Debt Financing comes into the picture when a company raises money by selling its Debt Instruments to investors. The money raised is for working capital requirements. It is the opposite of equity financing and occurs when a firm sells fixed-income products like bills or bonds.
An idea of How Debt Financing Works!
A business can raise money from three modes mentioned below:
- Equity Share.
- A mixture of Equity and Debt.
Procedure: A business choosing debt needs to sell its fixed income products to the investors, i.e., bonds. In return, the investor pays the capital needed to grow and expand the company. The investors who purchase the bond are the lenders.
As a business, you are required to pay back the debt financing. Paying back includes interest also. Therefore, the business must pay back the Principal and Interest amount.
In the meantime, if the company faces bankruptcy, the lenders will be given priority over the shareholders. Considering the workflow mentioned above, it is evident that a company should not go for Debt Financing.
But this is not the complete picture. Below, we list some hidden advantages that businesses observe when choosing Debt Financing for their business.
Advantages of Debt Financing
Debt financing is preferable for many companies due to some reasons. It can be because of cost-saving techniques or due to changes they provide in credit rating. The advantages of Debt financing are:
No Disturbance in Equity: Raising money through venture capitalists can be tempting. No wonder the method creates a huge infusion of money. But it also takes away the equity control. Equity is important as it brings voting right. As a business owner, you will need voting rights to influence the decision-making.
With debt financing, one can raise the money and keep control of themselves. The approach is the same as money borrowed from a bank. Debt Financing allows the infusion of cash into the business without any ownership or equity interruptions.
Lower Income Tax Rate: The interest charges for the debt leads to a reduction in tax payment. Ultimately it brings a tax advantage for the company.
Easy to Plan the Payments: With Debt Financing, you can easily know in advance where your future expenses will go. You will understand in advance your monthly, quarterly, and annual payments. This, in turn, will help you in budgeting your principal and interest. For making the financial plans for the business, it is important to know the cost that is significant for the company.
You also need to understand which cost will create a significant advantage for the company in the near future.
Multiple Ways to Approach Debt Financing: There are multiple ways in which an organization can approach debt financing. One of the most common options here is Loans. A loan is a point where you will get lump-sum cash that has to be repaid over a set time.
There are two types of business loan here, short-term and long-term. A business can take several years to repay the amount in long-term loans.
Other possibilities for debt financing include business credit cards, account receivables financing, invoice factoring, and corporate bonds.
Tax Benefit: It is important to understand the advantages and disadvantages of debt financing. Principal and interest expenses are business expenses. Before filling out the income tax expense, you got to see whether tax benefits are available for your company or not.
High Availability: Debt Financing is very common. It doesn’t involve much of a hustle. This option is available to almost every business in the industry. The size, structure, and credit history don’t matter for debt financing. You will be required to pay a high-interest rate if there is a significant risk involved. Debt financing is the last resort for every business as they are already struggling with the lack of funds.
Banks and other financial institutions are always available to lend money to the business through Debt Financing.
Reasonable Terms and Conditions: There is a scenario where Government provides reasonable terms and conditions. They list out easy terms and conditions for a business to manage. It is not possible that Government will qualify each business for reasonable terms and conditions. The fortunate business can have lower payments, have limited interest rates, and negotiable term lengths. Some get the option to restructure their agreement if financial difficulties emerge.
Business Profits: Another great reason to choose Debt Financing is profit sharing. With debt, you don’t have to pay your lenders the company’s profits. The lenders will never interfere in the growth of the company. Through this, a business can retain more profits within the company. A business only needs to pay back the principal and the interest amount.
For having an advantage over profits, most companies choose the debt financing option to raise money for the business. No wonder the fixed expense adds to the business, but it helps retain the profit to the business.
Reasonable Debt a Business Should Take
Now that the advantages of Debt Financing are clear, we would like to highlight an important factor. How much should a business keep as a debt ratio?
It is recommended that businesses keep the debt ratio between 0.3 to 0.6. The debt ratio defines how much the company’s assets are compared to the debts. This indicates the financial health of the business.
A higher debt ratio will make your business a risk factor and make borrowing tough, as it shows that a business took fewer assets to pay off its loan.
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Debt Financing is the means to save a lot for your business in return for interest payments. With all the positive sides of Debt financing mentioned above, it is quite clear that debt financing, if done properly, can be very cost-effective for the business. Also, no equity is harmed while taking the loan. With no equity changes, the voting power remains in the hand of the business owner.
It is advisable not to take too many debts for your business. Management of loans gets tedious, and failure to repay triggers penalty charges and harms credit score.