What is Debt Financing? Definition, Sources, Secured vs Unsecured, and More

Definition:

Debt finance is a type of finance that is acquired by a business for the principal amount to be paid along with interest at a future date. Generally, debt finance has a set time period for repayment.

When a business acquires debt finance, it may be subject to different terms and conditions which is set by the lender. These terms may dictate the period of payments, type, and rate of interest, payback terms, any securities by the business, etc.

Sources of Debt Finance

Debt finance may come from different sources such as private or public sources. Private sources may range from personal family and friends to banks, finance companies, credit unions, etc.

On the other hand, public sources of debt finance may include special loan programs provided by the government to support small or medium businesses.

Most businesses start from a small source of finance by borrowing from friends and family. Once a business has something to show for, further debt is obtained from banks or credit unions.

Debt finance through finance companies can also be acquired but they come at a higher cost to the businesses borrowing the finance.

Some businesses may also use owners’ credit cards as a source of debt finance. This may be the easiest form of debt finance to acquire for a new business, however, the interest rates charged by the credit card companies are very high.

Another form of debt finance is through trade credits. This can be obtained by buying materials from suppliers on credit and paying them at a later date. As compared to the other forms of private debt finance, this form of debt is shorter-term but the cost is often almost none to the business borrowing it.

Some governments also provide loans to small businesses to encourage entrepreneurs. This type of debt finance is considered a public source of debt finance.

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These types of loans are easier to acquire for businesses and may fall cheaper for the borrower with lower interest rates as compared to mainstream sources of debt finance.

Secured vs Unsecured Debt Finance

When obtaining debt finance, the lender may ask the borrower to provide some kind of a guarantee or collateral called security. This guarantee can be provided in the form of owners’ personal assets or business assets.

Unsecured debts require no guarantee. In case the borrower defaults on the debt, the lender can only recover the debt through a lawsuit. Therefore, lenders may carry out intensive creditworthiness checks on the borrowers before providing them with debts.

Unsecured debts also come at a much higher cost to the borrower as lenders charge extra interest rates as compared to secured loans due to the risks involved.

In contrast, with secured debts, the borrower must provide a guarantee. This guarantee can be in the form of assets.

In case of default, the asset is legally transferred to the lender who can sell it to receive the amount of debt provided. Due to the lower risks involved for the lender, secured loans come at a lower interest rate for the borrowers.

Short Term vs Long Term Debt Finance

Debt finance can either be long term or short term according to the requirement of the business using them.

For example, a business looking to fund its working capital needs may look into short-term options as compared to a business looking to fund a multi-year project or the purchase of a fixed asset.

Short term debt finance is, generally, obtained for smaller needs of a business, for example, funding the purchase of inventory or payment to suppliers.

Bank overdrafts and credit card loans are also considered short-term. The amount of a short-term loan is smaller, however, the interest rate per period is higher as compared to long-term loans.

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Long-term debt finance is obtained for the long-term needs of a business, for example, the purchase of a new factory building or purchase of a new subsidiary.

These loans have a longer period of payback but, in contrast to short-term loans, a lower interest rate per period. Long-term loans are also, generally, given in lieu of security as mentioned previously.

D/E (Debt-to-Equity) ratio

The debt-to-equity ratio, also known as the gearing ratio, of a business is the ratio of its total debt (liabilities) to its equity. The D/E ratio of a business is very easy to find for investors as all the information is available in a business’s balance sheet.

The D/E ratio tells investors how much a business relies on debts (as compared to equity) for financing its activities. It also tells the investors whether the business will be able to cover its debt finance obligations in case of an unforeseen downturn.

Generally, investors prefer to invest in businesses with a low D/E ratio as this denotes a lower risk for investors. If the D/E ratio of a business is higher than 1, it means it is overly reliant on debt, while if it is lower than 1, it means it is financing its needs more through equity than through debt.

However, this ratio differs from one industry to another, and investors look into industry averages before making a decision regarding a certain business in the industry.

Advantages

  • The biggest advantage of debt finance over equity finance is the retainment of control. Debt finance is temporary as compared to equity finance. Once the debt is paid off, the borrower has no obligation to the lender. Unlike equity finance, there is no dilution of ownership in the business.
  • Obtaining and successfully paying off debt finance can help increase a business’ credit ratings and make it easier for businesses to obtain loans in the future.
  • Credit terms and payments are known in advance; therefore, debt finance can help when a business is forecasting its cashflows for the future.
  • Interest payments made for debt finance may be considered as a tax-deductible expense for the business. This means that interest payments for debt finance may decrease the amount of tax payable for a business. Dividends paid for equity finance do not have the same effect.
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Disadvantages

  • To obtain debt finance, businesses have to have a good credit rating. Smaller businesses or businesses starting fresh may find it difficult to obtain debt finance.
  • Overreliance on debt may cause cash flow problems for businesses. When considering businesses to invest in, investors consider businesses with the least debt/equity ratio.
  • If a business fails to pay interest or principal amounts on time, it may face legal action from the lenders and may damage the business’ credit rating. Unlike equity finance, the lender does not support the business when the business cannot pay them on time.
  • Businesses also need to provide some sort of security, as mentioned above, for loans. This is generally considered a disadvantage by some borrowers who may not have or do not want to put in assets as a guarantee.

Conclusion

Debt finance is certainly a great source of finance for any business but it can have its drawbacks. Ultimately, it is up to a business to decide whether it wants to avail of this tool.

A business must consider many factors such as whether it wants to dilute its ownership, certainty, and regularity of payments, credit ratings, and security requirements before making a decision.

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