What Is Debt Financing & How Does It Work? Types, Pros & Cons

Understanding the dynamics of business growth and operations is pivotal to establishing a successful venture. One essential concept you should be able to define, “what is debt financing?” Debt financing is the process where a company raises capital by selling debt instruments, such as bonds, bills, or notes, to individual or institutional investors. These investors, or creditors, in turn, receive a promise for repayment of principal and the accrued interest.

This process works as a loan - the company is obliged to repay the borrowed capital, referred to as principal, along with the accrued interest, by a predetermined date. When comparing debt financing vs equity financing, equity financing involves offering company stock to raise funds. This doesn’t necessitate repayment but imparts ownership to the investors. Meanwhile, debt financing is a loan that must be repaid, often with interest.

Here, we’re diving deeper into the types of debt financing, its advantages and disadvantages, and how debt vs. equity financing compare.

What is the difference between debt financing and equity financing?

When a company needs funds for operations or growth, it has several options for business financing. It can sell equity, take on debt, or utilize a combination of both. Selling equity refers to offering an ownership stake in the company, which claims future earnings but does not demand repayment. When a business opts for debt financing, on the other hand, it sells fixed-income products like bonds to investors. Now it’s committed to repaying the principal by a set date. And if the company goes bankrupt, the lenders or creditors can claim the liquidated assets. Therefore, one of the biggest advantages of debt financing is that it’s less risky for investors.

Types of debt financing

Debt financing offers a variety of options for borrowers. Here are a few of the common types of debt financing:

Bank loans

Bank loans - available in various forms such as secured, unsecured, term, revolving, and cash flow - are the most common type. The borrower is obligated to repay the principal amount and accumulated interest within a specified period. 

Bond and debenture issuance

Another common debt finance option involves the issuance of bonds and debentures. While both offer interest income, debentures (being unsecured) are riskier than bonds. 

Factoring

Factoring involves entities selling their accounts receivables to third parties, providing a prompt influx of capital to facilitate short-term financial solutions. 

Remember, each type of debt financing carries its unique set of risks and benefits, making it essential to consider your business needs and financial position before choosing.

What is debt financing and how does it work?

The Debt-to-Equity Ratio (D/E) serves as a valuable metric to measure and compare how much of a company's capital is being financed with debt vs. equity. It’s the key way of understanding how debt financing works because as you increase the amount of capital raised via debt financing, your D/E ratio increases, too. Here’s how that looks in action:

Suppose Company XYZ has total debts amounting to $500,000, and the shareholders' equity is $1,000,000. The D/E ratio for Company XYZ can be calculated as follows:

D/E Ratio = Total Debt / Total Shareholders' Equity

Therefore, the D/E ratio for Company XYZ is:

D/E Ratio = $500,000 / $1,000,000 = 0.5

This result signifies that for every dollar of equity, Company XYZ has fifty cents in debt. In other words, half of the company's capital structure is financed by debt. This ratio helps investors and analysts understand the breakdown of debt and equity financing, which indicates the risk level of the company - higher levels of debt can indicate a higher risk of financial distress. As a result, creditors often perceive a low D/E ratio favorably. The lower your D/E, the better your ability to secure future funding.

Advantages and disadvantages of debt financing

Just like any financial instrument, debt financing offers pros and cons. Let’s dive into these further:

What is the main benefit of debt financing?

Debt financing offers a few main advantages. These include: 

• Leveraging small amounts of money into larger sums for growth
• Tax deductions on debt payments
• Retention of ownership control. 

What are the disadvantages of debt financing?

On the other hand, its disadvantages include:

• Interest payments to lenders mean that the repaid amount exceeds the borrowed sum
• Payments on debt must be fulfilled irrespective of business revenue 
• Debt finance can be particularly risky for smaller or newer businesses

While debt financing is a critical tool for companies to stimulate growth, it's crucial to ensure the ability to meet the repayment obligations. A calculated use of debt can indeed propel a business to newer heights. But remember, it's essential to balance the scales between the borrowed capital and the returns on capital expenditure.

Read: Cash equity: What is it?