Every business, irrespective of its size or industry, requires a steady flow of funds to sustain operations and drive expansion. While equity financing and retained earnings are common options, debt financing is often considered the preferred choice when substantial capital is needed over an extended period.
By borrowing money from external sources, companies can access significant businesses to invest in new projects, acquire assets, or bridge financial gaps.
To understand debt financing in detail, let’s start with what debt financing is and how it works.
What is Debt Financing?
Debt financing is when a company borrows money from external sources, such as banks or other financial institutions, to fund inventory, cash flow shortages, or growth. In return, the company agrees to repay the borrowed money along with interest over a specified period.
How Does Debt Financing Work?
Under debt financing, a borrower makes an agreement with a lender – such as a bank, NBFC, or other financial institutions, to borrow a specific amount of money. This agreement outlines the loan’s terms and conditions, including the interest rate, repayment schedule, and other relevant terms. After receiving the funds, the borrower is expected to make regular payments, usually monthly or quarterly, to repay the principal and interest.
The repayment schedule can vary. Borrowers can make equal installments throughout the loan tenure or choose flexible EMIs, where the payment amount can increase or decrease based on the borrower’s convenience and financial situation.
Types of Debt Financing
There are various types of debt financing available for businesses. Here are three main types:
Business Loans
Business loans, whether from a bank, credit union, or financial institution, are one of the most common methods of debt financing. These loans allow companies to borrow capital to support operational needs or fund expansion. When the loan is granted, repayment terms are established, and the borrowing company must repay the loan amount along with interest and/or fees within those terms.
Invoice Financing
Invoice financing, also called accounts receivable financing, lets you borrow money based on your unpaid invoices. Instead of waiting for customers to pay, you can get cash right away. You owe this borrowed amount to the financing company.
When the invoices are due, either you collect the money and repay the financing company, or they collect it directly from your customers. This method is great for quickly solving cash flow problems. It’s fast, easy, and often has no interest. Instead, a small fee is taken from the total amount.
Lines of Credit
Lines of credit allow businesses to borrow up to a certain amount whenever they need it. They only pay interest on the amount borrowed, offering flexibility.
Advantages of Debt Financing
Debt financing offers several advantages for businesses. These include:
Preservation of Ownership
When a business borrows money instead of selling part of its ownership stakes, it retains complete control over the business. This ensures uninterrupted decision-making authority.
Tax Benefits
Interest payments on debt are often tax-deductible, reducing the overall tax burden and increasing after-tax profitability.
Predictability
Debt financing provides a clear repayment structure with fixed terms, enabling better financial planning and budgeting.
Leverage
Businesses can borrow money as debt and use it to invest in projects that have the potential for higher returns. This leverage can increase profits in the case that the return on the investment exceeds the debt’s cost.
Rapid Access to Capital
Debt financing offers a quick way to secure funds without compromising ownership, making it suitable for businesses with strong cash flow and growth opportunities.
Example of Debt Financing
Imagine Zenith, a tech company, wants to develop a new product. It needs money to do this, so instead of selling part of the company, it decides to borrow money. This is called debt financing.
Zenith borrows ₹10,00,000 from a bank. It must pay back this money in 3 years, and the financial institution charges 8% interest.
Here’s how it works:
Month 1: Zenith gets ₹10,00,000 from the financial institution. It pays interest of ₹6,667, and the rest of the monthly payment goes towards paying back the borrowed money.
Months 2 to 36: Zenith keeps paying the same amount of money each month. But a little less of that money goes towards interest, and a little more goes towards paying back the loan.
After 3 years: Zenith has paid back all the money it borrowed (₹10,00,000) plus the interest.
So, instead of giving away part of its company, Zenith borrowed money and will pay it back over time with interest.
So, Zenith obtained the money to make its new product without selling part of its company and paid it back over time with interest.
Conclusion
Debt financing is important for businesses that need finances for growth or daily operations. By taking out loans, issuing bonds, or using credit lines, companies can access money quickly without giving up ownership. This method offers advantages like tax benefits, predictable payments, and the ability to increase profits.
Business loans are a common type of debt financing. LoanTap’s business loans provide a reliable way to support businesses in expanding, managing cash flow, and investing in new projects. You can get business loans at an affordable interest rate with minimal documentation and a longer loan tenure.
Frequently Asked Questions
How does a business determine the right balance between debt and equity financing?
A business can determine the right balance by assessing its financial health, growth prospects, and risk tolerance. The goal is to use money in a way that costs the least but still lets the business stay flexible and strong.
What is a business loan, and how does it fit into debt financing?
A business loan is a sum of money borrowed from a lender to be repaid with interest over a specified period. It is a common form of debt financing that helps businesses fund operations, expand, or invest in new projects. Business loans can be secured or unsecured and are customized to meet the specific needs of the business.
Can small businesses benefit from debt financing?
Yes, small businesses can benefit from debt financing by getting the necessary capital for growth and operations without giving up ownership. Small business loans, lines of credit, and trade credits are particularly useful for managing cash flow, expanding operations, and investing in new opportunities.
What should businesses consider before opting for debt financing?
Before opting for debt financing, businesses should consider the interest rates, repayment terms, collateral requirements, and financial health.
What is the difference between secured and unsecured debt financing?
Secured debt financing requires the borrower to provide collateral, such as property or equipment, which the lender can seize if the loan is not repaid in time. Unsecured debt financing does not require collateral but usually comes with higher interest rates due to the lender’s increased risk.
