Debt Financing
What is Debt Financing?
Debt financing is the process by which a company raises capital by borrowing money from external sources, typically in the form of loans, bonds, or debentures, with the promise to repay the principal plus interest over time. It allows businesses to fund operations, expand, or invest in new projects without giving up ownership.
Key Features of Debt Financing
- Fixed Obligation: Borrowers must repay the borrowed amount along with interest, regardless of business performance.
- No Ownership Dilution: Lenders have no claim to equity or control in the company.
- Time-Bound: Debt must be repaid within a specified period.
Types of Debt Financing
1. Short-Term Debt
- Usually repaid within 1 year
- Used for working capital needs (e.g., inventory, payroll)
2. Long-Term Debt
- Repayment period exceeds 1 year
- Used for capital expenditures like machinery or infrastructure
Common Sources of Debt Financing
| Source | Description |
|---|---|
| Bank Loans | Traditional term loans or working capital loans |
| Bonds | Debt instruments issued to investors, traded publicly or privately |
| Debentures | Unsecured bonds backed by the company’s creditworthiness |
| Lines of Credit | Flexible borrowing limits for short-term funding |
| NBFCs & Private Lenders | Alternative sources for faster or riskier loans |
| Government Loans | Subsidized loans for startups or MSMEs in specific sectors |
Advantages of Debt Financing
- Ownership Retention: Shareholders keep full control of the company.
- Tax Deductibility: Interest payments are tax-deductible in many jurisdictions.
- Predictability: Fixed repayment schedules help in financial planning.
- Leverage: Can magnify returns when used wisely with profitable investments.
Disadvantages of Debt Financing
- Repayment Pressure: Regular interest and principal payments are mandatory.
- Increased Risk: Over-leveraging can lead to financial distress or bankruptcy.
- Collateral Requirement: Secured loans may require pledging of assets.
- Restrictive Covenants: Loan agreements may limit business decisions (e.g., taking on more debt or selling assets).
When Do Companies Use Debt Financing?
- To fund expansion projects
- To cover short-term cash flow gaps
- For leveraged buyouts (LBOs)
- To refinance existing expensive debt at lower rates
- When equity dilution is undesirable