When a company needs money for a purchase, it can pay with cash, or finance the purchase.
There are essentially two ways to finance a purchase: equity financing, in which stock is sold in exchange for a share of ownership in the business, or debt financing, or a combination of both.
What Is Debt Financing?
When a company resorts to debt financing, it means it gets the cash it needs from other businesses or sources, incurring a debt to the original lender for either short-term needs or long-term capital expenditures.
Debt financing is when the company gets a loan, and promises to repay it over a set period of time, with a set amount of interest. The loan can come from a lender, like a bank, or from selling bonds to the public. Debt financing may at times be more economical, or easier, than taking a bank loan.
Whether a loan or a bond, the lender holds the right to the money being loaned, and may demand it be paid in full with interest under the conditions specified by the borrowing agreement.
Company owners reap more benefits from debt financing than they do from issuing stock to investors. Issuing stock results in a dilution of the owner's ownership interest in a company.
Also, the lender is entitled to only repayment of the agreed-upon principal of a loan, plus interest, and can have no direct claim on future profits of the business -- the way an investor would.
Except on occasions where variable-rate loans are used, the principal and interest are known amounts and can be budgeted. Interest on the debt can be deducted on the company's tax return -- reducing the actual cost of the loan.
Lastly, by borrowing money from lenders rather than issuing ownership shares (stocks), the company isn't required to comply with state and federal securities laws or rules, and doesn't have to send mailings to large numbers of shareholders, hold meetings with them, or seek a vote before taking certain actions.
Short-Term vs. Long-Term Debt
Long-term debt financing involves multi-year repayment terms, while a short-term loan gives a company quick access to capital -- sometimes even in as little as 24 hours.
Regardless of its purpose, the amount an owner plans to borrow is likely the most important factor. After that, another factor is the term length of the loan. The decision between a short-term and long-term loan will affect everything from the amount of interest paid over time to how much a lender will actually risk.
All loans involve risk. The amount of risk is often what influences the rate of interest, as well as the term of the loan.
Short-term loans, which are usually smaller amounts than long-term loans, tend to have higher interest rates than long-term loans, but long-term loans accrue more interest because the borrowed money is financed over a longer period of time. Also, short-term loans are a better way to overcome a momentary liquidity problem or financial setback, compared with taking a larger, longer-term debt obligation.
Long-term loans can involve multi-year repayment terms that can even last decades.
For this reason, while short-term loans may have higher interest rates, companies with long-term financing tend to pay more in interest because they are borrowing for a longer period of time.
Also, many lenders, like larger banks, have stricter lending standards for longer-term loans.
Types of Debt Financing:
Bank loans: The most common type of debt financing is a bank loan. The lending institution's application rules, and interest rates, must be researched by the borrower. There are lots of loans that fall under long-term debt financing, from secured business loans, equipment loans, or even unsecured business loans. What most such loans have in common is the lender expects you to promise some security or assets - collateral - to indicate the loan will be repaid even if cash to repay it doesn't exist in the future. That's what is required for a "secured" business loan - repayment is guaranteed by putting collateral forward as "security." A secured business loan often has a lower interest rate, because the lender accepts the collateral securing the loan. An unsecured business loan requires no collateral, but does require a 'financial assessment.' The lender may also want to see a specific income for a set period of time to be assured you have the ability to repay the loan. Unsecured business loans also usually are not given for a period greater than 10 years.
Other forms of debt financing include:
- Bonds: A traditional bond issue results in investors loaning money to your corporation, which borrows the money for a defined period of time at an interest rate that is fixed or even variable.
- Debenture: A debenture is another type of bond issue, but it is an unsecured loan certificate issued by your company. A debenture is backed by general credit rather than specific assets. This is why everyone issuing bonds from school districts to corporations have a "credit rating."
- Bearer bond: this last type of bond is no longer allowed. The bearer bond stated whoever held the bond was owed the money. It was outlawed as it became a method of tax evasion.
The debt-to-equity ratio is a means of gauging a company's financing character. To calculate it, investors or lenders divide the company's total liabilities by its existing shareholder equity. Both figures can be found in a company's balance sheet as part of its financial statement.
The D/E ratio shows clearly how much a company is financing its operations through debt compared with its own funds. It also, like with a bank's capital-to-asset ratio, indicates the ability of the company's own resources to cover all outstanding debts in the event of a business downturn.
Lenders prefer to see a low D/E ratio, which indicates more of the company's resources are based on investments than debt -- indicating the degree to which investors have confidence in the company.
If the D/E ratio is high, it indicates the company has borrowed heavily on a small base of investment. A company with a high D/E ratio is often described as a company that is "highly leveraged," meaning lenders are taking a greater risk than investors. That's because the company has been aggressive in financing its growth with debt.
Written as a mathematical formula, the D/E Ratio = Total Liabilities divided by Total Shareholders' Equity.
Pros and Cons of Debt Financing
So, let's have a look at the pros and cons of debt financing.
For one thing, you get to maintain ownership in your business. A bank or other lender will charge you interest on what you borrow, and set the terms for you to pay them back, but a lender isn't entitled to get involved with how you run your business like a major shareholder.
Also, the principal and interest payments on debt financing may be considered as business expenses by taxing authorities.
Because tax deductions affect your company's overall tax rate, it can actually be to your advantage to take on debt.
Making payments to a lender can be no big deal when you have ample revenue flowing. But what if your revenue is reduced by lower sales, or an industry downturn, or, worst-case scenario, your business fails?
Unlike investors, who, having ownership in your business, share in the risk of owning a business, lenders have only one interest: getting paid. You will still owe your lenders. In fact, if your business is forced into bankruptcy because it can't meet its obligations, lenders have claim to repayment before any equity investors.
Also, sharing the profits with investors will vary with how well your business - in which they share ownership - does. But you may still be paying a high interest rate each month for your debt financing, which cuts into your profits, just like owing on student loans cuts into your earnings.
Lastly, if you're borrowing a large sum, you credit rating could be affected, and a cut in your company's credit rating can result in higher interest rates on loans because of the increased risk to lenders. And if your business isn't generating the revenue with which you expected to pay off your monthly loan installment, too bad. Lenders typically expect payment in equal monthly installments. Late payments due to any reason, or, worse, default, can harm your credit.
The bottom line for obtaining debt financing of any sort: unless you are absolutely sure you can pay the loan back, do not obligate yourself to do it.