How Does Debt Financing Work?

What Is Debt Financing?

Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors. The individuals or institutions become creditors in return for lending the money and they receive a promise that the principal and interest on the debt will be repaid.

How Debt Financing Works

A company can obtain financing in three ways when it needs money. It can sell equity, take on debt, or use some hybrid of the two.

Equity represents an ownership stake in the company. It gives the shareholder a claim on future earnings but it doesn’t have to be paid back. Equity holders are last in line to receive money if the company goes bankrupt.

The other way to raise capital in debt markets is to issue shares of stock in a public offering. This is referred to as equity financing.

A company can choose debt financing which entails selling fixed-income products such as bonds, bills, or notes to investors to obtain the capital necessary to grow and expand its operations. When a company issues a bond, the investors that purchase it are effectively lenders who are either retail or institutional investors that provide the company with debt financing.

The amount of the investment loan is also known as the principal. It must be paid back at some agreed date in the future. Lenders have a higher claim on any liquidated assets than shareholders if the company goes bankrupt.

Special Considerations 

Several factors influence and affect debt financing.

The Cost of Debt

A firm’s capital structure consists of equity and debt. The cost of equity is the dividend payments to shareholders and the cost of debt is the interest payment to bondholders.

A company not only promises to repay the principal amount when it issues debt. It also promises to compensate its bondholders by annually making interest payments known as coupon payments to them. The interest rate paid on these debt instruments represents the cost of borrowing to the issuer.

The sum of the cost of equity financing and debt financing is a company’s cost of capital. It represents the minimum return that a company must earn on its capital to satisfy its shareholders, creditors, and other providers of capital.

A company’s investment decisions relating to new projects and operations should always generate returns greater than the cost of capital. The firm isn’t generating positive earnings for its investors if its returns on its capital expenditures are below its cost of capital. The company may have to re-evaluate and re-balance its capital structure in this case.

The formula for the cost of debt financing is:

KD = Interest Expense x (1 – Tax Rate)

where KD = cost of debt

The interest on the debt is tax-deductible in most cases so the interest expense is calculated on an after-tax basis to make it more comparable to the cost of equity as earnings on stocks are taxed.

Measuring Debt Financing

One metric used to measure and compare how much of a company’s capital is being financed with debt financing is the debt-to-equity ratio (D/E).

The D/E ratio is $2 billion / $10 billion = 1/5 or 20% if total debt is $2 billion and total stockholders’ equity is $10 billion, There’s $5 of equity for every $1 of debt financing. A low D/E ratio is generally preferable to a high one although certain industries have a higher tolerance for debt than others. Both debt and equity can be found on the balance sheet statement.

Other Types of Debt Financing

Common types of debt financing include more than just issuing a bond. Some options may be harder for small businesses to secure especially if they haven’t been in operations for long or if their financial position isn’t as strong as those of larger companies.

• Term loans: Term loans involve borrowing a lump sum of capital from a bank or financial institution that must be repaid over a predetermined period. They may have fixed or variable interest rates. These loans are usually structured with regular monthly payments that include both principal and interest.
• Lines of credit: A line of credit is a flexible loan that provides businesses with access to a specific amount of capital that can be drawn upon as needed. It works similarly to a credit card because businesses only pay interest on the funds they actually use. Lines of credit are particularly useful for managing cash flow, covering short-term operational expenses, and addressing unexpected costs.
• Revolving credit facilities: Revolving credit facilities function much like lines of credit but are typically larger and used by more substantial businesses. These facilities provide a pool of capital that the business can draw from and repay multiple times but they can’t exceed a credit limit up to a certain amount.
• Equipment financing: Equipment financing involves borrowing funds specifically to purchase business-critical equipment with the equipment itself serving as collateral. This type of loan or lease allows businesses to acquire machinery, vehicles, technology, and other assets necessary for operations without an immediate cash outlay.
• Merchant cash advances: Merchant cash advances provide businesses with a lump sum payment in exchange for a percentage of future credit card sales. This type of financing is popular among businesses with high credit card transaction volumes that need cash immediately. Merchant cash advances can come with higher costs compared to traditional loans, however.
• Trade credit: Trade credit is a form of short-term financing that’s extended by suppliers. A company can buy something and then pay 30 or 60 days later. This type of financing helps businesses manage inventory and produce the goods they need so they have the cash flow to then pay for that invoice.
• Convertible debt: Convertible debt is a hybrid form of financing where loans can be converted into equity shares in the company at a later date. A company can choose to issue a bond but give the holder the option of later switching from debt financing to equity financing.

Debt Financing vs. Interest Rates

Some investors in debt are only interested in principal protection while others want a return in the form of interest. The interest rate is determined by market rates and the creditworthiness of the borrower. Higher rates of interest imply a greater chance of default and therefore carry a higher level of risk. They help to compensate the borrower for this increased risk.

Debt financing can be difficult to obtain but it provides funding at lower rates than equity financing for many companies, particularly in periods of historically low interest rates. Another advantage is that the interest on the debt is tax-deductible. Adding too much debt can increase the cost of capital, however, and this reduces the present value of the company.

Debt Financing vs. Equity Financing

The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation. Debt financing must be repaid but the company doesn’t have to give up a portion of ownership to receive funds.

Most companies use a combination of debt and equity financing. They choose debt or equity financing or both depending on which type of funding is most easily accessible, the state of their cash flow, and the importance of maintaining ownership control. The D/E ratio shows how much financing is obtained through debt versus equity. Creditors tend to look favorably on a relatively low D/E ratio which benefits the company if it has to access additional debt financing in the future.

Advantages and Disadvantages of Debt Financing

Debt financing comes with some notable pros and cons just like any other type of financing.

Pros of Debt Financing

One advantage of debt financing is that it allows a business to leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible. Another advantage is that the payments on the debt can be tax-deductible.

Debt financing also allows businesses to retain ownership and control, unlike equity financing where ownership stakes are sold to investors. The business owners don’t have to give up any control or decision-making power in the company.

Debt financing can be more cost-effective compared to equity financing and the relationship with the lender ends and there are no further obligations when the debt is repaid. Equity investors typically expect ongoing dividends and a share of the profits which can be more expensive in the long run. The only way to extinguish this is through share reacquisition.

Cons of Debt Financing

The main disadvantage of debt financing is that interest must be paid to lenders so the amount paid will exceed the amount borrowed. Payments on debt must be made regardless of business revenue and this can be particularly risky for smaller or newer businesses that have yet to establish a secure cash flow.

High levels of debt can negatively impact a company’s balance sheet and its financial ratios. This can make the business appear riskier to investors and lenders and potentially lead to higher borrowing costs in the future. High debt levels can also limit a company’s flexibility because much of its revenue will be tied up in servicing debt.

Debt financing also often involves restrictive covenants. Lenders may impose conditions that restrict additional borrowing, dictate certain financial ratios that must be maintained, or limit the types of investments or expenditures a company can undertake. This is a risk management strategy to ensure that the lender has security in how the company is being run.

The Bottom Line

Most companies need some form of debt financing. Additional funds allow them to invest in the resources they need to grow. Small and new businesses especially need access to capital to buy equipment, machinery, supplies, inventory, and real estate.

The main concern with debt financing is that the borrower must be sure they have sufficient cash flow to pay the principal and interest obligations tied to the loan.