Debt means “amount of money to be repaid”
Financing means “providing funds”
Debt Financing is a time-bound activity wherein a company borrows money for any business activity which needs to be repaid along with interest at the end of the agreed future date.
Understanding Debt Financing
Debt financing occurs when a company raises money by selling fixed income products such as bonds, bills, or notes to investors to obtain the capital needed to grow and expand its operations.
In return for lending the money, the investors become lenders and receive a promise to be repaid the amount of the investment loan – (also known as the principal amount) along with the interest at the end of the agreed period.
Debt finance is the complete antithesis of equity financing, which involves raising funds by issuing shares. The primary distinction between debt and equity financing is that equity financing offers additional operating capital without requiring repayment.
Debt financing must be repaid, however, the company is not required to lose any ownership in order to obtain funding. In case the company goes bankrupt, the lenders will have a higher claim than the shareholder over any liquidated assets of the company.
Debt Financing is commonly used by small scale young businesses to acquire resources that facilitate growth.
Advantages of Debt Financing
- Ownership Control- Unlike equity financing, debt financing retains all the ownership controls over the business.
- Profit Retention – The only obligation of the companies is making repayment within the agreed time frames. There exist no obligations to share business profits with the lenders
- Tax deductions – The interest fees on a business loan are generally tax-deductible.
- Cost of procurement – Debt financing is often less costly than equity financing
Examples of Debt Financing
Bank loans, loans from family and friends, government-backed loans, overdrafts, mortgages, credit cards, and equipment leasing/hire purchase are some of the most common forms of debt funding.
Types of Debt Financing
Debt financing can be of three types such as;
- Installment Loans
Installment loans feature pre-determined repayment terms and installments. The loan amount is paid in a lump sum at the outset. Such loans are available as secured (with collateral) or unsecured loans (without collateral).
- Revolving Loans
Revolving loans provide the borrowers with access to a continuous line of credit that they may utilize, repays, and repeat (e.g., credit cards).
- Cash Flow Loans
Under the Cash flow loans system, the lenders provide a lump-sum payment. Payments on the loan are made as the borrower generates the income that was utilized to secure the loan (e.g., Merchant cash advances & Invoice finance).