Debt financing allows companies to raise money by selling bonds, notes and bills to individual and institutional investors. Raising funds for capital expenditure through debt provides flexibility and allows a business to keep complete ownership, unlike equity financing, where the investors become part owners of the company. Despite the advantages of debt financing, the instrument also has downsides, which makes it vital to understand before using it. In this article, we define what debt financing is and discuss its advantages.
What is debt financing?
Debt financing is a way of raising money by selling debt instruments to institutional and individual investors. The investors become creditors of the company and get rewarded through the payment of the principal and interests on the borrowed amount. Debt financing is attractive because it allows a company to raise working capital quickly without relinquishing control to investors. If a company can’t raise money by selling debt instruments, it can use equity financing, such as issuing shares of its stock in a public offering.
Unlike debt financing, equity financing makes investors owners of the business, and gives them a right to contribute to the running of the company. This makes debt financing a more attractive way to raise funds for businesses that want to remain private and keep their management independent.
What are the advantages of debt finance?
The advantages of debt finance are many, so it’s essential for businesses to weigh each of the pros before using the financial instrument. Below is a breakdown of the pros of debt finance:
7 advantages of debt finance
Here are some advantages of debt finance:
1. Maintain control
One of the biggest advantages of debt financing is that it allows a business to retain total control over its management and decision-making. With debt, a company can get an instant flow of cash to develop a product, mass-produce it or even expand operations without giving up control, although it’s going to repay the loan with interest.
If a business gets funding from angel investors, venture capital, private equity or the stock market, it does so in exchange for equity. People or institutional investors who have equity in a business also typically have voting rights and can dictate how to run the business, and this can cause problems in the future.
2. Get tax deductions
Because deft financing is classified as a business expense, it allows companies to get tax deductions. When you borrow money to finance business operations, you may be able to deduct the principal and interest payment from the company’s income taxes. Before choosing a debt finance instrument, it’s important to consult a tax professional to guide you on the best way to leverage it for tax savings.
3. Offer low interest rates
When you’re borrowing money to fund business expenses, it’s possible to get favourable interest rates. The interest rate is the amount paid on the principal for the use of the debt finance, and it often determines the true cost of the fund. Because of the multitude of debt instruments, you can choose options that provide the most favourable interest rates. The lower the interest rate and the longer the repayment period, the cheaper and easier it becomes to repay the debt.
Before choosing a debt financing instrument, it’s essential to work with a professional and reputable financial expert who can help you get the most favorable interest rates that allow the company have ready access to liquidity while making repayment easy.
4. Build and improve business credit
Using debt financing can help a business establish and improve its credit rating. If a business doesn’t have a record of loan repayment, it may be difficult for lenders to assess how it’s going to behave with their funds. Financing capital projects with debt instruments and meeting obligations can show other lenders that the business is trustworthy. This can help the company secure future debt financing easily and allow it to get more favorable interest rates.
5. Aids business growth
Debt financing can provide businesses, especially growth-stage and small and medium-sized companies, the liquidity required to expand and become more profitable. If a business can get a low-interest, long-term loan, they may have more cash to finance their operations without worrying about funding or investors looking for immediate returns. Debt financing instruments, such as credit lines and receivables accounts, offer near-instant liquidity to meet pressing business obligations.
6. Easier to plan payments
Debt financing allows a business to have a proper and well-coordinated repayment plan. Since the company already knows the interest due on the principal every month and the duration of payment, they can include it in their budget as part of the business expenses. The predictability of repayment allows the organization to focus on generating revenue and executing growth strategies to secure its financial health.
7. Offers more flexibility
Businesses have access to a wide range of debt financing options. The traditional debt finance instrument is the loan, especially low-interest long-term ones. Lines of credit are also popular and a more flexible debt finance option. Companies also use bonds, business credit cards and accounts receivable financing to improve their liquidity through debt finance.