In layman’s terms debt financing means borrowed money. Lenders and creditors earn interest by lending money to the borrowers. The essential use of debt financing is providing financing to the business or individual. However, the implications of debt financing are stretched beyond financing to investments as well.
Debt financing can be classified by type, maturity, or lender. The characteristics of debt instruments depend on several factors. Usually, debt financing sources are classified into long-term and short-term options.
#1 Long-Term Debt Financing Sources
1) Treasury / Government Bonds
These bonds are issued by government or treasury institutes around the world in capital markets. Investors seek regular returns with such investments. The creditworthiness of government institutes makes these bonds a secure type of debt financing.
2) Corporate Bonds
These are long-term debt instruments that large companies issue through capital markets. These are also secured loans but riskier than treasury issued bonds. Investors demand higher returns with these bonds than treasury bonds.
Bonds work as debt instruments for the issuers and investment options for the borrowers. Issuing bonds in the capital markets require substantial creditworthiness that makes it impossible for ordinary companies to raise financing through bonds.
3) Bank Loans
Traditional bank loans are the most common form of debt financing for all sizes of companies. Any bank loan with maturity over 12 months can be termed as a long-term debt source.
Borrowers require asset-backed collateral to secure bank loans. The absence of collateral can result in high-interest rate unsecured loans. However, bank loans are a widely used option for all companies. The bonds market remains an expensive and unreal option for regular businesses.
4) Financial Lease
Financial leases are long-term contracts that work like a loan. The lessee makes payments in installments against the ownership of an underlying asset. The maturity term of a financial lease is usually longer than one year.
#2 Short-Term Debt Financing Sources
1) Revolving Credit Facility
It is a type of loan in which the borrower can reuse the loan amount on a recurring basis. The interest is only charged on the used amount from the approved total borrowing limit. The benefit with the facility is replenishing loan that does not require multiple loan approvals from the bank.
2) Lines of Credit
Lines of credit resemble revolving credit loans. The borrower can withdraw any amount up to the approved limit. Interest will be charged only on the utilized amount.
However, unlike revolving credit, the line of credit facility does not replenish without approval. In a sense, it works as a hybrid of a short-term loan and revolving credit facility.
Banks offer the facility to their creditworthy customers to allow flexible financing options. In this arrangement, an additional credit limit is approved with a normal bank account for the borrowers.
The facility benefits companies in clearing issued payment instruments. It also works as an additional emergency buffer for individuals and businesses.
4) Business Credit Cards
Business credit cards also work like a line of credit facility. It can be used as a good short-term source of finance. However, the interest costs with credit cards are significantly higher than other types of loans.
#3 Other Sources of Debt Financing
Some other forms of debt instruments can range from short to medium terms. The working nature of these types of debt instruments also differentiates them from common debt instruments.
- Merchant Cash Advances
- Operational Leases
- Equipment financing
- Trade and merchant loans
- Factoring and Invoicing
- Venture Capital Debts
- Government and other Grants
Cost of Debt Financing
Generally, lenders of debt financing expect lower returns than equity investors. However, the cost of debt mainly depends on the secure nature of the borrowing.
A secured loan will incur lower interest than an unsecured loan. Similarly, a short-term line of credit like a credit card (unsecured also) will incur higher interest costs.
Advantages of Debt Financing
Debt financing is accessible for all companies that make it the most widely used financing option. It offers certain benefits to both parties:
- Debt financing is cheaper than equity financing.
- It is an accessible and easily available option for all businesses.
- Debt financing does not surrender the ownership rights of the business.
- Debt financing instruments vary by type, thus offer a wide range of options for borrowers.
Limitations of Debt Financing
Although debt financing is a go-to option for most businesses, it comes with certain limitations:
- Borrowers may need collateral to acquire debt financing.
- It does not offer a certain qualification of the borrower.
- Unsecured loans are expensive than equity financing.
- Secured loans may result in foreclosure or bankruptcy in case of default on the loan.
- High leverage with more debt financing may compromise the credit profile of the business.
- High-leveraged businesses may not qualify for equity financing as well.