what is DEBT FINANCING?
Debt financing is the practice of assuming debt in the form of a loan or a bond issue to finance business operations.
When used responsibly, debt financing is a helpful tool to accelerate the growth of a business. A healthy business may use debt financing to fund new products, new locations, or other expansions.
When used irresponsibly, debt financing can deplete cash on hand, strangle cash flow, and kill an otherwise healthy business.
An unhealthy business assumes debt to cover daily operations or seeks debt financing without a plan to grow the business.
Forms of Debt Financing
When businesses assume debt, they do so in one of two ways: they approach a lender, such as a bank, and take out a loan, or they issue bonds.
Loans are agreements wherein one party lends money to the other. These agreements stipulate terms such as interest rate, method of repayment, and the time at which the loan is due to be repaid in full.
Repayment terms can range from less than a year to any number of years that the lender and borrower negotiate.
Businesses seeking to take advantage of debt financing often see loans as attractive options. When loans are handled by professional institutions, the approval process is fast and standardized, and the balance of the loan—the principal—is provided all at once.
These benefits often come with caveats regarding the use of the loaned funds. In some cases loans are restricted to funding specific activities. Some lenders may stipulate that borrowers cannot assume new debt from other sources until their obligation has been met.
Bonds are a little more complicated than loans. More than just a simple agreement between two parties, bonds are known as “debt instruments.”
Portions of bonds can be bought and sold, and the interest that companies pay on their bonds is owed to the bond owner—whoever that may be.
Bonds are often associated with publicly traded corporations, because bond issue requires meticulous record keeping and management.
Additionally, bond issues are usually reserved for very large sums of money with repayment terms that span decades. Non-publicly traded companies can issue bonds; however, as with issuing shares of stock, there are severe restrictions on the ways in which this can be carried out.
Bonds can be an attractive form of debt financing for corporations with the means to undertake it. Corporations are free to set the interest rates that they pay to bondholders (often much less than banks would charge), and they have no restrictions imposed by lenders on the usage of the funds they receive.
Advantages of Debt Financing
Debt financing is most often compared to equity financing as a method of raising capital for a business. Equity financing is the practice of exchanging ownership of the business (and the profits it generates) for cash that be used in the near term.
Debt financing offers a number of distinct advantages over equity financing.
No Loss of Ownership
Mixed debt and equity financing arrangements do exist, but most debt financing agreements do not involve a loss of ownership.
This means that business owners and stakeholders will not see their equity in the business diluted when they take on the debt they need to finance growth.
Debt Financing Is Tax Advantaged
Both the principal and the interest payments of a loan may be deducted from taxes as a business expense.
This factor alone may not be enough to save a business that has assumed more debt than it can handle, but it does work to offset the costs of making payments (this is known as “servicing” the debt).
Debt Financing Helps Establish Credit
For new businesses with little to no operating history, debt financing, even in small amounts, helps them establish a credit history.
Of course, the same paradox exists for business owners as it does for personal borrowers: loans are only considered for businesses with an established credit history and a business needs an established credit history to be considered for a loan.
If your company has exhausted all other debt financing avenues, the Small Business Administration may be able to help in the form of a 7(a) loan.
Loans Are Often the Cheapest Option
While it is true that interest rates vary based on the lender and the risk presented by the borrower, loan interest rates are often lower than credit card interest rates or the rates associated with cash advances. Getting a loan is often a much more attractive option than using debt factoring companies, which purchase outstanding accounts receivable invoices in exchange for cash up front.
Disadvantages of Debt Financing
Debt is...well, debt. It has to be repaid, and in some cases, lenders can come after the business owner for payments even if the business fails.
Loan Repayment Consumes Cash Flow
The lifeblood of any small business is a healthy cash flow, when enough revenue is coming in to produce a surplus of cash on hand to handle business expenses.
If cash flow is disrupted or depleted, the business runs out of money to meet its obligations; this is a leading cause of small business failure.
The loan payments associated with debt financing add to the strain on a business’s cash flow and, if not handled properly, can cripple the company’s growth.
Interest Adds Up
The interest charged on loans can make this form of financing expensive. Interest payments add up and, depending on the principal amount, can total thousands of dollars. This is often seen as the cost of retaining total ownership as opposed to equity financing, where ownership is diluted.
The Debt-to-Equity Ratio
There is no one-size-fits-all answer to the correct amount of debt for a business. The amount that is healthy or appropriate varies wildly based on the industry and the overall health of the company’s balance sheet.
The debt-to-equity ratio is a common shorthand used to compare the amount of debt a business carries to the equity invested in it. Simply put, it is a measure of how many dollars of debt a company has for every dollar of equity, or value, in the business. For example, a business with a debt-to-equity ratio of 3:1 has three dollars of debt for every dollar of net worth.
As you might guess, the lower this ratio, the better. Lenders will take existing debt into consideration and may decline loans to businesses with excessive debt-to-equity ratios. Though there is no perfect standard, a general rule of thumb is that a ratio in excess of 4:1 represents a business that is overleveraged.