Debt financing is a form of financing using someone else’s capital under the form of, for example, loans, bonds or credit. That is to say that a company increases its working or investing capital by borrowing funds from somebody else. By consequence, the company becomes a debtor.
The alternative is equity financing which is the company’s profit or funds from investors.
The borrowed amount plus interest (the cost of the loan paid to the creditor) has to be paid off after an agreed period of time. Therefore, the company must keep in mind to pay off the borrowed amount either on installment basis (little by little) or as a one-off payment. Depending on the nature of the loan, the debt financing may be either short or long-term.
When is debt financing used?
Debt financing has a wide range of uses to cover both short-term (of the order of months) and long-term (of the order of years) needs. The financial range can also vary from hundreds to hundreds of thousands of dollars. Its popularity increases in a period of low interest rates on the market - debt financing is cheap and its use is profitable for companies. Debt financing can finance, for example, operational needs (e.g. overdraft loan) or an investment plan (foreign capital is used as an investment).
Such form of financing is commonly used for large purchases of assets such as real estate, machinery, equipment, technological units, and the like. In most cases, financial institutions require collateral which is usually the purchased asset. That’s why debt financing, in a larger volume, is not suitable, for example, for software development companies or other businesses with intangible outputs.
What are the forms of repayment?
- Operating loan is the most widespread form of debt financing. It is suitable for businesses with a certain history because banks’ credit risk assessment processes for loans are paying particular attention to it (based on financial statements or other documentation).
- Investment loan is used to finance the company’s development.
- Overdraft loan - is the kind of operating loan that is ideal to cover cashflow fluctuations (operating capital). However, it is an expensive way of financing because of the high interest.
- Operating Leasing is actually a rental payment - it is used mainly to finance cars, machinery and equipment that have a planned lifetime. The subject of financing does not become the property of the company.
- Finance lease (long term lease) - after repayment, the subject of financing becomes property of the lessee (customer or borrower) - the company will buy the asset from the leasing company for a residual amount
- Factoring se používá na financování (odkup) zásob a pohledávek, aby si firma mohla uvolněnit svůj provozní kapitál. Podobně jako konktokorentní úvěr patří mezi dražší způsoby financování.
- Forfaiting is used to finance (redemption) stocks and receivables in large volumes.
- Bonds are issued by a business and sold out to investors who buy them with the goal of making profit. After a certain period, the issuing company buys the bonds back.
- Mezzanine Financing combines loans and equity financing. This form of debt financing is suitable to support the growth phase of businesses.
- Mortgage is a relatively secure form of loan. It is used to finance real estate purchase and has a long maturity, typically 10 to 15 years.