If you’re looking for a way to grow your business, you may have heard of debt financing. What is it, and how can it help your company?
This blog post will answer all your questions and more. We’ll discuss how it works and the benefits it can provide businesses.
At the end of this article, you’ll learn everything about debt financing and be ready to decide if it’s right for your company!
Debt Financing Definition
It is a debt in which companies, businesses, and investors borrow some funds from financial institutions to expand their business working capital.
The money you borrow, you’ll pay with interest at a specific time. It can be a secured loan or an unsecured loan.
Types of Debt Financing and Their Characteristics
There are several types of debt financing, each with its characteristics. These include:
- Bank loans: It involves borrowing from a bank and repaying with interest. To get a bank loan, you must meet its requirements to be approved. A bank loan can be secured or unsecured.
- Secured debt: It is a type of debt financing backed by collateral. Secured debt is less risky for lenders since it gives them a claim on the borrowers’ defaults. Examples of secured debt include car loans, mortgages, and more.
- Unsecured debt: This type of debt financing has more risk since it is not backed by collateral. It also comes with high-interest rates. Examples of unsecured debt include personal loans, credit cards, etc.
- Cash flow loans: It is a type of debt financing that depends on a company’s cash flow rather than its assets. They are perfect for small businesses needing short-term finances.
- Revolving loans: With revolving loans, you can borrow up to the agreed limit and repay as you use it.
- Installment loans: They include borrowing a lump sum of money and repaying in fixed instalments as agreed.
- Bond issues: It involves selling bonds to investors who get credits for a loan for their businesses.
How Does Debt Financing Work?
It involves selling fixed-income products like bills, notes, bonds, and so forth, and you must repay them. The bond buyer is the institution that funds that company with debt financing.
This institution must repay the principal as agreed without fail. In a case of bankruptcy, lenders will claim liquidated assets rather than the shareholders.
Also, the company may opt for equity financing, issuing stock shares in the public offering. The sum of debt financing and the cost of equity financing is the company’s capital cost.
That being said, what is the cost of capital?
What is the Cost of Capital?
Cost of capital relates to the minimum profit rate a company must earn on money to share among its creditors and shareholders.
There are different costs of capital. Let’s dive deeper.
Types of Cost of Capital
There are different costs of capital. These include:
- Weighted Average Cost of Capital (WACC): The WACC is the company’s total cost of employed funds. These weights are proportion values for capital in total capital.
- Implicit Cost of Capital: Implicit cost of capital is the rate of firms’ return on the investment opportunity plus the shareholders’ foregone if the firm project is accepted. If the company keeps the earnings, the implicit cost will be the same as the income.
- Explicit Cost of Capital: The discount rate equates the present value of firms’ received funds with the presently expected cash outflow.
- Marginal Cost of Capital: The marginal cost of capital is the cost of raising one dollar. Also known as the differential/incremental cost of capital. The marginal cost of capital relates to the change in the total cost resulting from raising one dollar.
- Specific Cost of Capital: It is the cost of capital for each component, i.e., cost of debentures, cost of equity, and cost of preference.
Factors That May Affect The Cost Of Capital
There are several factors that affect the cost of capital. They include:
- Preferences of capital providers: If there are fewer, the price will gradually go down and affect the economy.
- Inflation: Inflation is a measured rate of increased costs of products in an economy. There are various causes of inflation: High demand for products and less production, high manufacturing costs because of a hike in materials and fuel, and high cost of living, hiking wages, and labour costs.
- Market opportunity: The market is constant, and there’s no circulation of money
Forms of Debt Financing
Debt financing works in three forms, namely;
- Cash flow loan: A cash flow loan base on what you earn. You get the remaining amount in the return percentage and fewer lender fees. Examples of cash flow loans are merchant cash advances and invoice financing.
- Business-term loan: A business-term or traditional term loan is a loan where you get a large amount and repay it with interest at a fixed rate within a scheduled period. These loans are also instalment loans and may be unsecured or secured depending on the term of the agreement.
- Line of credit: In the line of credit loans, you get a set credit line where you only pay interest on what you borrow. In addition, you access the loan when needed and pay it back soon or at a specific time.
How Do You Measure Debt Financing?
To measure debt financing, you use the debt-to-equity ratio. It helps the firm gauge how much it’s financing its business compared to funds.
To compute, divide firms’ total liabilities by existing equity shareholders. Both debt and equity are on the firms’ balance sheets.
The high debt-to-equity ratio implies the firm has borrowed more heavily than the investment. It shows lenders are at increased risk than investors.
The low debt-to-equity ratio shows that most of the firms’ resources base on investment than on debt. It offers investors high trust in the company.
Now that you know debt financing, examples, and how it works, what are its benefits for businesses and individuals alike?
What risks are associated with debt, and how can you minimise them?
Keep reading to learn more!
What Are The Main Benefits Of Debt Financing?
Overall, the main benefits include:
- Improve credit score: The main benefit is that your credit score improves when you pay on time and continuously. It’ll help improve your business profile and increase your chances of qualifying more.
- Easy to gain: It is more accessible than equity financing and business grants. It is lowly competitive, and the process takes a short time.
- You don’t give a portion of your ownership: With debt financing, you don’t give a part of your ownership.
- Less costly: It is less expensive than equity financing
- Tax-deductible: With debt financing, debts are tax deductible
What Are The Risks Of Debt Financing?
There are a few risks associated with debt. These include:
- You pay more amount than you borrowed
- It can be risky if the company is not getting good returns
That said, what are the best strategies to get out of debt quickly?
Read on to learn more.
How To Get The Most Out Of Debt Financing
Getting the most out of debt is not as easy as you may take it. Fortunately, there are strategies you may use, including:
- Pay more than the regular payment
- Refinance debt through debt consolidation
- Negotiate with the lender to reduce your debts at a reasonable price for a while
- Re-examine your budget
Committing yourself to attaining your goal of getting out of debt would be the best idea.
The above strategies may quickly get you out of debt. Remember always to pay your debt in time to increase your credit score.
How Do You Choose The Right Debt Financing?
Choosing the right debt financing is difficult, especially for a new business. Fortunately, with the right strategies, it is an easy task. Here are some things you may consider:
- Know your business well: The first essential thing is understanding your business well. Ask yourself; What works best for your business? What are the minimum and maximum business returns you’re expecting? How do you picture your firm in the coming five to ten years? These are the questions to answer.
- Type of debt financing: Now that you understand your business, the next thing is the type of debt financing, between long-term and short-term. Considering that you know your business return, it’ll be easier to choose between long-term and short-term. It would help you weigh the pros and cons to determine what would work for your business.
- Interest rate: It would be the best idea to make a comparison between different provided options. It’ll help you get the best competitive quotes from potential financial institutions or banks. It may also help you improve your credit score before deciding to receive large amounts.
- Requirements: What are the borrowing conditions? Some requirements include; a business plan, monthly expenses, debt-to-equity ratios, and more. Having a business financial strategy at the beginning will ease the process.
Debt Financing FAQs
Is Debt Financing A Loan?
Yes. It is a loan that you borrows funds and pays back with interest. It also has restrictions to prevent its primary purpose.
What Is Debt Financing Example?
Examples include SBA loans, mortgages, machines and equipment, lines of credit, and government-backed loans.
What Is Debt Financing Vs. Equity Financing?
Debt financing is borrowing funds and promises to repay with interest at a specific date. Equity financing is when the lender gives funds for part of business ownership. Both have advantages and disadvantages depending on one’s needs.
The Bottom Line
Debt financing is a better way to get the money you need for your business.
Understanding all the different aspects of debt financing is essential to making the best decision for your company.
This article has elaborated well on the topic and given you a better understanding of debt financing.
Are there questions to answer? Comment below!