Debt financing - also known commonly as debt funding or debt lending - is a method of raising capital by selling debt instruments, such as bonds or notes. Typically, the funds are paid off with interest at an agreed later date.
There are many reasons why businesses take on debt to access liquid capital. Businesses that fall on hard times, are situated in industries with low day-to-day cash flow (such as international trade with delayed payment terms), or are looking to make a substantial move - like a merger or acquisition - can benefit from debt financing when needed.
How does Debt Financing work?
When a company needs to generate quick cash, there are three popular ways they can go about it. They can take on debt and pay it back later with interest, sell equity in the business - giving the investors ownership in the form of a stake - or a blend of the two.
Many business owners choose the debt financing route and try to steer clear of equity financing to prevent conceding business ownership.
Companies can choose which method of debt financing to offer. Most methods involve selling fixed-income products to generate capital. For example, bills, bonds and notes are the most common fixed-income products sold to investors to generate cash flow.
When a company issues a bond or note, those that purchase them become the investors and the money raised from transactions is used by the company as short-term, expendable capital.
The value of the investment, the agreed interest rate and the payback time - known commonly as the principle - are stipulated in a 'debt finance contract' and must be paid at the agreed future date. Should the company go bankrupt, lenders and bondholders are prioritised over owners and existing stakeholders when receiving liquidated assets, so settling outstanding debt on time is critical.
Example of Debt Financing
To put it simply, think of debt financing as a loan.
Say a high street chain is having cash flow problems, with its capital tied up in stock and a £10,000 shortfall in a given month. The business decides to issue bonds to raise money to pay off bills and restock products.
Twenty investors come forward and purchase bonds worth £500 each that go straight to the day-to-day running of a business. These investors are promised a 10% interest on their bonds to be returned within a 30-day grace period.
The store can restock its goods, pay bills, hit sales targets and make enough money to pay back investors. At the end of the grace period, each investor receives a £550 return on their bond, giving them a small profit.
Advantages and Disadvantages of Debt Financing
Debt financing offers many potential advantages for conscientious businesses, including:
- No changes in ownership - Bank loans, bonds and notes aren't the same as giving equity - where businesses sell stakes in the company that grant them a degree of ownership. Owners can raise funds by incurring debt rather than conceding ownership rights, leaving them in control long-term.
- Reduction in tax liability - Because loan and bond repayments are typically tax deductible, debt financing is more cost-effective than accruing expendable capital through methods like equity financing, for example.
- Bolstering credit rating - Provided businesses pay loans and interest on time, their credit rating improves significantly. This means they are better positioned to take out bigger loans to fuel further growth in the future.
While there are many advantages to debt financing, there are also some potential downsides for unprepared businesses. These include:
- High interest rates - Because debt financing usually involves borrowing money, there are sizeable interest rates attached. If managed improperly, this can lead to further financial problems.
- Becoming reliant - Loans can stimulate growth and future asset purchases short-term. However, businesses that rely on loans to keep them afloat as a long-term solution will likely find themselves at risk of bankruptcy.
- Can hinder your appeal - Perpetual loans alter your debt-equity ratio in a way that can make a business unappealing to prospective investors.
Short-term vs Long-term Debt Financing
The only difference between short-term and long-term debt financing is the length of time businesses have to repay the loans.
Short-term debt financing options - whether it's a bank loan, bond or note - involve loan periods shorter than a year. Long-term debt financing options are typically considered to be any repayment options with a deadline of over a year.
Each has its benefits. Long-term debt financing typically comes with lower interest rates because of the reduced risk to the lender, with the business having more time to make the repayment and a longer period over which to pay interest. Short-term debt financing options are attractive to investors - meaning businesses can get cash quickly - but typically have higher interest rates on the downside.
Types of Debt Financing
Businesses can typically access immediate liquid capital by taking on short- or long-term debt using one of three main debt financing services. These are:
- Bank loans - Typically the preferred way to quickly accrue finances as they do not affect credit ratings if they are repaid on time.
- Bonds and debentures - Issuing bonds and debentures raises capital quickly, provided the repayment dates are issued. Debentures are typically the preferred option - as there is no collateral attached to them and they are upheld by trustworthiness - but strong prior relationships with lenders and a track record of timely repayments are often needed to qualify.
Debt Funding vs Invoice Factoring
While both methods are effective in allowing businesses to accrue cash quickly, they differ in the way in which businesses access capital and the finance provider chases repayment.
Unlike debt financing - which relies solely on different types of loans for liquid cash - invoice factoring isn't a loan.
Invoice factoring involves selling outstanding customer invoices (account receivables) to a third party at a discounted rate to access liquid capital more quickly than waiting for payment. However, while finance providers still offer immediate liquid capital to the business, they must chase repayment through the customer- this depends on if it is the recourse or non-recourse type of financing.
Debt funding differs in the repayment structure, with the borrowing business required to pay the lender back directly from its own cash flow, with interest.
Debt Funding vs Equity Funding
While debt and equity funding are similar, there is a fundamental difference in how the lender or investor is repaid.
Debt funding makes the promise to the lender of interest - essentially allowing them to make a small profit on each investment.
Equity funding promises the lender a portion of the business in the form of a stake which essentially hands over partial ownership relative to the value of the investment.
Frequently Asked Questions (FAQs)
- How much does debt financing cost?
There is no fixed cost of debt financing - repayment figures will change depending on the amount borrowed, the interest rates offered and the time frame in which the debt must be repaid.
However, there is a formula for calculating tax rates:
Formula
Cost of debt = Interest expense x (1 - Tax Rate)
Because interest on debt is tax-deductible, in more cases than not, expenses are calculated on an after-tax basis.
- Is debt financing a loan?
Yes - debt financing is essentially a loan. But each type of debt financing loan differs.
Capital can either be accrued from a traditional bank loan or by issuing bonds and notes to prospective investors.
- What are the reasons for debt financing?
There are many reasons why a company may want to access liquid capital by incurring debt. The main reasons are:
- Raising capital for growth in the form of expansions, mergers and acquisitions
- Working as a short-term solution to cash flow problems
- Limiting the impact of potential issues like ownership and equity shifts
- Debt financing options are typically tax-deductible, making it a cost-effective option to access capital
International trade finance with Stenn
Is your business's international trading restricting cash flow? Stenn finances invoices for hundreds of small and medium-sized organisations with manageable payment terms.
Find out how Stenn can help free up liquid capital from your unpaid invoices today. And why not read more about the financing options available to your business in our Resource Hub?
About the Authors
This article is authored by the Stenn research team and is part of our educational series.
Stenn is the largest and fastest-growing online platform for financing small and medium-sized businesses engaged in international trade. It is based in London, provides financing services in 74 countries and is backed by financial giants like HSBC, Barclays, Natixis and many others.
Stenn provides liquid cash to SMEs within the global financial system. On stenn.com you can apply online for financing and trade credit protection from $10 000 to $10 million (USD). Only two documents are required. No collateral is needed and funds are transferred within 48 hours of approval.
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