Companies use various methods to raise working capital. Among them is debt financing. This article dives deep into debt financing. Keep reading to learn how it works.
Understanding Debt Financing
Debt financing happens when a company raises funds through the sale of debt instruments to institutional or individual investors, who become creditors. As creditors, these investors are promised interest on their debt amounts.
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Debt instruments that most companies sell include notes, bonds, and bills. The principal spent by investors to purchase these instruments must be repaid at an agreed future date. It is worth mentioning that when a firm goes bankrupt, creditors receive their claims on liquidated assets before shareholders.
Why Companies Should Consider the Cost of Debt
Before selling debt instruments to raise funds, companies must factor in several considerations, including the cost of debt. As mentioned earlier, a company promises interest to creditors on their principal amounts. This interest is the cost of debt. Therefore, companies are expected to generate enough returns to repay creditors. If they fail to produce positive earnings, they may not fulfill their debt obligations. That said, companies must set realistic interest rates when selling debt instruments.
What Are Other Types of Debt Financing?
Along with issuing bonds, bills, and notes, companies use other debt financing methods, including:
Term loans: Companies that use term loans to raise capital borrow a lump sum from a financial institution and then repay over an agreed period. Term loans may attract variable or fixed interest rates. Banks that issue these loans require companies to make monthly payments, which include both interest and principal.
Lines of credit: Through a line of credit, a Financial institution can grant a company access to a certain amount of money, which can be used when need be. Lines of credit operate like credit cards in the sense that borrowers only pay interest on the used amount. They are used to cover unexpected costs and short-term operational expenses.
Revolving credit facilities: They operate similarly to lines of credit. However, the main difference between revolving credit facilities and lines of credit is that the former allows borrowers to access larger amounts of money than the latter.
Equipment financing: This involves obtaining a loan to buy equipment to be used in a company, with that equipment serving as security. Equipment financing is ideal for companies that want to acquire new technology and machinery necessary for their daily operators but lack cash.
Merchant cash advances: Companies that have high monthly credit card transactions can raise funds through merchant cash advances. In this case, lenders usually demand a share of the profits generated in the future sales of credit cards.
Trade credit: With trade credit, companies can purchase equipment and then make payments two or three months later. This financing method allows businesses to produce the products they need to raise money for payment of the purchased equipment.
Convertible debt: This type of financing gives bondholders the option to convert their principal amounts into a company’s equity shares.
Equity Financing vs. Debt Financing
Equity financing involves the sale of company shares to raise capital. Companies that use this method do not have any repayment obligation. On the other hand, debt financing requires companies to repay creditors. However, these businesses don’t give up a share of ownership to get funds.
Pros and Cons of Debt Financing
Pros
With debt financing, companies retain ownership even after receiving funds. By comparison, equity financing means investors control a portion of the business.
Furthermore, obligations that come with debt financing are short-term, considering that a company’s relationship with its creditors ends immediately after the debt is fully repaid. Equity financing, on the other hand, gives investors an opportunity to earn dividends in the long term, which can be costly.
Cons
The major downside of debt financing is interest. Since companies must pay creditors both interest and principal, the paid amount is usually higher than the borrowed amount.
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