How Debt Financing Works
July 19, 2021
Debt financing is one of the two primary ways most businesses raise the money they need for daily operations such as inventory and wages, or for major expenditures such as the acquisition of new equipment or construction and renovation costs.
Debt financing vs. equity financing
The other common way businesses raise money is through equity financing. This involves selling an equity stake in the business, better known as stocks or shares, in exchange for cash. Although businesses give up equity, shareholders don’t get paid back for their initial investment unless they sell the stock back to the business, or to another buyer. However, businesses often pay their shareholders regular sums called dividends. For the business, this is known as the cost of equity.
In debt financing, businesses take on debt instead of giving up equity, which allows ownership to maintain greater control of the company. Debt financing may be easier to obtain than equity financing for smaller and newer businesses that don’t yet have the public profile to sell shares. However, there are instances of small, high-potential companies that are able to attract significant equity investment.
What is debt financing?
Debt financing can be as simple as taking out a loan from a financial institution, or it could be a more complicated process involving the sale of debt products, such as bonds or bills. In either scenario, the business agrees to pay back the original loan, plus a predetermined amount of interest, to the creditor who issues the loan or the investor who buys the bonds or bills. Creditors and investors can be either individuals or institutions.
Financing is typically set up with either a long-term repayment plan (from three to 10 years), or a short-term plan (usually one year).
Revolving debt, such as a business credit card, lines of credit, and other debts such as government loans and mortgages are all other examples of debt financing commonly used by business owners to finance their daily operations or other costs.
Shareholders vs. lenders
An important distinction exists between shareholders and creditors, or lenders, when it comes to businesses that go bankrupt. In such situations, creditors are ahead of shareholders in the line to get paid. In fact, equity claims are considered subordinate to all other claims, and aren’t even paid until all other creditors have been reimbursed in full.
The cost of debt
Just as dividend payments are the cost of equity, interest payments represent the cost of debt. Generally, businesses make regular interest payments to their creditors known as coupon payments.
Changing interest rates will have an impact on the cost of debt. When rates are low, the cost of borrowing decreases. However, some debt financing products have variable interest rates that move in lockstep with central bank rates, meaning the cost of borrowing might rise before the debt is paid off. Fixed interest rates provide certainty for businesses, but sometimes at a higher cost.
In general, businesses will be able to get lower rates when borrowing by demonstrating stable, consistent revenue and financial reliability, or by securing the loan with some kind of collateral (including business assets such as inventory or real estate).
While nobody likes paying interest, there is one good bit of news for businesses when it comes to the cost of debt: interest payments on business debt are tax deductible, meaning businesses can often lower their bill at tax time by writing off the cost of borrowing money.
Is debt financing a good idea?
In general, debt financing is less costly to businesses than equity financing, because equity financing tends to be a bigger risk to investors than debt financing is to creditors. Needless to say, debt financing becomes even more affordable when interest rates are low. In such environments, businesses don’t need to generate such big returns in order to cover the cost of their borrowing.
Debt financing is also particularly attractive to companies who are reluctant to give up control by selling equity shares in the business. However, debt financing can be risky for businesses with inconsistent revenues and shaky cash flow, as these companies may struggle to meet their payment obligations, leading to financial penalties and higher borrowing costs.