What is Debt financing?
One of the most significant challenges faced by small firms is gaining access to money in order to pursue expansion strategies. The benefits and drawbacks of debt financing should be carefully considered.
One of the universal laws of business is that you need money to make money, but you need cheap money to last. Furthermore, where will all of that cash be sourced from? Numerous alternatives exist.
Debt is just a term; it shouldn’t frighten you. The term “debt finance” refers to the practice of obtaining funding via bank loans or other forms of unsecured debt. The money lent must be repaid with interest to the creditors.
Cost-effective debt can help small firms finance capital expenditures, including inventory replenishment, personnel expansion, and the purchase of land, buildings, and machinery.
A number of different debt financing options are available. Term loans, small company loans, merchant cash advances, and credit cards are all options.
When applying for a loan, you should know exactly how much you need and what kind you require because each one has its own set of benefits. So, before settling on a solution, do some serious thinking about what is out there.
How does Debt financing work?
Companies can raise capital through the sale of shares, the incurrence of debt, or a combination of the two. A share of the company’s equity is equivalent to a share of ownership.
It does not have to be repaid, but it does provide the shareholder with a claim on future profits. In the event of a firm bankruptcy, equity holders receive no money.
Debt financing comprises selling fixed-income products like bonds, bills, and notes to investors so that a business can expand and thrive. Lenders that acquire a company’s bonds can be individuals or large financial institutions interested in providing the firm with debt funding.
The principal amount of the investment loan is due at a specified time in the future. Lenders have priority over stockholders in the event of a bankruptcy liquidation.
Debt Financing vs Equity Fiancing:
Equity financing, in contrast to debt financing, does not require repayment and can be used for working capital expansion. Equity financing usually requires selling a piece of the company. Debt financing, on the other hand, only needs to be paid back.
Financial structures that include both loans and equity are the norm for most businesses. A business may opt for debt financing, equity financing, or both, based on its liquidity needs, the necessity of retaining ownership, and the cost of obtaining capital.
The debt to equity ratio (D/E) compares the proportion of funding that comes from debt to that which comes from equity. If the company ever has to raise further debt funding, having a low D/E ratio will likely impress potential lenders.
Why do Companies prefer debt?
Debt can be used for many purposes in business, including working capital (to buy merchandise, for example), capital expenditures (to buy equipment, for example), and acquisitions (of other businesses). Most of the time, the term or maturity of the debt should be the same as that of the asset being financed.
Short-term debt is debt with a maturity of less than one year and is typically used to finance short-term assets like inventories, accounts receivable, and other similar assets.
Because both equipment and real estate are expected to last longer, businesses usually borrow money for three years or more, while mortgage loans for real estate usually cover fifteen years or more.
Reasons for Debt financing:
There are many reasons for choosing debt financing over equity financing. Such as;
- Since a loan doesn’t change who owns the company, it doesn’t reduce the amount of equity that the current shareholders have.
- A lower cost of growth capital may be available in the form of debt if the company is expanding rapidly.
- As the principal on the debt is paid back regularly, the business’s equity value goes up, which is good for the owners.
- Also, the interest paid on debt is tax-deductible, which makes it a very cheap way to fund a business.
- Debt financing may be easier to get than equity financing, and shareholders may not have to agree to it.
- There are a sizable number of financial institutions willing to lend money for a wide range of projects and ventures.
- When a debt is paid off, it disappears forever. The company cannot repurchase outstanding equity without the shareholder’s approval.
Advantages of Debt financing:
Following are the major advantages of debt-financing;
Non Dilution of Ownership
When you take out a loan, you have to pay back the loan’s principal plus interest to the lender. In contrast to venture capitalists, they have no control over the direction of your company. As a result, you get to keep all of the control over your business and its future decisions in your own hands.
Improve Credit Score
Lack of capital, or working capital, is a major contributor to the failure of small firms. If you’re looking for low-interest, long-term debt financing, your business’s credit must be stellar. One of the most significant benefits of getting a business loan is the chance to establish a good credit history for your company.
Establishing your company’s credit history early on can save you money over the long run by reducing your reliance on high-interest personal loans and other forms of startup capital. Better terms with suppliers are another benefit of having solid business credit.
Debt financing’s tax benefits are significant. The interest and principal payments you make on the loan qualify as business expenses, which can be deducted from your business’s taxable revenue. Loan repayments are deducted from taxable income since they qualify as a business expense. This reduces your net tax obligation at the end of the year.
If you have particular questions about how your debt impacts your taxes, you should consult a tax expert or other financial consultant.
The high-interest rates associated with credit cards, P2P lending, short-term loans, and other forms of debt financing are counterproductive. Nonetheless, there is encouraging news. A loan from the Small Business Administration (SBA) is an excellent way to get access to cheap capital.
An SBA loan is the norm for inexpensive financing due to its long repayment period and low-interest rate. There are several other loan programs available besides SBA loans if you don’t get approved for one. You should think about how much the loan will really cost you.
If you want to avoid falling into a debt trap, it’s important to work with a lender who is honest and upfront with their dealings. Learn how interest and amortization affect your overall payment. As a general rule, you should be careful if you usually make more than one payment a month or if figuring out payments is very complicated.
Long-term debt can be used to finance the purchase of inventory or equipment, the hiring of new employees, or an increase in marketing efforts. A low-interest, long-term loan can provide your business with the reliable working capital it needs to operate efficiently and profitably all year long.
Think of it as the difference between being stuck in a financially stifling firm and having the freedom to pursue new avenues of growth and expansion, which could lead to greater earnings.
Disadvantages of Debt financing:
Following are the major disadvantages of debt-financing;
Collateral is one of the “5 Cs” of borrowing money. The Small Business Administration (SBA) defines collateral as “extra security used to assure a lender that you have a second source of repayment for a loan.” Collateral is anything of value that can be liquidated by the lending institution to satisfy the loan.
Machines, structures, and (in certain situations) even stocks can fall within this category. Many forms of credit necessitate the use of collateral because of the risk they pose to the lender. Typically, the size of the loan determines the size of the collateral the borrower is required to provide. Borrowers may view this as a disadvantage.
The number of predatory lenders is on the rise, and so are the methods they employ to dupe naive business owners. Obviously, this is not a problem exclusive to debt finance, but it is something to keep in mind. Some dishonest lenders may employ non-APR measures to conceal the exact cost of a loan.
Always go with a lender who is open and honest with their numbers. It is important to be familiar with the interest rate and monthly payment associated with your loan and to evaluate these figures in relation to the principal amount borrowed.
Each company loan will be recorded in your credit history. You should be aware that this may negatively affect your grades. So when you apply for a loan, be sure you know how the prequalification credit check will affect your score by talking to the lender.
Similar to any individual, companies are graded based on their credit score. Those with an “AAA” rating are termed the best companies to offer credit and, hence, their cost of the loan will be less when compared to those graded “BB” or lower.
What are the Deciding Factors?
Deciding Factors in regards to debt financing are questions that must be answered. Such as;
- Do you feel secure making payments on a monthly basis?
- How crucial is it to know just how much money you’ll be expected to spend each month?
- Can you be approved for a loan? Can you tell me about your credit rating? What is your credit history?
- Is there any collateral you can use? Do you find it easy to use?
- How crucial is it that you manage the company’s entire ownership?
Taking on debt to fund a company’s operations might be beneficial. But that doesn’t imply a business can keep piling on debt unchecked. There is no doubt that having some debt helps reduce the Weighted Average Cost of Capital (WACC) and boosts the Return on Equity (ROE). When a company has debt, it has more money to give away because the interest paid on debt is tax-deductible.
However, it’s important to keep in mind that a high debt-to-equity ratio could unnerve investors. Further, once the company’s debt rises above a particular threshold, it may find it difficult to secure additional financing. As a result, a company’s ability to take on debt is reduced.
Debt overload is a genuine concern. However, debt-free companies do exist. None of the equity methods will be effective unless the company is receiving stable cash flow. When the expansion is a top priority, however, capital expenditures will increase. Most businesses will need to use debt financing in this scenario.
Avoiding debt altogether may turn out to be a poor business decision, even in these trying times. Why? Because without debt and enough cash flows, the company’s growth may be stunted. It’s possible that rivals may be able to steal away customers, and the company’s zero-debt policy will put it out of business in the long run (in the long term).
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