written by: N Nayab•edited by: Ronda Bowen•updated: 1/24/2011
Debt financing is funding investments or expenditure using money borrowed from an outside source under condition of repaying the principal and the agreed-upon interest on a set schedule. Read on for an understanding of the pros and cons of debt financing.
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What is Debt Financing?
Debt financing is borrowing money from external sources to run a business, or make new investments.The borrower receives the amount required, usually a large captal sum upfront, and agrees to repay the same with applicable interest in installments, usually equated monthly investments. Most debt financing are long term in nature.The borrower usually needs to pledge some collateral security such as existing assets as a safeguard for the creditor in the eventuality that money invested does not bear fruit and the debtor is unable to repay the loan.
An important source of this type of financing is the bank, but many private companies, and even friends and relatives offer such financing.
Debt financing is a major type of funding and has both advantages and disadvantages.
Reviewing the pros and cons of debt financing, debt financing offers many advantages for the debtors. Some such advantages include:
Control: Debt financing allows the borrower to retain ownership on the control of the business, unlike equity financing which require the borrower to part with share of company ownership and surrender decision making autonomy. In debt financing, the third party creditor has no monetary interest in the business, except for the principal and interest income.
Retain Profit : Debt financing allows the entrepreneur to retain the profit earned by the business without sharing it with the debtor. The lender does not have any share or stake in the profit and only gets the loan payments in the set time, and only for the agreed upon period. This is in contrast to equity financing which requires sharing the profits and losses for eternity.
Limited Obligation: In debt financing, the borrower’s obligation ends with the repayment of the principal and the interest to the lender. The obligations that come with taking up a partner in equity financing remains permanent and irrevocable, unless the partner willingly sells his or her stake and the entrepreneur can buy ut back at the price offered.
Tax Deduction: One of the most attractive aspects of debt financing is tax advantages. The interest on borrowed money, paid to the lender is tax-deductible. This means exemption from paying tax for the part of business income used to pay interest, lowering the tax liability of the business.
Timely Payments: Timely repayment of debt enhances and improves the credit rating of the business, making it easier to obtain other types of financing in the future.
Easy Administration: Debt financing is easy to manage and administer, and require no extensive or complex reporting requirements. In contrast, issuing shares to source equity financing require compliance with complex regulations under the Federal and State Security laws and regulations.
Future Planning: In debt financing, the principal repayments and interest are calculated before hand, and does not depend on market conditions. This allows for better planning and forecasting.
Less expensive: Long-term debt financing turns out to be less expensive for businesses owing to spreading out of the capital repayment over many months, and the likelihood of the investments maturing and providing good returns as they reach its peak.
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Cons of Debt Financing
The advantages of debt financing notwithstanding, this financing model also have many shortcomings. Some of them include:
Repayment: A debt requires repayment irrespective of whether the debtor makes a profit or loss with the loan. This is in contrast to equity financing where the repayment bases itself on the actual performance of the borrowed money
HighCost: The fixed interest costs can raise the company’s break-even point, or the point where no profit and no gain occurs.
Restricted Cash Flow: Debt repayments are a fixed obligation regardless of profits, loss, or delayed payments. This raises the risk of insolvency for the business, especially during difficult financial periods.
Budget:Debt financing requires accounting and budgeting the principal and interest in the cash flow statements.
Restrictions: Just as equity financing restricts the decision-making powers of an entrepreneur, debt financing also impose restrictions such as not allowing for alternative financing options when the debt remains in place.
Collateral Security: Creditors require some type of collateral security to cover the value of the loan.
Risk Outlook: Debt financing increases the company's risk outlook, for higher the business’s debt-equity ratio, the more risky the company becomes for other lenders and investors.
Comparing the advantages and disadvantages of debt financing, debt financing remains suitable if the cash is put to high growth ventures with stable cash flows.