Finance

Advantages and Disadvantages of Debt Financing

Debt Financing definition 

Debt financing is a phenomenon that occurs when a company generates capital for its working capital and capital expenditure from the sales of debt instruments and institutional investors. As a result of lending the money, the individuals, firms or institutions turn into creditors and are promised that the principal and interest incurred on the debt are repaid.

Another way to raise capital in the debts market is through the issuing of shares of stock publicly. This is referred to as equity financing.

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Whenever a company is in need of money, it can obtain finances through three methods, namely; equity, debt or a combination of the two known as hybrid. Equity stands for the ownership stake in a company. It provides shareholders with claims to the future earning which do not necessarily need to be paid back. In a case of bankruptcy of the company, equity holders always receive their money after everyone. Another method of raising company capital for the firm is through the issuance of debt which is known as debt financing. This is what is being discussed in this article

Advantages & disadvantages of Debt financing:

Debt financing will take place when a company sells its fixed income products, like bonds, bills, or notes, to investors in order to obtain capital required for growth, development and expansion of its operations. When a company bond is issued, the investors purchasing the bond are lenders who may come as retail or institutional investors which provide the company with debt financing. It is compulsory to pay back this quantity of the investment loan, known as principal, after some time which will be an agreed date. In the situation in which the company goes bankrupt, lenders will have a right to a higher claim on any of the liquidated assets than other shareholders.

Cost of Debt Financing

Capital structure of a company comprises of equity and debt. The cost of equity comes as dividend payments to the shareholders while the cost of debt financing comes as interest payment to bondholders. Any time a debt is issued by a company, it not only promises to pay the principal amount, it also promises to compensate the bondholders by the payment of interest, referred to as coupon payments. These coupon payments are made annually. The interest rate paid on these debt instruments are the borrowing cost to the issuer.

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The total of the cost of equity and debt financing is called the capital cost of the company. The capital cost of the company is a representation of the minimum return which a company must earn on its capital for the satisfaction of all obligations to shareholders, creditors and other capital providers. Investment decisions of a company as regards its new projects and operations should always earn revenue greater than the company’s cost of capital. If the revenue that accrues on its capital expenditure us lesser than the company’s cost of capital, then the firm is generating negative earnings for its investors. This would mean that the company has to re-evaluate and re-balance its capital structure.

Measuring Debt Financing

A method used my metric analysts for the measurement and comparison of how much a company’s capital is gotten from debit is the debt-to-equity ratio or in short form, or D/E ratio. For example, if total debt is $2 billion and total stockholders’ equity is equal $10 billion, the D/E ratio is $2 billion / $10 billion = 1/5, or 20%. This translates to mean that for every $1 of debt financing, there is $5 of equity. Generally, a low D/E ratio is more preferable to a high one, even though some companies have a higher debt tolerance than others. Debt and equity are both stated on the balance sheet.

Interest Rates on Debt Financing

Some lenders or investors in debt are only interested in the protection of their principal, while other investors want earning in form of interest. The interest rate is determined by market rates and credit worthiness of the borrower. High rates of interest would mean a greater chance of not paying up, and therefore a higher risk level. Higher interest rates are used in the compensation of the borrower for increased risk. Asides interest payments debt finances need the borrower to comply by rules on financial performance. These rules are called covenants.

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Debt financing may not be easily obtained, but for a lot of companies, it gives them funds at a lower rate than equity financing, most especially during periods of low interest rates. Another disadvantage of debt financing that the interest paid on the debt is tax deductible. Too much debt financing may increase the company’s capital cost but will reduce the present value of the company.

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Harish

Finance and market analyst and chief writer on howtofinance. Passionate to read books and articles on marketing and accounting. Also edits other articles and publish them here.

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