What Is Debt Financing and Its Examples?
If you are dealing with any kind of business, debt financing is a buzzword.
It is one of the cardinal concepts while running your business.
This is necessary for raising funds.
In very simple words, it is the debt that you raise for running your business.
The money can be for both capex or running expenditure.
Debt financing is a convenient way of loaning money based on future expenses.
Businesses can expand without committing a huge amount of their capital.
Often, this is the best way to enhance shareholder value.
Debt financing is particularly lucrative when interest rates are low.
This is because the cost of debt is significantly lesser.
Investors get attracted to the lower cost of borrowing and higher returns.
It is needless to mention that it is closely linked to the economic condition.
When the economy or the sector is underperforming, the cost is less.
Similarly, when the economy is growing, returns are relatively high.
However, the extent of debt exposure remains a concern.
Debt financing is closely linked to your leverage limits.
If your business is over leveraged, it can be detrimental to the business.
A lot of investors like Buffett only goes for low debt companies.
Definition of Debt Financing
So, the question is how you will define debt financing.
If you think of raising funds for a business, there are broadly two or three ways.
It will be either via equity or debt or a mix of both.
In case of equity holding, there is always a question of a stake.
The other option is raising funds via issuing debt.
Normally companies sell fixed income offerings for debt financing.
It could range from bonds, bills to notes issued to investors.
Therefore, debt financing is borrowing money with no immediate payment.
The repayment obligation is a thing of future.
The bond buyers or investors are the lenders and provide the fund needed.
Inevitably the lenders enjoy stronger claim on liquidated assets.
The interest rate is also pre-decided in this case and has to be paid in future.
Often startups and new entrants use this form of funding.
This gives them access to the all-important fund without diluting stake.
Maintaining ownership is a key consideration for these businesses.
This is exactly why the debt to equity ratio is such a parameter in determining value.
It is perhaps the best indicator of the extent of leverage by a company.
From an investor’s standpoint, it helps them decide on the intrinsic value.
For the business owner, they can decide their future expansion.
In case they feel the business is over-leveraged, they can decide to hold capex.
The Interest Rate Factor
When you consider debt financing, the interest rate is a key factor.
The return on the investment is essentially the interest rate.
Market forces determine the interest rate.
But in many ways, it reflects the creditworthiness.
So higher the interest rate, greater is the chance of a default.
A higher interest rate also reflects a higher rate of risk in an investment.
This is because the higher rate of interest provides the necessary cushion.
It helps compensate the borrower for the greater degree of risk that they are taking.
However, it is this interest rate that decides the relative cost of the debt.
At times of low-interest rate, it can be a cheaper option than equity.
This interest rate also has a tax interest.
What I mean is this interest rate is tax deductible.
So, you can always look for this tax relief for your business.
But be careful about over leveraging the business.
That will increase the overall cost and also reduce current value.
Therefore, the interest rate is a key element in the overall scheme of things.
On the one hand, it decides on the cost of the debt and on the other the value.
In terms of valuation, this is undeniably the most important factor to watch.
In many ways, it determines how feasible debt financing is.
The economic condition is the other key factor.
This is what determines the rate of interest.
The market forces also decide the time for which the rates remain at a level.
Thereby, debt financing remains closely linked with interest rate and the economy.
Types of Debt Financing
Well, as you can understand, there are several types of debt financing.
By some means, the money is the consideration.
Meanwhile, in others, it is the time in consideration.
Different types of debt have a varying degree of rates and risk.
Often the purpose of the expense is also a determinant.
Different expenses take different time periods.
They also need to be serviced differently.
Needless to mention, there is a different calculation of the rate of interest as well.
So, the final calculation depends on all these factors.
Together they work towards determining the different variants.
Debt Financing Over Long-term
This is a kind of debt that you undertake for long-term expansion.
You could be using it for a variety of capex too.
Often businesses use this to buy equipment and different types of machinery.
For buying land or buildings as well, you will go for this kind of long-term loan.
The term long-term refers to time period beyond one year.
Invariably the repayment schedule is long drawn.
Often the life of the machinery or land and repayment terms is connected.
Often these long-term loans are secured with the assets bought.
This then becomes a guarantee for the lender.
Short-term Debt Financing
This is the other popular variant of debt financing.
As the name indicates, the period of debt is shorter.
Often this is less than a year.
Mostly, businesses use short-term debt financing for day to day expenses.
It refers to the money they will require as working capital.
Businesses need this money for paying wages or buying inventory.
Short-term debt financing can be used even to buy regular supplies.
One of the best examples is the line of credit or credit card debt.
However, even this kind of debt is secured by collaterals.
It is more of a temporary arrangement to get over the short-term crisis.
In business terms, it is used to service current expenses.
It can also be a direct outcome of cash flow mismanagement.
This is perhaps one of the most popular types of debt financing.
They ensure a specific payment over a well specified time period.
The money that the investors buy it for becomes the loan.
The return that they earn after the promised period is the interest.
Let’s say that you bought a 10-year bond.
So, the bond is valid for 10-years and matures after this date.
But the bondholder can also sell this bond.
Normally, this becomes an emergency investment for the investor too.
More importantly, the company issuing these bonds get the money when they need it.
Normally the rate of interest in bonds is lower than bank loans.
This is perhaps the most conventional debt financing instrument.
Whether corporates need short-term or long-term, this is the first port of call.
If the amount is very high, often a consortium of banks may come together.
In this number of banks pool their resources to provide the required amount.
However, bank loans are not as straightforward as the credit card ones.
The corporate has to provide some collateral in exchange for the money.
So, just in case they are not able to pay the loan amount, they can sell this.
Real estate is, in fact, the most common type of collateral.
Most corporates take the loan against their office building or even a piece of land.
They can even use the machinery they are buying as collateral.
Paying Suppliers Later
Though this may not look like a loan really, but it is debt financing.
Even the largest of business houses have payment outstanding to suppliers.
In fact, there is just a handful of players who buy everything on cash.
Most suppliers provide goods with a pre-decided payment window.
Some follow a 90-day cycle while others can have a longer duration.
So for that period, they are effectively selling the product on debt.
They pay the suppliers whenever the bill is due.
In this case, they are able to source more raw material for a limited amount.
This can also reduce the working capital needs to a large extent.
However, corporates have to be careful about hidden cost.
Combining Debt & Equity
There are some financial instruments that combine both debt and equity.
Basically, these have features of debt as well as equity instruments.
This is why many times they are also called hybrid tools of investment.
There are some convertible options too.
In this case, the debt is then converted to shares.
This provision is at times available in bank loans as well.
In this type of debt financing, the bank can convert the loan into equity shares.
Of course, there are a series of condition attached to this type of arrangement.
The time and the duration are very important.
But at the same time, it is the best way to combine debt and equity features.
This helps generate adequate funding when required.
But at the same time, it limits the extent of leverage.
This, of course, increases the lender’s say in the complete business.
In many ways, it makes the business a little more vulnerable too.
In case the lender so decides, it can dilute the business stake.
Advantages of Debt Financing
One of the most important advantages is the limited role of lender.
The lender does not have too much say beyond giving the money.
But when the lender has an equity position, they also have more say.
They might also take a call on the business operation given the stake.
However, debt financing has no such obligation.
The borrower only needs to return the money to the lender on time.
There is no other interaction between the two parties.
Moreover, the cost of debt is tax deductible.
So businesses can hope to get the tax advantage from these as well.
In case of long-term debt financing, there is an extended repayment period.
Corporates can pay over a stretch of months and years.
This reduces the immediate stress on the working capital.
Corporates can easily plan for this and allocate money for repayment.
The rate of interest is always pre-decided.
This can help businesses plan their funding more systematically.
They can be better geared to deal with any crisis.
Problems with Debt Financing
But debt financing is not entirely a win-win pact for businesses.
There are some distinct disadvantages too.
If you are opting for long-term debt financing, the banks will surely take a collateral.
Even for some short-term arrangements, collateral is necessary.
In case you cannot provide collateral, a personal guarantee is necessary.
That means even if the business fails, you have a personal liability of the loan.
This also leads to personal collaterals at times.
Business owners often put their personal assets at stake.
This means that your family also has to face consequences of your business issues.
Personal collaterals mean the bank can even seize these in case of default.
That becomes a huge problem during troubled times.
Moreover, there are fixed payment schedules in debt financing.
This means that corporate have to allocate this money separately.
That means businesses cannot use funds for capex till the loan is paid.
The high cost of interest may also eat into the profit numbers.
This is particularly problematic when interest rates rise.
Also, don’t jump to debt financing without a proper plan.
That will be detrimental to your future growth prospects.
Always back your financing plans with strict repayment schedules.
Missing these can also increase the cost component.
Also, you have to carefully calculate your future resources.
This will help you decide how much you can repay and by when.
Otherwise, the repayment schedule can pose a huge burden to your business.
It can erode into your profits and cut down the scope for improvement.
Examples of Debt Financing
However, all this is a theoretical exchange of information.
Often the ground realities could be way more challenging.
So it is much better to understand debt financing with an example.
It will help provide the right perspective for clear understanding.
Let me first explain using a short-term and low key example.
Let’s assume I have a bakery for the past ten years.
But for so long, I was happy with my corner shop.
It generates sufficient profit to cover my expenses, pay wages and the like.
But now I feel I should expand.
That is how I can take my business to the next level.
So, I decide to meet an officer and discuss ways to leverage my current assets.
I am not keen on any partnership or equity stake.
Now I manage to get a $50,000 loan for 15 years.
The interest rate is fixed as per existing economic conditions.
The loan officer uses my bakery shop as collateral.
I get the loan and based on the additional profit I earn, I start repaying the loan.
If I don’t manage my cash well, I do run the risk of foregoing right over my shop.
The bank can easily seize the property.
But that also inspires me to work even harder and keep improving profit.
Debt Financing by Corporates
Well, this was a fairly straightforward debt financing example.
But often it tends to be more complicated, especially when you have large corporate borrowers.
The fund raised can be used for acquiring properties too.
But again, in this case, the challenges remain the same.
It is very important to maintain the cashflow limits.
Corporates can go for company bills, corporate bonds or T-notes too for raising fund.
It may not always be straightforward loans.
For example, when the Indian Railways were expanding, they issued bonds.
The average investor bought these instead of large returns.
So it was a win-win situation for both parties.
The corporate manage to raise the fund.
The investor willingly paid for it in anticipation of higher returns.
Debt Financing Can Be a Convenient Form of Raising Funds
It gives corporates a lot more leeway and helps them fund capex uninterrupted.
But at the same time, the repayment schedule is crucial.
Most importantly the extent of repayment needs to be calibrated carefully.
If the business owner is not strict with cash management, it can be a problem.
It can actually lead to severe fund crunch in future.
It can even erode the extent of profit.
So, go for debt financing when you have a sound business plan to back it.