What is Debt Financing? How It Works, Types, and More

Debt financing is one of the two primary sources of funding for any business, the other is equity financing. It is the process of borrowing money from a lender in return for a premium paid in the form of interest.

Debt financing comes with greater covenants and strict approval criteria. However, its interest cost is a tax-deductible expense. Also, the cost of debt is lower than the cost of equity for several reasons. Hence, it remains a preferred choice for many companies, as long as the option is viable.

Deeper Definition

Debt financing is the process of borrowing money in return for a premium called interest. Borrowers use debts to service the operational and financial needs of the company. It does not offer any ownership stakes to the creditors unless in special cases.

Debt financing can be obtained for short-term and long-term financial requirements. It can take several forms such as bank loans, bonds, credit cards, etc. In all cases, the borrower promises to repay the borrowed sum known as the principal amount. The lender is compensated with interest payments in addition to the principal repayment.

A company can raise capital through equity, debt, or hybrid instruments. The hybrid form of financing can be categorized either way that largely depends on the characteristics of the financial instrument for borrowings.

How Does Debt Financing Work?

Debt financing functions by direct agreements between the borrowers and lenders. A lender will appraise the credit profile of the applicant before approving the facility. The cost of borrowing I.e., the interest rate will largely depend on the creditworthiness of the applicant and the interbank borrowing rate.

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Debt financing comes with a cheaper cost of financing than equity. However, several factors contribute to determining the cost of debt. For instance, a secured borrowing backed by collateral will incur lower interest costs than unsecured borrowing without collateral.

Types and Sources of Debt Financing

There are two types of debt financing; short-term and long-term debts.

Short-term debt is a debt instrument with a maturity date of up to one year. Usually, it comes with a variable interest rate and unsecured form. The interest rates of these debt instruments are higher.

Whereas long-term debt is a debt instrument with a maturity period of over a year, often up to ten, fifteen, and twenty years. It comes with fixed interest rates and is often backed by collateral.

Debt financing can come through several sources. Here are some commonly used sources for debt financing.

Bank Loans

These are traditional loans obtained from commercial banks. These loans can be secured or unsecured and can come with variable or fixed interest rates. The interest rate is charged in line with the interbank interest rate.

Bonds

Large companies and corporations can issue bonds, commercial papers, and notes to raise capital from the market. These are often unsecured debt instruments that come as a fixed interest rate and are backed by the borrower’s creditworthiness.

Line of Credit

These are revolving loans issued by commercial banks. These come with variable interest rates and can be reused up to the maturity date several times.

Government Loans

Government loans come through federal and state government institutes for various purposes. These loans come with easy approval and lower interest costs.

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Peer-to-Peer Loans

These loans are issued by P2P platforms that work on crowdfunding principles. These loans are often issued for a very short-term period with high interest costs.

Credit Cards

Credit cards are revolving loan instruments issued without collateral. These instruments can be issued to personal or commercial applicants and incur high interest rates.

Equipment Lease

Companies can use the leasing facility instead of buying equipment with upfront cash. These loans are backed by collateral in the form of the purchased asset as a pledge.

Special Considerations with Debt Financing

Debt financing remains a preferred choice for businesses. All types of borrowers rely on debts for several reasons. Here are some key considerations with debt financing.

Approval

Financing approval largely depends on the creditworthiness of the applicant. A secured borrowing backed by collateral can be approved easily than an unsecured one.

Cost

The cost of debt is interest charged to a loan. The yardstick for charging interest is the interbank interest rate. Collateral, credit history, leverage, and type of loan are contributing factors of debt cost.

Leverage

A company with higher leverage will face difficulties in obtaining debt financing. The cost of debt will also be higher.

Advantages of Debt Financing

Here are some key advantages of debt financing.

  • Borrowers keep the ownership of the company and pledged assets unless in default.
  • Interest costs are tax-deductible.
  • Can be obtained for short-term or long-term purposes.
  • It helps to build credit and leverage for a company.
  • It helps to keep the cost of capital lower.

Disadvantages of Debt Financing

Here are some key disadvantages of debt financing.

  • Lenders must be paid irrespective of the borrower’s financial position.
  • A default may result in foreclosure or seizure of assets.
  • Unsecured loans can be costly.
  • Approval is not guaranteed, especially without collateral or in high leverage.
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Conclusion

Debt financing is borrowing money in return for a premium paid as interest. The interest portion is tax-deductible for borrowers. It can be obtained for short and long terms with several sources available.

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