve their firm's value. A company may lose some of its assets if it is not able to repay the loans, but with debt financing, it does not lose its corporate control to outsiders. Debt financing also helps organisations with credit maintenance, which means that the creditworthiness of a company enhances when it establishes a continuity of debt borrowing. If it is necessary for a company to take a loan, its creditworthiness can be beneficial in achieving a competitive interest rates from banks.
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Types Of Debt Financing
There are many types of debt financing available to business owners, which include the following:
Cash flow lending
When a bank issues a loan to a company, it analyses the organisation's credit history, assets and profits. This helps it minimise the risk of losing money by evaluating the company's future capacity to repay the loan amount. Cash flow lending works similarly, where lenders assess a company's cash flow instead of their assets to determine the viability of the loan. The factors for cash flow lending also include the frequency of transactions and sales figures of a business.
Small business loan
When small business owners start their companies, they require credit to support the costs of operations. They may get a loan from a government agency for the growth of their business. This business loan offers flexible repayment options. Some schemes also offer collateral-free loans, which means that a lender does not require any guarantee from the borrower. Small business loans help companies to do business with ease and also enable the government to generate income, create employment and promote economic growth.
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Recurring revenue loans
Recurring revenue loans offer companies a flexible repayment option based on the company's revenue history and gross profit margin. To pay off this loan, a company gives a percentage of its monthly revenue. There are several factors that lenders consider before issuing such loans, like assessing a company's existing revenue traction, analysing its revenue growth and evaluating its customer retention. With this type of debt financing, a company's revenue becomes a tradable asset.
Financial institutions, like banks, issue conventional loans. To get such loans, it is necessary for a company to fulfil strict requirements, like possessing credit and long-term investment history. Established companies are more likely to get such loans from banks. These are usually long-term loans that banks issue for various purposes, such as hiring new staff or purchasing equipment. Conventional loans may have a lower interest rate, given a company shows a minimum income over a fixed period of time.
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Peer-to-peer (P2P) lending is social lending, where individuals lend money to borrowers without a banking intermediary. The borrower directly takes money from people, who lend the money based on the evaluation of the borrower's credit information. Lenders and borrowers sign up on a platform, like a website. Then, the borrower submits their request for a loan for the investors to fund. In P2P lending, investors can ask the borrower questions regarding their products or services to decide whether or not to invest.
Line of credit
In a line of credit, a business has access to certain funds, which it can use when necessary. This amount has a cap and a borrower only pays interest on the amount they use. Having access to this allows a business to function with enough funds and pay for short-term debts and expenditures. This improves the financial standing of a business when it is in the transitional or growth stage. Banks that give a line of credit loans generally expect borrowers to possess substantial equity in their business.
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Credit cards instantly help businesses access extra money and move forward with their business operations. This type of debt financing is convenient and highly accessible. A business credit card has various terms, just like with personal credit cards, such as repayment schedules and interest rates. Although a credit card's ready access may seem ideal, its double-digit interest rate is a factor that a business may consider before using it, as high credit card interest may affect its growth.
A company issues bonds to fund its routine operations or to finance specific projects. An investor buying bonds loans money to the bond issuer for a specific period of time. The bond issuer makes regular interest payments to the investor at a fixed rate on the amount it has borrowed. A bond's price at the time of issue is par value and the interest payment is the coupon. A bond may or may not include collateral. Companies that are unable to get a bank loan generally issue bonds to solve their funding problems.
Merchant cash advance
Generally, small to mid-size retailers and businesses apply for a merchant cash advance to receive working funds. Before giving money to the borrower, the lender determines a company's ability to repay the amount. The assessment of this figure usually determines the loan amount. Borrowers repay merchant cash advances on a routine basis, like daily or weekly, and lenders may receive the payments directly from the borrower's payment processor.
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Advantages Of Debt Financing
Below are some advantages of debt financing:
The borrower retains control over the business: Irrespective of who the lender is, they do not acquire any portion of the borrower's business. It is the relationship between the lender and the borrower that exists for the loan period duration.
The borrower retains claim on future profits: The borrower's company does not share profits with the lenders, as it only entitles a lender to the repayment of specified loan principal and interest. Unlike equity financing, borrowing entities do not give profits to shareholders.
The borrower possesses the advantage of a tax-deductible interest: In debt financing, the borrower may claim interest payment on their business taxes. This results in a lesser cost of the total loan.
The borrower experiences a less complicated process: Many debt financing instruments do not include collaterals or complying with a government's laws and regulations. A company that has taken a loan may not necessarily share financial details with the investors or seek their votes before making decisions.
The borrower plans future expenses better: Since debt financing may often include loans that have specified payment schedules and a fixed payment amount, a company is better able to plan its future expenditures. This also allows them to manage other operational expenses better.
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Disadvantages Of Debt Financing
Below are some disadvantages of debt financing:
There is a strict loan repayment: In case a company collapses, it still owes the debt amount to the lender, which is necessary to repay with interest. If this happens, the company may have a meeting with lenders to discuss some flexible loan payment options.
There is a loan guarantee: Lenders often review the personal finances and assets of business owners to secure and guarantee the loan. Hence, a business owner may use their personal funds to produce a guarantee for their loan.
There are high monthly expenses: Most debt financing options have monthly loan payments. This may raise a company's expenses and reduce the cash for emergencies.
There are lender's restrictions: Since lenders put money into a business, they may restrict a company's activities that may result in a loss. For instance, a lender may not allow a company to explore additional financing options.
There is risk with a high debt-equity ratio: Lenders and investors consider giving loans to companies risky when the company's debt-equity ratio is high. This ratio is a representation of a company's debt vs equity financing.
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