Types Of Debt Financing, Advantages & Disadvantages Of Debt Financing

Types Of Debt Financing
Types Of Debt Financing

Debt financing is a kind of solution to those businesses organizer who are willing to expand their business but having lack of various factors which are required for expanding.

In this discussion, we would understand the meaning and types of debt financing along with the advantages and disadvantages of debt financing. So, this particular is divided into given sub-heads for making it easy to understand.

What Is Debt Financing?

Debt financing is nothing but a technical term that usually means borrowing money to raise business capital. The money borrowed is paid back to the lender in certain decided installments along with some interests.

Debt financing is done to raise the capital expenditures in a business by selling their debt instruments, i.e. bonds, bills or notes, etc, to either an individual or any institutional investors.

In this way of borrowing, the person who lends money becomes the creditor. Generally, the small business and newly incorporated companies adopt this process for raising the capital to develop their business.

The debt financing works as when the company or any business needs money, it can opt the way of debt financing to raise capital in which the company or the business sells it debt instruments or fixed income products like bonds, bills or notes, etc, either to a retail investor or to any institutional investors which provide the debt financing to that business or company.

The money borrowed must be paid back with some interest in some fixed time period as agreed and such money is known as principal and in case, such business or company goes bankrupt, the lenders possess probably a high claim as compared to the shareholders on any kind of liquidated asset.

In order to measure the debt financing, the investors generally measure the debt-to-equity ratio and then, the investors are analyze the comparison between the percentage of the capital of a company and the finance taken by debt. To measure the debt-to-equity ratio, the formula is:-

Debt-to-equity ratio = total debt / total equity.
Where, total debt = short–term + long–term debt.

Types Of Debt Financing

1. Bank loans: The debt financing by way of bank loans is the most common type of debt financing which can be either the secured loan or unsecured loan.

The secured loans can be referred to as when the assets of the company are provided to the lender as the safety deposits which in case of failure of paying back of the loan, the lender may sell those collaterals.

The secured loans have lower rates of interest whereas the unsecured loans are given with a high rate of interest as nothing is given as a safety deposit or collateral is given to the moneylender.

2. Bonds: The debt financing is done by way of bonds too and in this process, the bond gives the surety to the moneylender that the person borrowing money will repay the loan in the agreed span of time along with the payment of interest on time.

Bond is a kind of financial instrument which are generally recognized of secured nature.

3. Debentures: A debenture is of unsecured type of bond in nature which is used for debt financing. A debenture is assigned with backing up of credit rating of the person borrowing money which is based on the financial stability of the borrower.

Advantages And Disadvantages Of Debt Financing

The Advantages Of Debt Financing

  • No loss of ownership to the business, i.e. if a person opts for debt financing to raise capital the person borrowing money can still preserve its ownership of his company.
  • Another merit of opting for debt financing, there is a tax deduction on the payment of debt.
  • Accelerated growth can be seen in any business by way of raising capital. In short, debt financing can fuel the growth of the business or company.
  • Debt financing is cost-effective as compared to equity financing.

The Disadvantages Of Debt Financing

  • When the money is borrowed, it is supposed to pay back along with its interest.
  • Where the businesses are having inconsistent cash flow, opting for debt financing may be risky for the business holders.
  • The money lenders generally charge high-interest rates for the principal amount.
  • It also adversely affects the credit rating.

Difference Between Debt Financing And Equity Financing

Debt financing

Equity financing

An individual can retain sole or100% of ownership in a company.

In this type of financing, some portion of ownership is sold in order to raise capital in a business.

There is mandate paying back of loan before or on the agreed date.

There is no such issue of paying back.

There is a required payment of interests on time and a failure in which may seriously harm the credit rating of borrower.

There is no such issue of mandatory payouts as the dividends are to be paid only if in case of earned profits that too as per the discretion of the management of that company or business.

If in case bankruptcy occurs, the creditors or the money lender are prioritizing to be paid at first.

In case of bankruptcy, the equity shareholders are ones who paid at last.

The money lenders or the creditors are free from worrying about the losses or profits; there payments will be done in any case.

In equity financing, the equity shareholders have to worry about the losses or profits of the company or business as they have to share certain amount of losses and in the profits too.

Also Read: What Is ESOPs How Does It Work? 

Conclusion

It is a known fact that enough access to capital seems like a barrier to the newly incorporated companies or small-scale businesses who desire to facilitate the growth of their business.

Debt financing is a technical way of raising capital in the business to stimulate the growth of the business as it may be proved cost-effective. As well as, we have seen the differences between the equity financing and debt financing both have their pros and cons so, it is suggested to choose wisely.

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