Debt Financing: how it works, examples, and alternatives

As a CFO of an organization, one of your key goals is to optimize working capital or capital expenditure in a way that creates a compelling mix of equity and debt financing. Moreover, you must pay attention to the debt-to-equity ratio, as excessive debt repayment causes financial distress and impacts your company’s cash flow. 

Wondering how to reduce tax implications, improve investor perception, and minimize financial risks? This article walks you through the basics of debt financing, ways to measure it, and find suitable alternatives.

What is debt financing?

Debt financing, also known as debt funding or debt lending, is a method of raising capital by 

• selling debt instruments like bonds, 
• notes, 
• peer-to-peer lending, 
• credit lines, or 
• bank loans to individuals and institutional lenders. 

Companies return the principal with interest to the creditors. This method of raising working capital is also known as financial leverage. 

Organizations rely on such financing to obtain liquid capital or enhance cash flow during mergers, acquisitions, or financial challenges. In contrast, new businesses with lower credit ratings and high profits depend on equity financing — another method of raising capital by selling stock shares to the public. 

With debt, companies can keep the ownership of shares with themselves, which doesn’t happen in the case of equity financing.  

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Types of debt financing

Enterprises, startups, and small businesses use short-term and long-term options in debt below to access liquid capital immediately. 

1. A bank loan is the most common way of accruing debt financing quickly. Public and private banking institutions analyze financial statements to assess whether an organization is eligible for loans. Loan sizes and interest rates vary depending on the borrowing company’s financial situation. These loans don’t impact credit ratings when organizations repay them on time. 

2. Secured and unsecured business loans are another type of loan businesses use to raise debt capital. Secured loans require collaterals, meaning even companies with low credit ratings can get these loans if they have an asset. Unsecured business loans don’t require organizations to have collaterals. However, firms applying for these loans must have excellent credit scores for approval.

3. Bonds enable private corporations and large enterprises to loan money from investors in return for repayment by a specified date. Secured bonds carry specific assets owned by the issuing organization. Bondholders receive the asset titles when the organization defaults on the bond. 

4. Debentures or debt securities feature floating or fixed interest coupon rates and no collaterals. These instruments suit organizations looking to raise funds to meet business operation costs or future project expenses. Debt securities pay dividends and interests to shareholders by the agreed repayable date.

5. Equipment loans are ideal for businesses looking to purchase manufacturing or other tools for production. 

6. Family and credit card loans are common with startups and small businesses that don’t wish to opt for traditional debt financing methods. 

7. Trade credit refers to business credit organizations receive from suppliers for goods and services. These credits allow buyers to pay suppliers at a later date.

Now, let’s understand how debt financing works.

How does it work?

Organizations seeking financing can sell equity to shareholders, rely on debt instruments, or use a mix of the two. With debt financing, they can sell fixed-income products like bills, bonds, or notes to raise capital for meeting operational expenses. 

Most of these instruments work in the same way. Retail or institutional investors become lenders as they purchase bonds that an organization issues. The borrowing organization promises to pay back the investment loan or principal by an agreed future date. Investors have the right to claim liquidated assets in case the company goes bankrupt in the future. Equity holders are typically the last to receive money in such scenarios.  

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Cost of debt financing formula

The cost of debt refers to the total interest amount a company owes to investors on debt instruments like bonds, debt securities, and loans. You can calculate an organization’s before-tax or after-tax cost of debt using the formula below.

Before-tax cost of debt = Total interest / total debt

Start by calculating your organization’s total interest on all debt financing instruments. Once you have the sum of all interests, add up the total amount of debt. Now, divide the total interest by total debt to find the before-tax debt cost.  

After-tax cost of debt = Effective interest rate x (1-total tax rate)

After-tax debt cost calculation requires finding the weighted average of all interest rates. Now, multiply the interest rate by the difference between one and the total tax rate to calculate the post-tax debt cost.

Examples of debt financing

Let’s look at an example to understand how this financing works. 

Imagine that Moorthy & Sons is an Indian e-commerce chain specializing in grocery and household items. They are present across multiple cities in South India and are looking to expand operations in the West. 

Based on their annual financial report, they realized they needed at least ₹ 80,00,000 to open the first two stores. They raised this fund by issuing bonds to 20 investors at 10% interest rate. Each investor invested ₹ 4,00,00 for a year. Each investor earned ₹ 40,000 in the end. 

Debt financing vs equity financing

Debt financing involves taking out a loan and repaying it with interest. In contrast, equity financing means selling a company’s equity shares to raise capital.

It also involves an organization borrowing money from lenders like banks, financial institutions, or private investors. In this model, investors become creditors and don’t gain ownership of the business. The interest rate doesn’t fluctuate throughout the loan term. As a result, this method of raising capital aids organizations in cash flow forecasting. 

Equity financing is a method of increasing capital by selling ownership shares of your business to investors in exchange for funds. These investors become shareholders, having a stake in the company’s ownership and potential future profits.

Aspect	Debt financing	Equity financing
Ownership	An organization retains complete ownership.	Equity investors retain the ownership of the shares they purchase in a business.
Repayment obligations	The borrowing company must repay the capital with interest by the agreed timeline.	There are no immediate repayment obligations.
Interest payments	A company using debt financing must repay interest at period intervals.	Equity financing doesn’t require interest payments.
Advantages	Debt interest is tax-deductible. Plus, the borrowing organization retains complete control and ownership.	Equity investments don’t require credit scores and periodic capital repayment.
Disadvantages	Organizations must have a good credit history and collaterals.	Equity financing doesn’t offer tax advantages. Plus, there’s always a risk of losing company ownership in the long run.

Debt financing vs interest rates

Debt financing refers to borrowing money by selling debt instruments. Companies opt for this type of financing to fund project expenses or capital expenditures. 

Conversely, the interest rate is the return on investment lenders expect while lending money to borrowers. Different factors, including economic climate, a borrower’s credit ratings, and inflation, affect the interest rate. Higher interest rates result in higher debt costs for the borrowing company. 

Higher interest rates compensate lenders for the increased risks they take while lending to borrowers. Borrowers also must meet covenants or financial performance rules in cases of high-risk debts. However, the interest rate tends to be lower than equity financing in the long run.

Debt funding vs invoice factoring

Debt funding involves selling debt instruments, whereas invoice factoring sells accounts receivable for immediate cash. 

Invoice factoring or accounts receivable factoring is selling outstanding customer invoices to a third-party financial institution for liquid cash. The invoice financing method enables borrowing businesses to obtain a percentage of the due invoice amount for the financial service provider. Once the financial institution collects outstanding customer payments, it takes out a fee before sharing the remaining balance with the borrower. 

Unlike debt funding, invoice factoring isn’t a loan but can be helpful for short-term cash flow problems. 

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Short-term vs long-term debt financing

The crucial difference between short-term and long-term debt financing is the loan repayment period.

Short-term debt funding options allow organizations up to a year to repay the borrowed money. Investors lending money for a shorter duration may demand a higher interest rate because of increased risks. However, this option is ideal for companies struggling with short-term cash flow fluctuations.

Long-term debt financing instruments have a repayment period of over a year, meaning organizations get more time to pay the lenders. The interest rate tends to be lower because of the reduced risk to the lending individuals or institutions.

How to measure debt financing

The debt-to-equity ratio is one of the most common ways to measure debt financing. This metric enables organizations to measure how much of the capital is debt and equity, which they can find on balance sheets. 

Let’s look at an example of how to measure this type of financing. Imagine that Moorthy & Sons has a total debt of ₹ 90,00,000 and stockholder equity of ₹ 1,00,00,000. The debt-to-equity ratio is = ₹ 90,00,000/₹ 4,50,00,000 = ⅕, or 20%. This ratio shows that Moorthy & Sons has ₹ 5 equity for every ₹ 1 debt financing. 

Generally, most organizations prefer a lower debt-to-equity ratio unless they are in industries with high debt tolerance.

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Advantages and disadvantages of debt financing

Below are some key advantages and disadvantages.

Advantages

Debt financing allows organizations to pay lower interest rates, benefit from tax deductions, improve business credit, and retain control.

• Offers lower interest rates: Businesses can choose from a wide variety of debt instruments to find the best option for them. As a result, they are often able to find low-cost financing methods with longer repayment terms and lower interest rates. Moreover, equities tend to be more expensive than debt funding. 
• Tax deduction benefits: The principal and interest payments appear as business expenses on the financial statement. Since both are tax-deductible, debt funding significantly reduces an organization’s net obligations. Consider consulting with a tax professional to understand the impact of debt on taxes better. 
• Improves business credit: A good credit rating is essential for businesses seeking low-cost, long-term debt funds. It’ll be difficult for them to establish trustworthiness without a record of loan repayment. That’s why this financing is an excellent option for improving credit ratings and getting favorable interest rates in the future. 
• Retain control: Debt funding doesn’t allow individual or institutional investors to vote or have any say in business operations. As a result, business owners can keep decision-making and management in their control. 

Disadvantages

Common challenges include collaterals, credit rating, and cash flow-related issues.

• Requires collaterals: Most lenders ask for collaterals like business assets or cash while assessing whether they should give loans to an organization. These collaterals reduce lenders’ risks as they can liquidate these assets to recover money in case of default.  
• May decrease credit rating: Companies relying solely on debts may affect their credit score poorly. Investors treat these organizations as risky because they may experience difficulty in making repayments in case of liquidity lapses. That’s why it’s wise to be careful while opting for debt financing. 
• Creates cash flow issues: Organizations using debt funding for business expenses may experience cash flow problems in case of unsteady revenue. Even seasonal fluctuations can cause significant financial discomfort for these businesses. Since loans require monthly repayments, organizations must ensure their repayment ability before financing debt. 

Are there alternatives?

Organizations typically opt for the following financing alternatives in the absence of debt funding.

• Asset-based lending uses working capital assets like accounts receivables and inventory as collaterals to disburse loans.
• Subordinate debt is income statement-based lending, which considers financial statements and forecasts to provide business loans.
• Convertible debt is a fixed-income, long-term debt that a company converts into equity after a specified period. 
• Invoice financing is an alternative method that sells accounts receivable to a third-party financial services provider for immediate cash.
• Peer-to-peer lending lets organizations borrow money from individual investors without a financial services intermediary like a bank.

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Conclusion

Opting for debt financing enables businesses to enjoy tax deductions, maintain ownership control, and lower the cost of capital. However, it can be tricky to obtain debt as financial institutions and investors require collateral and a strong credit history. Organizations must consider working with accounting and tax professionals to fully understand how debts can impact their cash flow and whether it suits them.

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