Elevate your business with smart debt financing

There are many obstacles to overcome while starting and expanding a business, but securing adequate financing is one of the biggest. There is always a need for financial resources, whether it is to expand into new markets, improve operational skills, or just to make ends meet. This need for external capital can be met through three primary methods:

Equity financing, where the company raises capital by selling company shares.
Debt financing involves borrowing funds from a lender
A hybrid of debt and equity which combines borrowing and selling shares for funding.

The choice between these financing options is influenced by several factors. In this blog, we will look into the specifics of debt financing. We will explore what debt financing is, the various types available, and touch on the advantages and disadvantages of debt financing.

What is debt financing?

Debt financing is the process by which a business borrows funds to maintain its operations and then promises to pay back the money borrowed plus interest over a certain period of time. Because there is no requirement to give up any equity or control, this financing option is unique in that it lets the business maintain complete ownership.

Capital Financing with Debt: Intro to Corporate Finance | Part 4

Types of debt financing

Debt financing can come in various forms, each with its specific features, benefits, and considerations. Here’s a breakdown of the main types:

Bank loans: Bank loans, the most common type of debt financing, come in secured and unsecured forms. Because there is less lender risk, secured loans have lower interest rates and require the use of business assets as security. Conversely, unsecured loans don’t need collateral but usually come with higher interest rates because they depend on the stability and expansion potential of the business.

Bonds: In order to obtain funding, a business will sell bonds to investors, guaranteeing the repayment of the principal amount plus periodic interest payments after a predetermined period of time. Bonds are typically secured and provide their holder with a set income stream.

Debentures: They are similar to bonds, except they are often unsecured and depend more on the issuer’s reputation and credibility than on security. They can have a range of credit ratings that reflect the issuer’s financial health and degree of risk.

Bearer bonds: These are bonds where ownership is determined solely by possession of the bond paper, as they are not registered in the name of a particular bearer. In many regions of the world, bearer bond issuance has been suspended because of worries about tax fraud and illicit funding.

Also read: Corporate bond – definition and how they’re bought and sold

Advantages and disadvantages of debt financing

Advantages:

Tax benefits: Debt interest can be written off as a business expense, which lowers overall tax obligations and might free up more funds for company investments.
Control and ownership: You don’t have to give up ownership or control of your business when you use debt financing. Beyond the parameters of the loan, lenders have no control over how businesses are run.
Predictability: Better financial planning and budgeting are made possible by debt finance, which has fixed interest rates and payback plans. It gives a clear view of the debt’s future expenses.

Disadvantages:

Repayment pressure: Repaying debt on the due date can be difficult, particularly for companies with variable cash flows, regardless of the profitability of the firm.
Impact on credit ratings: A company’s credit rating may be negatively impacted by high debt levels, which may make it more difficult or expensive to obtain new financing down the road.
Potential for higher costs: Tax deductions can help with certain interest costs, but debt financing can become expensive when interest rates are high because of things like low credit ratings or unfavourable economic situations.
Collateral requirements: Collateral is necessary for secured loans, meaning that if the company is unable to repay the debt, it could forfeit important assets.

Debt financing vs equity financing

Aspect	Debt financing	Equity financing
Definition	Borrowing funds to be repaid with interest over time.	Selling shares or stakes in your business in exchange for capital.
Ownership	Retains full ownership; lenders have no control over business decisions.	Investors may be given a voice in business decisions and receive a portion of the ownership.
Repayment	Fixed repayments including interest, regardless of business performance.	No repayment obligation; investors receive dividends if the business profits.
Risk	Risk of default and asset seizure if unable to repay.	No repayment risk, but potential loss of control and higher expectations.
Tax benefits	Interest payments are tax-deductible.	No tax benefits for issuing equity.
Funding amount	May be limited based on creditworthiness and collateral.	Potentially large amounts of capital can be raised without collateral.
Impact on credit ratings	High levels of debt can negatively affect credit ratings.	No impact on credit ratings, but dilutes ownership.
Timing	Usually faster, given credit approval.	Can be time-consuming due to negotiation and valuation processes.
Cost	Interest costs are potentially lower than the cost of new equity.	Since a portion of future revenues are forfeited, the cost of equity is frequently higher.
Suitability	Preferred for short-term funding or when maintaining control is important.	Better for long-term funding needs and where losing some control is acceptable.

Also read: Understanding the difference between equity and debt IPO for the right investment

Bottomline

Debt financing is a sensible way to finance company expansion without giving up ownership. But you really need to be sure you can afford to pay back the loan. It can be a useful tool to accomplish your company’s objectives and promote success if you plan ahead and understand the terms.

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