Debt Financing

What is Debt financing?

Debt financing is a method of raising money by selling debt instruments to individuals and/or institutional investors for their working capital needs or capital expenditure. In return for providing funds, the lenders are repaid interest along with the principal amount at a future date.

The other method through which money can be raised is through equity financing, that is by issuing shares. Equity capital gives the shareholders ownership of the firm. Unlike in the case of interest on debt, the company has no obligation to pay dividends to equity shareholders.

Debt can be raised through various debt instruments like debentures, loans, bonds, etc. The lender is a debt holder or creditor, and the company owes them a scheduled interest payment along with the repayment of the principal amount.

Debt financing is often utilized by mature businesses that have less perceived business risk. This is because interest payment obligations need to mandatorily be met by organizations, so enterprises with the ability to meet this tend to subscribe to it.

Companies also use debt over equity financing when they don’t want to dilute the voting rights of the existing shareholders. If the company issues more equity shares, then the owners have to give up a percentage of their ownership and dilute their voting rights.

Hence, debt financing plays a crucial role when owners want to retain their ownership and voting rights, as it gives them more control over the company.

How does Debt Financing work?

There are three ways in which a company can raise money, these include the following below.

Equity

By equity we mean, a company selling its shares in the stock market. It represents ownership in the company. It also results in the dilution of ownership of the previous shareholders. The investors are given ownership and voting rights in return of the equity shares purchased.

The company generally issues shares through an Initial Public Offering (IPO) in the primary market when it is going public and issuing shares for the first time. After an IPO, a follow-on offer means selling and buying shares directly between investors in the secondary market.

The profits earned by the company can be utilized in two ways. It can either be distributed in the form of dividends to the investors or can be plowed back into the business in the form of retained earnings, for future growth and expansion. Therefore, the company has no obligation to pay dividends.

Equity shareholders have the last claim on assets in case of liquidation. They are paid after the company has fulfilled its commitment to all the outside liabilities and preferred shareholders.

Debt

Debt financing refers to the issuing of instruments like bonds, notes, and bills to institutional or individual investors to raise capital. The company has an obligation to pay the interest and the principal amount to debtholders. If the company goes bankrupt, then debtholders have a high claim on assets as they are the first ones to be repaid.

Mix of both equity and debt 

The company decides its capital structure and what it wants in its capital mix. A company can use both debt and equity to maintain an optimum balance in the capital structure.

Types of Debt Financing

Following are some of the most common debt financing instruments used by companies all over the world to raise capital.

Debentures

Debentures are of two types: secured and unsecured. Secured debentures are secured against the assets of the company. In case the company fails to pay the principal and interest amount, then the debenture holders have the right to sell the mortgaged asset to realize the amount owed by the company.

Unsecured debt instrument that is unsecured by a collateral. Investors investing in such an instrument need to check the business's creditworthiness (issuer). Since debentures are generally unsecured and have no collateral, they must be purchased on the issuer's creditworthiness.

Many credit rating agencies like Fitch, S&P Global, and ICRA help investors to know how creditworthy a company is. A good credit rating shows that a company is less risky and not likely to default on its payment obligations. It would help investors make an informed decision to whether to invest in the company or not.

Large corporations and government institutions issue debentures to raise money. These pay interest to bondholders and pay them the principal amount on a predetermined future date.

Term loans

It is a loan generally given by a bank that has a specified repayment schedule, and the interest charge on such loan might be fixed or floating charge.

• Fixed charge is a charge on a specific asset or a group of assets. The lender can take possession of the asset in case the borrower defaults in payment, e.g. mortgages.
• Floating charge is a charge on a company’s general assets which is subject to change over time. The assets subject to charge are not specified, and the lender cannot take possession of the asset until the borrower makes default on the loan. For example, debentures, bank loans, etc.

Bonds

It is a debt instrument where an issuer issues bonds to the borrower. It can be considered as an I.O.U between the lender and the borrower. Fixed or floating interest rate needs to be paid along with the principal amount, which is determined at a future date.

Commercial paper

It is an unsecured, short-term debt instrument issued by a company to finance its short-term liabilities like bills payable, trade payables, etc. Commercial papers have a fixed maturity of not more than 270 days.

Credit lines

It is also called a Line of Credit (LoC). It is a flexible credit facility extended by a financial institution to the company. Whenever a company needs money, it can borrow from the bank and later be repaid.

Cost of debt

A firm uses a mix of both equity and debt. They both have costs associated with each other. The cost of equity is the dividend payment to shareholders, and the cost of debt is the fixed or floating interest payment to be made to lenders.

Apart from this interest payment, the borrowers need to repay the full principal amount on a specified future date or at maturity.

Kd = Interest Expense x (1 - t)

Here, 

1. Kd - cost of debt
2. t - tax rate

Interest on debt is tax deductible. Therefore, interest expense is calculated on an after-tax basis.

If we combine the cost of debt and the cost of equity, we get the total cost of capital of the firm. The firm’s overall cost of capital is the minimum required return that an investor, lender, and creditor expects the firm to earn in return for their investment.

The company’s internal rate of return (IRR) should also be greater than the total cost of capital. If not, it shows that the company is not producing positive cash flows from a project, and investors are at a loss.

Example of Debt financing

Pooja has a small bakery shop in her hometown, Delhi. Her business is doing great, as there have been positive cash flows for the last 3 years. Along with positive cash flows, her business is also earning enough revenue and generating profits.

Now, she wants to expand her business further and introduce a cafeteria along with the bakery items. However, she does not have enough cash to expand her business as the cash might be used for daily operations in the business.

She thought of taking a credit/ loan from a bank of $10,00,000. Therefore, this loan from the bank is called debt financing. Pooja will use this loan to enter into a new line of business.

Financial Ratios for Debt Analysis

Financial ratios help in analyzing the financial performance of companies. Here are some ratios that help analyze a company's ability to manage its debt.

These ratios help in assessing the debt component of the firm with respect to other financial metrics like cash flows, equity, total capital, assets, etc.

Debt to Equity (D/E) ratio

It represents how much debt a company has compared to its shareholder’s equity. It is calculated by dividing total liabilities by shareholder’s equity

D/E Ratio = Total Liabilities/ Shareholder’s Equity

Liabilities here refer to the total liabilities that are mentioned in the balance sheet.

Shareholder’s Equity (Net Assets)= Assets- Liabilities

A higher D/E ratio symbolizes high risk. It means that the company is using more debt to finance its daily operations. If a company does not have enough cash inflows, then the company might default on its obligatory payments, leading to bankruptcy.

A lower D/E ratio shows that the company is using its assets rather than borrowings. The company is using equity to finance day-to-day operations of the business.

Debt ratio

It represents the number of assets that were financed using debt. It is calculated by dividing total assets by total liabilities.

Debt Ratio = Total Assets/ Total Liabilities

A high debt ratio is considered bad because it shows that total debt is too much for the company to pay back.

Debt comes with a fixed obligation of interest charges. Hence, if the company is not producing enough cash and has a high debt ratio, it is most likely to default. It will make the company go bankrupt or insolvent, making it risky.

Interest Coverage Ratio (ICR)

It measures how a firm can pay the required interest rate on its outstanding debt obligation in time. Lenders and creditors use this ratio to measure the riskiness of lending capital to a company. It is calculated by dividing earnings before interest and tax (EBIT) with interest expense.

Interest Coverage Ratio (ICR) = EBIT/ Interest Expense

Earnings before Interest and Taxes (EBIT) is operating income, which is recorded in the Income statement of a company. It indicates profit generated by a company’s operations. It is calculated by deducting expenses from revenue excluding tax and interest.

A low ICR is generally considered a bad indicator because it indicates high chances of being at default, therefore leading to risk.

Long-term vs Short-term debt

According to the requirements of the company, debt can be raised for the long term or short term. The differences between long-term and short-term debt are as follows:

Debt vs Equity

A company can use both debt and equity to raise capital and finance its operations. Following are some major differences between debt and equity to help us examine each option carefully:

Pros and Cons of Debt financing

Following are some of the advantages if a company chooses debt financing for raising money:

1. There is no dilution of ownership. 
2. Debt instruments are tax deductible.
3. The cost of debt is less as compared to equity. 
4. Repayment of the debt makes the liability towards creditors zero.
5. Taking debt improves the credit rating of a company.

Debt financing also has some disadvantages, which include:

1. If cash inflows are irregular, then it could lead to a default in repayment.
2. The interest and principal amount are an obligation and thus need to be paid.
3. If the company is unable to clear its debt, then it may even lead to bankruptcy.

Researched and Authored by Chhavi Gupta | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Debt Consolidation
• Debt Covenants
• Debt Default
• Debt Equity Ratio
• Debt Restructuring