What is Debt Financing / Debt Funding?
Debt financing is when companies borrow external money to fund projects, or in the case with startups, to kick start operations.
Debt comes in the form of loans, meaning the company has to pay back the principal in the long run plus all interest intervals as per the loan’s terms of agreement agreed upon with the issuer.
Most loans and credit facilities are issued by banks, therefore companies usually go for this option.
4 Benefits of Debt Funding (Pros/Advantages of Debt Financing)
- One of the main benefits of debt funding is that you get to keep the company’s full ownership because you don’t sell the shares.
You are only required to meet back repayment of the debt that you borrowed plus any interest that had been accrued.
- Debt also plays a crucial role when it comes to tax payments and tax deductions because interest which comes from borrowed loans is a tax-deductible expense.
Principal and interest are placed in the same category as all other business expenses.
- Loans are temporary and any/all interests plus principal are well structured and stated from the beginning, therefore companies are able to plan ahead, and incorporate these cash outflows into their financial statements appropriately.
- Being able to pay back debt in a timely manner creates a reputable credit rating for the company, and thus the ease and availability of more loan options if and when required.
Companies are also able to negotiate terms and different kinds of structured debts if they have high credit ratings.
4 Risks of Debt Financing (Cons/Disadvantages of Debt Financing)
- Excessive debt could hinder the growth of a company, mainly because most of the income and profits generated from the company would be redirected to the debt obligations.
- Efficient credit ratings are not easily attained; this is considering that companies need to be in good credit ratings so as to qualify for specifically bank loans.
- Debt financing costs such as interest payments are expected to be paid on the specified dates, therefore companies that have varying cash flows may have issues when they are not able to meet the debt payments per the terms.
- In most loan offerings companies are required to give up some part of their ownership in assets such as company office/s, machines, etc. as collateral in the case they are not able to pay back the loans.
Collateral could easily go beyond company assets to personal belongings such as house/s, cars, etc.